Every now and then I run across some important finance type saying something so patently crazy, such a complete howler, that it just stops me little brain. The most recent one of these was from Myron Scholes in the New York Times magazine this weekend. The theme of the mag was ‘debt’ in various forms, and Scholes was the subject of a snappy, short interview where he made the comments that put me on the floor.
First, though, who is Myron Scholes? Well, he’s a nerd’s nerd, the co-creator of the Black-Scholes model for pricing derivatives, for which he won the Nobel Prize in economics. After years as an econ professor he was invited along with a number of other finance nerds to build their very own hedge fund, the spectacularly misnamed Long Term Capital Management (LTCM for those in the know), which was founded in 1994 and went bust four years later. LTCM was initially famous for spectacular returns and legendary secrecy about their trades, using multiple brokers to hide their methods even from the people accessing the markets for them.
In 1998 the firm developed a new notoriety for being the first hedge fund to very nearly blow the entire financial system sky motherfucking high. Scholes was not a day-to-day trader for LTCM, but he brought acadenuc cred to the table. Scholes believed that if equations can predict to perfection the movements of photons or traffic, then equations should also be able to predict the actions of markets and the people who move money in and out of them. But his equations failed when panic hit the market. The combination of the Asian economic crisis and the Russian debt default produced a hurricane of panic and fear, and the model took no account those emotions. It’s arguable that panic and fear simply can’t be modeled, though there are those who try. As a result a number of positions run against them at the same time and their leverage was so vast that it put them in serious danger of default. Fearing an unprecedented shock to the system, the New York Fed more or less forced the big brokers and banks to sit down and work out a deal to avoid a Short Term Capital Blowup.
In the end, LTCM lost $4.6 billion in a couple of months. A good run for a Nobel Laureate, no?
The story of LTCM is told brilliantly in ‘When Genius Failed’ by Roger Lowenstein, a book that would easily make my top five on a list of finance books that every civilian should read. The Cliffs Notes version is that a combination of slavish devotion to risk models, massive leverage (before the meltdown LTCM intentionally maintained 20-1 leverage or greater), off-balance sheet exposure (with derivatives, the firm was often levered well over 200-1), derivatives, and near zero transparency to outsiders or regulators, the same factors that took us to the brink of collapse last year. The fact that Mr. Scholes was a decade ahead of the rest of his peers shows why he needed to be recognized for his pioneering investment strategies.
With Wall Street in ruins, one might expect Scholes to be, at least, a bit cautious and circumspect about what he and the risk quants hath wrought. Not so. Here are two of the questions posed by reporter Deborah Solomon.
Solomon: Some economists believe that mathematical models like yours lulled banks into a false sense of security, and I am wondering if you have revised your ideas as a consequence.
Scholes: I haven’t changed my ideas. A bank needs models to measure risk. The problem, however, is that any one bank can measure its risk, but it also has to know what the risk taken by other banks in the system happens to be at any particular moment.
Solomon: What good is a theory of risk management if it applies to one tree instead of the forest?
Scholes: Most of the time, your risk management works. With a systemic event such as the recent shocks following the collapse of Lehman Brothers, obviously the risk-management system of any one bank
appears, after the fact, to be incomplete. We ended up where banks couldn’t liquidate their risk, and the system tended to freeze up.
Does this man have no shame? It’s disorienting, listening to such lame absurdities from a genuinely brilliant man. I’ve heard Scholes speak and he’s impressive, with that super smart guy forcefield that makes you believe stuff you know damn well is nonsense. Listen to him and after 30 minutes or so you start thinking, ‘Hey, maybe those U of Chicago efficient market guys ARE right.’ But Scholes’s reply to Solomon’s first question is just plain stupid. It’s like a racing consultant telling an Indy 500 driver, ‘I have a great model for you for winning the race, but it only works if there is nobody else on the track.’ That model might even be useful in some sense, for practice or planning strategy, but once the flag drops it’s not going to work.
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16 Comments
Add your own1. John | May 20th, 2009 at 8:58 pm
It certainly is the world’s fault for continuing to be suckers for this kind of crap. Fool me once, shame on me, etc.
What I don’t understand is how is it possible for these people to borrow so much money to invest it back into the financial markets? Who is stupid enough to lend them unsecured money? If your bank isn’t making loans to a corporation, why are you lending money to some black box hedge fun to buy that corporation’s stock?
2. JimDate | May 21st, 2009 at 12:15 am
Shouldn’t it be “Nobel Prize winner”?
3. KKK | May 21st, 2009 at 12:23 am
I wonder what is thats lacking in a really good article like this?
May be it’s like… too late?
Where were you in 2004 Mr. Walker?
4. OldSkeptic | May 21st, 2009 at 1:32 am
The joke is, in 2004 I did a paper which, in passing, proved the Scholes-Black model was wrong. Want to know how long it took me to disprove it? 1 hour tops.
I also built another model which was much harder and far less precise, but had that great feature you normally want .. it actually worked.
Response to my (I think great) piece of work … absolutely nothing. Over a few beers I talked to some people that actually accepted what I said but, responded … “everyone uses it so we have to”.
5. Tam | May 21st, 2009 at 4:48 am
‘He’s stonewalling for a very simple, sleazy reason: his whole life depends on it.’
He sounds an asshole but, I have to admit, in his position I’d probably do the same. No one would exactly thank him for admitting he was wrong, would they?
6. Realist | May 21st, 2009 at 2:36 pm
Yeah, the quantitative economics of our day…
The model may be complete shit and always off target, but at least I use STATA. Also masks the fact that a good part of the derivative instruments market is faith-based.
But then again, our economics profession bursts with totally discredited people claiming the mike. Think Krugmann.
7. Anonymous Coward | May 21st, 2009 at 4:00 pm
Oooooooooohh, the sound of rolling dice to me is music in the air
‘Cause I’m a gamblin’ boogeyman, although I don’t play fair.
It’s much more fun, I must confess, when lives are on the line;
Not mine of course, but yours old boy, well that’d be just fine.
8. Feckeroller | May 21st, 2009 at 4:40 pm
Why if international and American elite is so scheming and evil it gave us the plebs Viagra and first fuckable artificial vaginas in history. I mean realistically, our revolutionery representatives and independent thinkers what else are you asking for? Top models? Frankenstein 3d epoch knowledge them being Hep B, C infested adipose agglomerates of ‘brush tool’ bytery. Gorgeous Slavic sex women? Ames tried them and returned to NY.
13 yo boy-lovers? But who told you the elite are the bad guys in the ‘can I can I not’ have a 13 yo boy-lover’ practical disposition?
9. captain ameirca | May 21st, 2009 at 6:53 pm
this article needs some proofreading. unless acadenuc is a real word. and it may well be. evil nationalists such as myself and http://www.dictionary.com are ot known for our extensive vocabularies.
10. Echelon | May 22nd, 2009 at 12:33 am
capt. america, what is your secret? You’re a nigger (black person)?
11. aleke | May 22nd, 2009 at 11:07 am
What the fuck is 8 and 9 saying
12. Rob | May 29th, 2009 at 8:57 am
Sad there are still malevolent weirdos in the world that make the world worse and shabbier for the rest of us – i.e., you need to monitor and remove some of these comments – 8,9, 10.
Other than that, the explanation for Scholes and his cohorts came apparent to me when I saw them interviewed on a PBS special a few years ago — the guys are very, very arrogant, full of hubris, and self-centered.
13. Tyr | June 2nd, 2009 at 4:04 pm
Shouldn’t that be FAKE nobel winner ? The economics prize isn’t awarded by the Nobel committee.
14. paul cripps | August 22nd, 2009 at 11:50 am
your right these walking dead cunts have no shame
15. Jeff Miller | August 1st, 2010 at 10:27 am
As I understand the Black-Scholes model, if a 747 is flying East to West from Chicago to Los Angles at 30,000 ft cruising at 450 mph, and at the precise moment that the jet crosses the Continental Divide, the engines quit, the probability that it will come down 50 mi East of the Divide is precisely the same as the probability that it will come down 50 mi West of the Divide. It does not take momentum, trends, or trading ranges into account.
An astutue trader can capitalize on this by selling calls at or near the top of a trading range and selling puts at or near the bottom of the range. In both cases, the options are over-priced.
16. diego bergen | January 10th, 2012 at 12:27 pm
what frightens me more than the curious case of doc scholes…….
is what is going to happen when peeps start believing this website…..
with the understanding this website is not some NSA vulture net for nonzombies…ha ha
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