The Road To Economic Tyranny Is Littered With High IQs
Unlike so many other disciplines that arrived slowly over decades if not centuries, if you were to date the absolute start of modern finance it would be March 29, 1900. That was the day Louis Bachelier successfully defended his doctoral thesis at the University of Paris. His topic and the breadth of his work was so uniquely unusual that while considered successfully established it wasn't well-received nor did it offer a particularly lucrative future course; by the start of World War I nearly a decade and a half later, Bachelier was drafted as a private in the infantry (essentially cannon fodder).
Though Bachelier's instructor was none other than physicist Henri Poincaré, such was the novelty that his vision wasn't immediately appreciated, taking instead decades to finally get some due. This despite his attempt to retrieve the mathematics of Brownian motion in the service of trying to quantify financial speculation that actually predated Einstein's celebrated work by five years. Eventually, that dissertation became published as Théorie de la Spéculation and came to form the basis of what are now the modern theories of finance.
In it, Bachelier established Wall Street's "random walk", noting confidently, it was all mathematics, after all, that, "there is no useful information contained in historical price movements of securities." In other words, the price of stock or bond yesterday has no bearing on the price today. That opened the door to statistics in finance under normal, random distributions.
This was, of course, given how the latter half of the twentieth century turned out, of great influence to the intellectual giants of the discipline. Though finance itself struggled as something of a bastard stepchild to economics for most of its history, the adaption of mathematics and statistics allowed it to appropriate distance and depth that challenged even economics as a matter of supreme exploration. Among those stretching the boundaries were Markowitz, Miller, Modigliani and Robert Merton.
As Merton would recall in his 1997 Nobel Lecture, he was a trained mathematician who was compelled to economics as an almost social "duty":
"My decision to leave applied mathematics for economics was in part tied to the widely-held popular belief in the 1960s that macroeconomics had made fundamental inroads into controlling business cycles and stopping dysfunctional unemployment and inflation. Thus, I felt that working in economics could ‘really matter' and that potentially one could affect millions of people. I also believed that my mathematics and engineering training might give me some advantage in analyzing complex situations. Most important in my decision was the sense that I had a much better intuition and ‘feel' into economic matters than physical ones. Nowhere was that more apparent to me than in the stock market."
Merton's influence in factors such as "continuous-time finance" and optimum consumption theory are what led him ultimately to the Nobel, but it was on Wall Street that he eventually became legendary - and not for the best of reasons. In the forward to his 1992 book, Continuous-Time Finance, Merton's former instructor at MIT, Paul Samuelson, wrote:
"Paradoxically, one of our most elegant and complex sectors of economic analysis-the modern theory of finance-is confirmed daily by millions of statistical observations. When today's associate professor of security analysis is asked, ‘Young man, if you're so smart, why ain't you rich?', he replies by laughing all the way to the bank or to his appointment as a high-paid consultant to Wall Street."
The mathematicians had entered the Wall Street realm en masse in the 1980's, so by the time John Meriwether, a giant himself as the chief of Salomon Brothers bond-arb group, wanted to start a hedge fund in 1993 it was perfectly reasonable that Robert Merton could easily come aboard, along with another Nobel Laureate and mathematical luminary, Myron Scholes. Meriwether's firm was named Long-Term Capital Management (LTCM, or LTCP as it was sometimes referred), quite a deceptive misnomer.
If the price of a security today has nothing to do with yesterday, then what matters are correlations - what everything else is doing today. The role of historical data, then, is to define correlations and patterns to reject stale "information" in favor of a dynamic re-arrangement of what explicitly is supposed to be a "market." That was what JP Morgan was doing in the late 1980's and what came to be the foundation for RiskMetrics, a service that launched in October 1994 and was widely (and wildly) subscribed in relatively short order.
The center of what came to be LTCM was exactly the same as was what was offered by RiskMetrics, namely Value-at-Risk (VaR) calculations of some of the most elegant conceptions. Of course, we all know how it turned out at LTCM, but even to this day there isn't enough appreciation for what that represented, not just in math and money and finance but explicit reality of banking and economy, even law and freedom.
The math at LTCM was utterly complex and often amazing, so much that it was clear nobody outside really knew what they were doing but were only too eager to gain exposure. Wall Street presented enormous leverage to LTCM, through wholesale repo in everything the firm offered and traded. Further, the trades were given zero margin at the outset - the entire portfolio that LTCM had leveraged was done so at zero initial margin. In the aftermath, nobody could understand why that was and how LTCM grew as big as it did as fast as it did, but it came down to the simple fact that math in finance had become something of the newest mysticism.
If Robert Merton and Myron Scholes tell you that they have discovered a way to book huge returns with little risk, there isn't so much pushback without fear of being embarrassed at doing so. That seems to have been the case all over Wall Street, as LTCM amassed huge leverage from just about every foreign and domestic "dollar" bank as existed. The firm started out with $1 billion in equity financing in March 1994, and by the end of 1997 that had grown to about $4 billion. That was the slim foundation for a total portfolio of more than $120 billion! By way of comparison, JP Morgan Chase's total assets listed in its March 1998 10-K were $365 billion. Off balance sheet, notional derivative exposure was thought to be about $1.45 trillion (that sum is misleading, as notional exposure is not only netted further by offsetting positions, but notional itself isn't the actual definitive concept including in setting risk).
The firm had delivered 40+% returns in 1995 and 1996, but had underperformed in 1997, up only 17%. LTCM's managers decided to return about $2.5 billion in equity to the fund's shareholders, which served to drive up leverage even further. Wall Street lenders, more than aware of the massive leverage, were under the illusion that they were wholly protected by collateral presented in their repo arrangements, but also because the complex VaR calculations were so very reassuring about ultimate risk - and that Merton et al were behind those calculations.
There is little information about LTCM's VaR during the summer of 1998, when conditions heated beyond anything they expected (randomness was on apparently on vacation as the Russians defaulted). In August 1998 it was reported that the firm's VaR was just $35 million; meaning that it expected 99 (or 95, the confidence interval wasn't specifically notated) out of 100 days that the most they could lose was $35 million. In late August, the firm "lost" $550 million in a single morning.
The huge exposure, particularly in the off-balance sheet derivative book, is what got the Federal Reserve so interested in shepherding a solution. By the middle of September 1998 (always two weeks before quarter-end; see Stearns, Bear, and Brothers, Lehman) Bill McDonough, FOMC Vice Chair and head of FRBNY, was gathering senior officials from more a dozen large firms to start discussing a resolute "capital" injection to LTCM. Interestingly enough, in a special FOMC conference call on September 21, two days before the "bail out" of LTCM by Wall Street, LTCM was never mentioned; not once. Instead, Alan Greenspan was looking for the committee's approval to testify, jointly with Treasury, in such a way as to presage a rate cut coming at the usual FOMC meeting a little over a week later, on September 29. In other words, LTCM was serious enough for Greenspan to want to telegraph a rate cut and to do so in a way that didn't look like Fed was nearly panicked (which an intermeeting cut would have been taken as).
That left discussion about LTCM to that September 29 meeting. I urge everyone in the strongest possible terms with even a few spare moments to go through the FOMC transcript for that meeting, even if only for the LTCM discussion (which starts on page 97). Much like the meetings in late 2007 and 2008, the Fed's utter cluelessness is on full display, as is how wrong it is for the economy to be so attached to these people's self-description of their function. The worst part about it is how eerily similar it is to those 2008 meetings - the people all changed, the deck chairs shuffled, but the confusion and results were exactly the same, including and especially how LTCM was Bear Stearns and Lehman Brothers before they really knew what it meant (coincidentally, or not, Bear was LTCM's main prime broker!).
First and foremost, the Federal Reserve as a bank regulator had no idea who or what LTCM was, even by 1997 when the firm was exposing 17 large institutions to really untested wholesale transactions when $100 billion was a lot of money. As Richard Spillenkothen, Director of the Division of Supervision and Regulation, affirmed, there was no mention of LTCM in any of the bank examinations that were done in the middle of 1997, despite the fact that LTCM was enormous by then (and had over $1 trillion derivative book with these banks as counterparties on a lot of it). Yet, about a year later Bill McDonough was surveying banks in the turmoil of September 1998 and telling the committee afterward, "It was fascinating to me that every head of the 8 to 10 firms that I talked to subsequently during the day brought up the problems of LTCM/P independently of anything that I said."
In trying to understand how that could be, and how some very smart people on Wall Street, including every one of the major firms, could be so tangled in such a huge mess, Alan Greenspan questioned:
"The review [when Greenspan was in banking] was quite thorough. I knew that I was getting a bit of a snow job--the type of thing where mistakes never are made and everything is perfect. But even adjusting for that, the examination was at a level that would not have allowed this LTCP problem to happen. But it did happen and a number of extraordinarily effective counterparties were involved. The question is why it happened in this case. Is it just that the lenders were dazzled by the people at LTCM and did not take a close look?"
Repos have had that allure, especially combined with Nobel-level math saying a VaR of only $35 million or whatever - there "can't" be any risk with everything collateralized and the math projecting an infinitesimally small probability of being wrong about it. As McDonough offered:
"Beyond that issue, it should be emphasized that the lenders had very good collateral management systems so that if the LTCP began to lose on a position, it would need to put added collateral in place. What we have to get our hands around conceptually is whether there was something that we missed that could have provided us with some notion of just how big the overall position of LTCP had become. I don't know how we could have done that. We do not regulate that firm. But given the number of institutions they dealt with around the world, was there a way that should have enabled us to be more aware of their overall position? One is inclined to say, ‘you bet.' But exactly how we could have done that I am not so sure."
This is the very heart of the matter and there is no danger in being overstated in making such a claim. The Fed, in that moment of failure, diagnosed this as "money as money" and "finance as finance" with the two wholly separated by systems, theories even completely distinct philosophies. To emphasize that point further, Greenspan reminisced, talking specifically about VaR:
These are very special cases. In fact, as some of my colleagues know, my favorite speech is one where I discuss separating the risks that confront the monetary authority from the risks that the commercial banks have to face. I have always argued that the commercial banks are responsible for 99.95 percent of the risks with their own capital. The rest are these 50-year events, which the central bank will handle. The trouble is that this is what this event clearly was.
By holding on to such anachronistic notions, the FOMC was at a loss to describe not what was a once-in-50-years event, but something that would recur almost exactly in the same manner less than a decade later - and to a much more enormous and devastating scale. The FOMC struggled with the idea that collateral was actually "money" in the wholesale case, as "money supply" had actually attained multi-dimensional facets. One particular exchange illuminates this misconception quite well:
CHAIRMAN GREENSPAN. Let me go back. Can you explain to me how, if everybody is 100 percent collateralized--not 110 but 100 percent--we can end up with these huge losses for lenders?
VICE CHAIRMAN MCDONOUGH. The lenders continue to be collateralized as the firm starts to lose money but only so long as the firm has capital to continue to provide added collateral to make up for the losses. As the losses continue to mount, the firm at some point-
CHAIRMAN GREENSPAN. But, are we looking at losses in the value of the collateral or is collateral being withdrawn? If I am a bank lender and I lend $200 million to a hedge fund, ordinarily I would be over-collateralized. I would hold more than $200 million in, say, U.S. Treasury bills.
VICE CHAIRMAN MCDONOUGH. Remember, on day one there was no initial margin.
Collateral, in other words, wasn't collateral as Greenspan understood it from his days as a banker. Rather, collateral was actually currency; and in a dynamic arrangement as wholesale finance was even then, it was a highly fluid currency. Worse, from the Fed's perspective, though they did not know it and would not for almost two more decades, the functions of money-like behavior extended especially into the derivative book which was what Wall Street was really scared about. If LTCM had to liquidate, the hedges LTCM was counterparty on (the private balance sheet risk absorption that LTCM was offering as a counterparty) would disrupt bank trades far and wide - globally - just as we saw starting in August 2007. What that meant in practical terms was that any bank would have to re-mark everything from VaR to hedge prices to then re-adjust "capital" charges that much lower in a single stroke. In short, systemic leverage would have to contract and nobody had any idea how that was even possible or where it would all lead (the results in 2008 suggest they were both right to worry and stupendously wrong about why and what to do).
That meant that currency was not only collateral, but balance sheet risk functions traded freely (and then not) via derivatives. The basis for what is really a much-removed kind of distinct leverage, in many ways far more important than what is reported on balance sheets, is those mathematical foundations that are, at best, incomplete. And because they are incomplete in how they actually model reality, the math-basis for finance functions as an artificial and, dare I say, unnatural boost to leverage. The fact that this became widely adopted in the middle 1990's was akin to a massive money-printing operation - that is why 1995 and the late 1990's figures so prominently as the starting line for the serial asset bubbles that plague the 2000's so far.
Bear Stearns and Lehman Brothers discovered that they could exploit this wedge, where the FOMC thought in separate terms of money and finance, and become the fullest expressions of what LTCM pioneered. It is no coincidence that Wall Street banks, and their global cousins, left traditional banking at that time and became, essentially, hedge funds that were treated, and understood, as if they were actually banks. And the worst effect of that was in how money, currency and finance became then inseparable. That was the ultimate legacy of the mid-1990's transformation.
VICE CHAIRMAN MCDONOUGH. The biblical justice in this situation is that the principals of LTCM apparently believed so firmly that this system would continue to work that they appear to have borrowed rather heavily to increase their own risk positions in their firm. So, there is a general and spreading belief that we may have some extraordinarily elegant people in private bankruptcy court in the fairly near future.
MS. RIVLIN. How many more LTCMs are there?
VICE CHAIRMAN MCDONOUGH. We do not know of any other hedge fund that would be remotely of the size of LTCM/P. If John Meriwether can do it, there certainly would have to be other smart individuals with computers who could engage in the same sort of activity. So, there have to be little versions of LTCM/P.
The answer to Ms. Rivlin's question was right there at that FOMC meeting in September 1998 - the entire banking industry at the top transformed into LTCM's, taking the "dollar" with it. The way in which that happened was, again, mysticism in Robert Merton and John Meriwether believing in the modern alchemy of stochastic power. For as Samuelson smirked in writing Merton's foreword in 1992 about "laughing all the way to the bank" McDonough's admonishment provided the bookend betrayal of "extraordinarily elegant people in private bankruptcy court."
That should have been the end of it, as if there wasn't enough proof at that moment the flaws of the whole thing. Instead, what was clearly beyond decadent, monetarily speaking, became universal! It was and remains the entire basis for the eurodollar system of global "money." The FOMC in September 1998 went through all of this soul-searching and dumbfounded realization to conclude, at the end of that meeting, that this was still, somehow, the wave of the future:
MR. FERGUSON. My other question is one that I also ask to make sure that we will have an answer. It involves an issue that is similar to the one that Larry Meyer was raising. Does this experience in any sense bring into question the approach we are taking with respect to risk-based supervision? To some extent, it involves what we do and when we do it. We need to figure out how that approach might have to be adjusted based on this experience.
VICE CHAIRMAN MCDONOUGH. This tells you that the move toward risk-based supervision is the right way to be going.
MS. RIVLIN. If you do it right! [Laughter]
In light of history, it never was done right; such "laughter" is thus quite highly grating and painfully frustrating even stretching across nearly two decades of time. And that is the point, that this is not science or even about math. It is entirely an affair of power and politics. The intermingling of finance and money was to beset the power arrangement in all economies into finance itself; once there, it was never going to go back no matter how much reactionary influence made the most sense. Rather than admit the mistake, as a true scientific discipline would, this ideology insists only toward "doing it right" no matter how many bodies (figuratively, and hopefully not literally as history of such malaise and really depression warns) are piled onto the attempt.
As in the opportunity of 1998, the circumstances of 2008 found themselves with much the same outcome. Instead of repairing to a more reasonable outlook on money as a primary economic tool again separate from the great potential of finance (which is what is so tragic here, namely that it was the combination of money that warped financial innovation into something disastrously unwieldy), all global central bank power was trained on rebuilding as exactly as possible the same systems - again, as a means of maintaining and expressing power and control. If money were to be separated out, removed from the gigantic chains of the "random walk", people would have the very real option of simply walking away from Alan Greenspan, Ben Bernanke and even Robert Merton as they set about describing new ways to better command economic performance (as if that were actually a realistic goal).
The word utopia derives from the Greek "ou" and "topos" which literally translates to "not a place." The vast chained knowledge of equations passed down for more than a century is sure that the Greek word is wrong, and that the true City of Gold is as easy as setting the right values on your computer. If this were just some stock and bond speculation gone awry, it would be an entertaining tale from afar, but by taking over money as if it were the math, and in many ways really is, the tragedy is our shared experience that continues even now. If the road to hell is paved with good intentions, the road to economic tyranny is littered with the efforts of some of the smartest people in history; those elegant intellectuals thinking themselves more worthy to re-arrange society, to all other exclusion, in a more "optimal" structure and finding themselves, and us, instead at bankruptcy court.
As perhaps a perfect ending to this transformative tale, John Meriwether himself started anew in 1999 with another hedge fund, JWM Partners. It closed in February 2009 with reported losses of 44% - no word on how small the calculated VaR. Instead, relatedly, the world is right now in bloom of calculating how the global economy could seem so highly correlated at the short end of the economic stick.