Inventing Money
The Story of Long-Term Capital Management and the Legends behind it.
by Nicholas Dunbar
(John Wiley & Sons, New York, $29.95, 245 pages)
by Gregory Bresiger
They were a group of mathematicalgeniuses. They couldn't miss.
John Meriwether, Robert Merton and Myron Scholes all but invented modern finance by using complex scientific trading techniques. They had seemed to create a new way of minting money. Between 1994 and 1998 this trio ran up the LTCM portfolio to $100 billion with positions commanding a notional value of $1.25 trillion.
In 1998, Long Term Capital Management, a heretofore incredibly successful hedge fund, suddenly lost 90 percent of the value of the portfolio. An earthquake shook the trading world. LTCM had to be rescued by the Federal Reserve Bank of New York and 14 other banks because it was believed letting the hedge fund go down the tubes would have adversely affected the entire market.
Nicholas Dunbar has written a very interesting book. But, as some hostile reviewers have implied, it doesn't answer all the questions raised by this financial and trading debacle. Which financial institutions are too big to fail and which ones should be allowed to fail because the nature of capitalism is supposed to punish those firms that consistently misread the market? And are hedge funds too secretive? Should they have tougher regulation? And should investors in these funds have more warnings? And should offshore operations be under more scrutiny? Traders Magazine caught up with Dunbar to discuss some of these issues. (Dunbar is technical editor at Risk Magazine in London).
TM: Henry Kaufman, in his book "On Money and Markets," has predicted that an "even bigger debacle" than the LTCM crisis will happen again. Do you agree?
Dunbar: Yes. But I think it will be in a different form. It won't be precisely like LTCM. But it will be in a form that no one can now foresee because that's the way these things usually work.
TM: After the LTCM mess, is there a clear policy that central banks can adopt in deciding when and when not to rescue a firm?
Dunbar: It is something that Alan Greenspan has been trying to talk down ever since the LTCM problem. There's now a belief in the U.S. trading community that nothing too bad can ever happen to the market; that the Fed will always step in to solve problems; that it will always cut interest rates very fast. You've heard Greenspan say that there is no too big to fail policy, but there is, in fact, an agreement that the federal government will step in.
TM: But there was no federal bailout for LTCM. No direct bailout.
Dunbar: Right. But there were drastic cuts in interest rates, which clearly was the U.S. government making life easier for the banking system. So you could argue that by cutting rates, there was an element on governmental/financial aid to the market.
TM: Like the 1987 crash?
Dunbar: Right, there is today so much pressure on the regulators that the pressure to intervene is tremendous.
TM: Back to hedge funds. Does the way they're run in the United States, with little regulation, make them inherently dangerous?
Dunbar: The way hedge funds work here is that people who invest in them, people with considerable wealth, don't need to be protected in the same way that the average person is from the consequences of their investment decisions. But I think it is more of a question of letting people invest how they like. You can't just say that people can't invest their money in something because it is dangerous.
TM: In light of the LTCM disaster, are you optimistic or pessimistic about the future of the hedge fund industry?
Dunbar: Generally, I am optimistic because most hedge funds are very different from LTCM. The days of trying great things, of making a run on the British pound or some other currency. Those days are gone.
TM: What is the lesson of the LTCM disaster?
Dunbar: Size is dangerous. It is only really large hedge funds that have had problems in the last few years through the use of leverage. They try to sell positions that they actually cause the market to collapse. As long as these funds stay fairly small, can provide useful diversification and provide proper risk management, then I am optimistic for their future.
TM: Was it the implosion of exotic financial instruments or just plain ego that caused LTCM to fail?
Dunbar: It was a combination of mathematical assumptions about the market that was wrong combined with a feeling of invulnerability. They just thought that it couldn't possibly happen to them; that they were the best. And they convinced half of the banking industry in the United States to believe in them.
