Wednesday, May 9, 2007

P(x) = 1/1,000,000,000,000,000,000,000,000

In the first months of 1998, markets were smooth. ... The mood at Long-Term was relaxed, too. Though the fund's leverage was up, and though the partners had taken out huge personal loans, their exposure seemed tolerable. ... According to their models, the maximum that they were likely to lose on any single trading day was $45 million—certainly tolerable for a firm with a hundred times as much in capital. According to these same models, the odds against the firm's suffering a sustained run of bad luck—say, losing 40 percent of its capital in a single month—were unthinkably high. (So far, in their worst month, they had lost a mere 2.9 percent.) Indeed, the figures implied that it would take a so-called ten-sigma event—that is, a statistical freak occuring one in every ten to the twenty-fourth power times—for the firm to lose all of its capital within one year.1

Let's see if I have this right. Long-Term Capital Management failed in 1998 due to a combination of the following reasons:

1) A coincidence of unusual and unforeseen exogenous events, capped by Russia's default, which led to severe and ongoing market disruptions and a convergence in correlations (and covariances) of returns across different markets and different risk classes

2) Personal greed on the part of the fund's principals

3) Credulous and scale-independent application of supposedly sophisticated value-at-risk models

4) Massive up-risking of LTCM's portfolio into non-core trade positions when returns in its core business diminished due to increased competition

5) Excessive leverage, both on-balance sheet and off, facilitated by short-sighted, uninformed, and greedy prime brokers

6) De facto coordinated attacks by other market participants (including its prime brokers) when LTCM got into distress

7) Institutionalized arrogance and hubris

LTCM did not blow up because its principals were stupid or inexperienced, in a conventional sense (pace Nassim Taleb). Say what you will, you cannot accuse people like Meriwether, Hilibrand, Scholes, Rosenfeld, and Merton of being stupid or inexperienced. It also did not blow up because they had bad ideas, per se. Leveraged arbitrage—which, cutting through the crap, is what LTCM did, at least until it got greedy (or desperate)—is a time-tested trading strategy.

It failed due to the human element: vanity, hubris, greed. Oh, plus an unlooked-for exogenous event or two.

Nowadays, with orders of magnitude greater capital invested with hedge funds committed to chasing down ever more fleeting market opportunities, it strikes me that the pressure on hedge funds to deliver returns is no less than it was for LTCM in 1998. Plus, the last time I looked, no-one had repealed human nature, or its foibles. Finally, the nature of unlooked-for exogenous shocks is such that—*ahem*—they are unlooked-for.

So explain to me, all of you strident hedge fund apologists, why "It's different this time."

Go ahead: I'm listening.

1 R. Lowenstein, "When Genius Failed: The Rise and Fall of Long-Term Capital Management," Random House, 2001, pp. 126–127.
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