Reference no: EM131737816
Case Scenario: THE COLLAPSE OF LONG-TERM CAPITAL MANAGEMENT
The full story of this saga can be found in the entertaining and informative When Genius Failed, by Roger Lowenstein, formerly a reporter for the Wall Street Journal. We provide only the outlines of this case here as they apply to the concept of moral hazard and monetary policy. The management team of LTCM certainly appeared to have impeccable credentials, including some principals who had won the Nobel prize for developing the Black-Scholes model and its successors. Basically they traded ‘‘volatility,'' by which we mean the following. When the prices of various options rise sharply relative to their underlying value as calculated by the Black-Scholes model, those options should be sold, and when the prices are below their calculated value, they should be bought. This strategy does not require one to be able to predict the direction the market is heading; it is simply a variant on the oldest market rule of all: Buy Low, Sell High. But because options are so highly leveraged, the rate of return can be much greater than average long-term gains in the stock market. The Black-Scholes model and its successors are based on the concept that market fluctuations are normally distributed. However, that is false; in fact, the Black Scholes assumptions are never true.
2 Campbell et al. discuss several reasons why that is so; one of the major reasons is that market distributions have what is colloquially known as ‘‘fat tails,'' which means that very large fluctuations occur much more often than would be predicted by the normal distribution.
3 That also means that values far away from equilibrium occur much more often than predicted. Thus when options values rose well above equilibrium levels, the algorithms based on normal distributions assumed that they must soon decrease again, whereas sometimes they kept rising further. Because LTCM management made increasingly large bets on these positions, they lost $4 billion during 1998 and were forced to declare bankruptcy. That meant that many large financial institutions that had loaned them money would also come under severe financial pressure. Furthermore, any attempt to liquidate these positions quickly would have increased their losses even more, because no one wanted to take the opposite side in these trades.
When small investors buy Enron, or Global Crossing, or World com at its peak value, only to see their equity position complete erode over the next year or two, they have no recourse. They invested based on known information, and they lost - even if the information turned out to be faulty. Lawsuits attempt to recover losses, but since the companies in question went bankrupt, there are few assets that can be used to offset these losses due to fraudulent statements. Certainly no responsible economist has suggested that shareholders ought to be compensated for their losses. Thus when major league investors - those with hundreds of millions or even billions in assets - entrust their money to managers who make serious mistakes, why should they be bailed out? One answer is the doctrine of ‘‘too big to fail.''
A series of events that caused Citicorp, J. P. Morgan Chase, Morgan Stanley, and Merrill Lynch to declare bankruptcy obviously would not be in the best interests of society, and might even lead to another Great Depression. The Fed obviously has responsibility to assure that does not happen. Nonetheless, why were the foxes allowed to guard the chicken coop? Or in more formal terms, why did the Fed not monitor the positions of LTCM and put pressure on major financial institutions to reduce their exposure to this company when it became clear that their once-vaunted moneymaking skills had eroded? Greenspan was often asked about the increased risks involved in the expanded trading of derivatives, and his general answer was there was nothing to worry about. Another answer is that the Fed intervention did not really cost anyone money. It can be said that the Federal government was not required to bail out bankrupt financial institutions; the problem was solved by increasing liquidity and reducing interest rates. This answer, although technically correct, rings false. The perceived decline in the risk of moral hazard was at least partially responsible for the unsustainable bubble in high-tech stocks over the next year and a half. In that sense, the stock market - and the economy - did pay the price for the LTCM debacle. In the future, the Fed will probably monitor more carefully those situations where massive trading in derivatives could lead to huge losses if the calculations are only slightly incorrect. If it continues to bail out those who would otherwise be big losers, financial bubbles would then probably become increasingly prevalent.