The Nobel Winners Who Almost Crashed the Economy

27:19Take all my money. Brainiacs. Yeah, yeah, please. And one interesting thing about this moment is the people running the firm, Merton and Scholes and the rest of them, they knew that this was extraordinary. This was more than they expected. And I don't just mean that in a kind of hand wavy way. They weren't like, oh, that's more than we expected. It was more than their math told them was likely. And at this point, there are traders who are not PhDs in the firm who are, you know, popping the champagne and saying we're geniuses. You know, they're like, we're going to do this again and again and again.

27:53But the math guys in the room are looking at this saying this is off our calculations. This is better than we thought, which is just as bad as worse than we thought. Well, it's not. It's not actually a mathematical perspective. So they they have done all the math. And in fact, you know, all firms tell their their investors we might lose money. Right. Your lawyers make you say we might lose money. But there is this amazing investor letter. It's actually an addendum to the investor letter that the firm sends out. The addendum is written by Merton and Scholz. Loewenstein talks about this in his book.

28:27And they don't just say, yes, our firm might lose money. They put numbers on how much they might lose. So, for example, they say, yes, there is a 12 percent chance that the fund will lose at least five percent of its money in any given year. This is their worldview, that outcomes are mathematically knowable in a probabilistic way. And this is the worldview that is spreading. You know, this is kind of the end of history worldview, the triumph of free market capitalism. And in 1997, this worldview is validated in the most validating way possible when Merton and Scholz win the Nobel Prize. Very rare for an investment trader to win the Nobel Prize.

29:13Yes, like they're making billions of dollars for their firm and many millions of dollars for themselves. And like, oh, by the way, you're a genius. Oh, by the way, here you go. And, you know, the prize is specifically for that work, figuring out how to price options. But the committee, there's this phrase from the committee that is important here. The committee, the Nobel committee says, their work facilitated more efficient risk management in society, which is a beneficial thing for the world. You know, there's a lot of risk out there. And if you don't know how to price that risk, that's concerning.

29:47Things can blow up all the time. But if you have formulas that allow us to figure out exactly how much risk something is taking and how to price that risk, everyone can calm down. Part of the calm 90s we're talking about. The world is better when prices more accurately reflect fundamentals. I should mention, by the way, Black, Fisher Black of Black Shoals, would have won as well, but he had died by this point, and you can't win the Nobel posthumously. So now, long-term capital has extraordinary returns, and on top of that, they just won the Nobel Prize. The line forms to the right. Just be calm all the way around their building in Greenwich, Connecticut.

30:28People want to give them money, clearly. But they can't take more money at this point. This is a problem. This is a classic hedge fund problem where, you know, they're not just putting money into the stock market in these, you know, giant liquid markets. They're making these weird arbitrage bets on bonds in Italy. And there's only so much money you can put into those bets before it starts to move markets. Or at least this is what they tell their investors in the fall of 1997, around the time that Merton and Scholz win the Nobel Prize. Here, Robert, read from this letter that Meriwether sends to investors around this time.

31:02The fund has excess capital. This has occurred primarily because of a substantial increase in the capital base from the larger than expected past realized rates of return and high reinvestment rates elected by the fund's investors. Oh, we're too good. We're too good at our jobs. We just made too much money, is what they're saying. They're saying that. And what they decide to do is force the investors to take back their money. And a lot of investors are like, no, don't give us our money back. Keep it. And of course, the partners keep their own money in, crucially. But in late 1997, long-term capital does in fact pay out$2.7 billion to its investors.

31:42Now, the next thing that happens is amazing. The fund does not trim its bets, does not say, oh, now that we've given this money back, we're going to, you know, be a little bit more modest. What they do is they borrow more money. They increase their leverage and keep the same bets going. It worked so well. Why not double down? Why not double down? So now a bigger share of the fund is the partner's own money. It's levered up even more. So if it works, if they keep making money, the partners will go from really, really rich to really, really, really, really rich. By the way, we haven't mentioned the other side of leverage, which is if the market goes against you, instead of losing a little, you lose a lot.

32:27What is going to happen after the ad break? They're Nobel Prize winning geniuses. They're going to be rich forever. We'll see.

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35:07And we're back on the roller coaster. The cars have just gone up the hill at the beginning of the roller coaster. It's to the very, very top. And you know what we're going to talk about now? Bond spreads. Okay. Let's do bond spreads. If you have two different bonds, they may pay different interest rates. If you have a very safe bond, like U.S. government bond, it may pay 4%. If you have a risky bond, it may pay 18 % to compensate for the risk. 18 % is crazy. I know. So the spread is the gap between them. So in this case, 14%, 18 minus 4. The key thing to know is the magnitude of the spread is a measure of fear, really, right?

35:50The wider the spread, the more worried investors are. When they're really confident about the economy, the spread will be narrower. Because they think everyone's going to pay out their bonds. The risky bond isn't that risky. But if the economic conditions start to get worse, you start to worry about your high-risk bonds. You demand a higher interest rate, and the gap widens. Widens, and people flee to the safe bond, which makes that interest rate even lower. Yeah. So it's the beginning of 1998. And in a lot of parts of the world, bond spreads are wider than usual. They're not insanely wide. It's not like financial crisis-wide, but they're wide.

36:29You know, there are reasons for this. In 1997, there was the Asian financial crisis that flowed through Thailand, Indonesia, South Korea. So investors are still worried about this. And this is reflected in wide bond spreads. And the partners at Long Term Capital, and more importantly, their financial models, thought global bond investors were too worried about this. They thought bond prices would converge, spreads would fall, things would go back to historic norms. And if you zoom out to that broader historic arc we were talking about earlier, this makes sense. You know, fall of the Soviet Union, triumph of the free market, progress of rational economic actors.

37:09All of this points in the direction of a smoother, less volatile, calmer market and lower bond spreads. And the economy in the U.S. is doing tremendously well. We have the Internet finally. There's all these dot-com stocks. It looks like a new age in economics. Around the time we balance the budget, start running a surplus somewhere around here. Yeah. So long-term capital puts on debts all over the world that volatility will go down, that spreads will converge in Europe and in Latin America. And they're also putting on bets in Russia, in the new capitalist frontier. And the Russian economy was kind of a mess by this point.

37:50People were starting to worry that Russia might default on its debts. But there was this thing people said at the time, which was no nuclear power has ever defaulted, meaning no, you know, big, serious country has ever defaulted. Just kind of nuclear power is kind of weird. But it was a thing people said. And, you know, the International Monetary Fund, the IMF had been really active in countries around the world, helping them stave off defaults. And so the traders at long term capital look at Russia and they think, no, these fears are, you know, one more example of irrational fears. They figure Russia's going to pay its debts, spreads will converge.

38:24And also, they do hedge some of their bets for additional safety. I do love, though, that they're kind of optimists. I know it's the data and it's backed by the computers. But what they are saying is that the world is going to be a calmer, better place. It's kind of a beautiful thought. I wouldn't borrow a bunch of money and put billions of dollars on it. But yes, yes. I mean, in a certain way, not exactly, but kind of like you and I both just do the boring retirement thing of just buy index funds, mostly of stocks. And that's a version of that, right? We're just going to ride a growing economy because that's what has happened.

39:01But we don't borrow a bunch of money to do it. We don't. So long-term capital is betting that around the world spreads are going to converge. This is not what happens in the spring and early summer of 1998. Spreads start to get a little bit wider. And in June of 1998, long-term capital loses 10%. Biggest ever one-month loss. Not disastrous, but big. In July, their returns stabilize. And then comes August. And on August 17th, the thing happened that was not supposed to happen. Russia defaulted. Russia said, we are not going to pay some of our debts. and also the Russian banks where long-term capital had put their hedges.

39:47Like, we're not going to pay those foreign investors. We're not going to pay out on those contracts. Who would have thought you can't trust the Russians? Kind of surprisingly, it actually takes a few days for it to hit global markets. Robert Smith, I have pasted here a paragraph from a 1998 Wall Street Journal story for you to read. It was August 21st, a sultry Friday, and nearly half the partners at Long-Term Capital Management LP were out of the office. Outside the fund's glass and granite headquarters, a fountain languidly streamed over a copper osprey clawing its prey. I sent this to you. I sent this to you.

40:27You and I have like a running thing about newspaper stories with like gratuitous descriptions of place. Number one, it means that the reporter did not get inside the building. So the reporter's describing whatever they can. But number two, it means settle in for a long story of hubris. Yes. I mean, if you are a financial firm and the Wall Street Journal is describing the fountain outside your office, you are in terrible trouble. Something very wrong has happened. In this case, what has happened on this sultry August day is that investors all around the world, all around the world, are terrified by what has happened in Russia.

41:06And they are reacting by selling risky bonds and buying safe bonds. But not just in Russia. They're afraid of risky bonds around the world. Any country that could conceivably be related to Russia in some way, they're like, we got to get out of there. We got to get out of there. And you will recall. Yes. That when this happens, it makes bond spreads get wider. And this is the opposite of the bet that long-term capital has made all around the world. and they're widening in a more correlated way than long-term capital's models would have predicted, right? Like, sure, okay, maybe they'll widen in Russia, but they hadn't guessed that they would widen everywhere all at the same time in this way.

41:47Which is why they spread their bets around the world, because you're thinking, okay, one country, this could go wrong, two countries, it could go wrong, but other countries halfway around the world would not react the same way. That wouldn't be rational. And so, because the world is reacting in this way, because these things are happening, long-term capital is getting destroyed. Their models had predicted that the most they could lose in a single day was$35 million. On that sultry Friday, they lost more than$500 million. Time to reboot the computer. Something's wrong here. Unplug it, unplug it.

42:24Turn off, turn those machines back on. So it's late August in Connecticut. So, of course, all the rich guys, The partners are off on vacation and the traders at the office are picking up the phones and calling them because that's what you had to do in the 90s. On their giant cell phones. Yes. They get Meriwether at a dinner in Beijing. Some other guy was in Sun Valley, Idaho. Another one was in Italy. They were they were on top. By Sunday morning, two days later, they are all back in the office in Connecticut trying to figure out what to do. And they think, OK, this is going to fix itself. Like there's no fundamental reason why spreads are doing what they're doing.

43:05It's not like there's a war and economies have, you know, been blown up and destroyed. Things are going to go back to normal. And when that happens, we'll make more money. So all we need is some cash, some capital to ride this out. Because remember, when you've borrowed a lot of money against a little capital, people are going to start asking for the money back. You're going to need some money essentially in the bank to ride out the storm. But if you have a pile of money that you can pay that back, that's fine. You can keep going and keep going. and eventually make untold billions. Yeah, you can make your money back in more.

43:35This is their plan. And around this time, Meriwether calls this old Wall Street friend of his for advice, maybe some contacts for raising money. The guy's name is Vinnie Matone. Vinnie is the old school style trader, you know, the cheeseburger for breakfast kind of guy. And Loewenstein in When Genius Hailed has a beautiful description of this scene of Vinny coming to talk to Meriwether. Oh, this is going to be good. Vinny wore a gold chain and a pinky ring, and he showed up at long term in a black silk shirt open at the chest. Where are you? Matone asked bluntly. We're down by half, Meriwether said.

44:16You're finished, Matone replied. For the first time, Meriwether sounded worried. What are you talking about? We still have$2 billion. We have half. Matone smiled sadly. When you're down by half, people figure you can go down all the way. They're going to push the market against you. You're finished. I like to think of Vinny Mattone as this street smart Yoda telling Meriwether that the force is not with him. It's beautiful because long-term capital management was depending on computers and logic and this optimistic view of the world. And Vinny, the street smart guy, is like, what you didn't factor in is the fact that this is a competitive game.

45:02And much like the Osprey in the fountain outside of your office, other investment firms are going to grab you out of the water and consume you. And so it's just such a beautiful moment that Vinny knows the way the world really works outside computers. Meriwether isn't ready to give up, though. On September 2nd, he sends this letter to long-term capitals investors, tells them that the fund was down 44 % in August. One month. It's a very bad month. But he says, you know, spreads are going to close again. Our strategies are sound. This is, in fact, a good time to invest. And he makes this move in this letter that, at a certain level, I am just in awe of.

45:48I can't believe he did it. It's fantastic. So, Robert, here, read this paragraph from the letter. Since it is prudent to raise additional capital, the fund is offering you the opportunity to invest in the fund on special terms. If you have an interest in investing, please contact Richard Leahy at Long Term Capital Management 203-552-5511 for further information. Call now! Operators are standing by. Where's my phone? Where's my phone? Actually, have you called this phone number? No, put it on speaker. Okay, well, 12031. You say, I'm trying to reach, I want to invest? What are you going to say if they answer?

46:26I don't know.

46:31The number you dialed is not in service. Spoiler alert.

46:39Robert, the investors did not call now. And in fact, the letter leaked to the press before even all the investors had got the letter. Some of them found out about it by reading about it in the news. And now, in case they hadn't before, everybody knew that long-term capital management was screwed. Knew, like Vinny said, they were going to be screwed. And they called it the LTCM death trade, where everybody is getting out ahead, right? Because think about it. These are thinly traded markets. Long-term capital has huge positions. You know they're going to have to sell. So even just to protect yourself, like if you own anything that they own, you want to sell before they sell because they're going to drive the price down.

47:17So everybody is selling the stuff that they own. So the prices are falling. Right. So this, in addition to the market behavior, is compounding long term capitals troubles on a single day, September 21st. They lose again more than 500 million like that bad day in August, five hundred and fifty three million dollars more. And they're still have all this leverage. In fact, in a way, your leverage ratio goes up the more you lose. Right. because they still owe all this money. Their capital base is shrinking. And now the lenders are afraid that long-term capital is not going to be able to pay them back.

47:53So they start saying, no, you have to give us our money back or we're not going to roll over these short-term loans that we've been rolling over. And if you're not rolling over the loans, you have to sell even more. And the more you sell, the more loans you have to pay off. And so that's the death spiral. That's the death spiral. And then there's, if we widen the circle, there is now a bigger concern. Because long-term capital is so big, and so intertwined with all these other Wall Street firms, there is a bigger fear, which is if they blow up and can't pay back their debts, then all of these other banks that they owe money to might not be able to pay their debts.

48:29And then we'll have a financial crisis. We'll have all of these firms linked to each other going down and potentially hurting the whole economy, bringing down the whole economy. And this is super important because this is how crises happen. nobody really cares about Nobel Prize winners losing all their money. No, they should be able to. Like, we want firms to fail. We want that. And even the banks that lent the money, they took a risk, and they might lose money on this deal. But the situation is you don't know the full list of everyone who lent money to long-term capital. And so when you're out in Wall Street and you want to make a deal, you have to ask yourself constantly, wait a minute, is the person I'm about to make a deal with?

49:10Are they exposed to this? Are they exposed to someone who's exposed to this? It can slow down all investment at once because you just don't know where the risk is. This is the problem. Yes. This is why in the 1800s there were panics every few years because this would happen again and again. And in fact, to stop it from happening or at least reduce the risk of it happening, America created a central bank, the Federal Reserve. And as long-term capital is about to blow up in September, the Federal Reserve does its job. They say, oh, wait, we better make sure this doesn't cause a financial crisis.

49:46You know, there is a branch of the Fed in New York that deals with Wall Street. A guy we used to work with said the New York Fed is actually more baller than the main Fed headquarters in Washington, the Board of Governors. And they have a special conference room there. They do. Just for moments of crisis. And they invite everyone into this conference room. Yes. It's Wednesday, September 23rd when they use the special crisis conference room, which is not a special crisis conference room. And they call all the heads of the big Wall Street banks to a meeting. And the Fed says to all these bankers, look, you're all doing business with long term capital.

50:23You're all screwed if they go under. Figure something out. We, the Fed, we're not going to put money in. We're not going to bail you out. You're all in this together. Work together to figure it out. Oh, kumbaya, just work together. Yeah, a bunch of Wall Street bankers love to hold hands and help each other out. Hyper competitive. They want to stab each other in the back. This is their normal day. And now the Fed, and this does happen occasionally, the Fed is saying, hey, for the good of everyone, can we set aside our immense greed and hatred of each other on this day? And just be a little more long-term greedy, right?

50:58Like, it is in your greedy interest for this not to blow up. And so the bankers sit in this room. And over the next several hours, they actually come up with a plan. They're going to put in$3.65 billion into the fund of their own money, of the bank's money. And the partners at Long Term Capital, their equity will be wiped out. They won't get any of this money and they won't own any of the fund anymore. And Merriweather, you got to love him, negotiates. is like, because part of it is they need Meriwether and his traders to stay on. There's like literally thousands of trades they have put on, and they're not worthless, importantly, right?

51:38They need somebody to run this fund, not to just liquidate it at fire sale prices. And so Meriwether's like, well, if you want us to stay on, you're going to have to pay us, you're going to have to give us a bonus. And so, in fact, Meriwether and a bunch of other people agree to stay on at Long Term Capital, get paid hundreds of thousands of dollars for their labor. And in fact, over the next year, the thing happens that they said would happen. Spreads do converge. They actually turn a profit. The banks got all the money back that they put into the fund in that emergency moment. And in early 2000, long-term capital management ceased to exist.

52:14I love this story because this is a classic issue in finance, which is if you could go back and replay history a hundred times, long-term capital management would be great. 99 of those times. Like they knew what was going to happen. They made the correct bet on that. Maybe borrowed too much money on this, but they weren't wrong. Their timing was off. Their liquidity was off. They didn't have the money to deal with the kind of debt and leverage that they had. But it's interesting that you can be right and still almost destroy the world economy. Yeah, I mean, they weren't wrong in terms of the sort of mathematical risk.

52:55But for me, there's this idea that is really useful here, which is the distinction between risk and uncertainty. And, you know, colloquially, we use those words largely interchangeably. But there was this economist in the 20s named Frank Knight who wrote this book called Risk, Uncertainty and Profit. And his argument was, you know, we use risk in really different ways at different times. We use one word to mean quite different things. In particular, we use risk when we can really, really measure the probability of what's going to happen. and also when we cannot. Here's an example. You're betting on a coin toss.

53:38You bet on heads. You know that there's a 50 % risk that you're going to lose. Now, say that coin happens to be a Russian ruble, and it's 1998. What's the risk that Russia is going to devalue the ruble, which would make the ruble worth a lot less if you win? I mean, you can go back and look at history in terms of nuclear-powered countries and default, And what is that? 10, 12? You can talk to experts. You can study history. You can do a lot and you can come up with some probabilistic estimate of a Russian devaluation. Maybe it's 10 percent. Maybe it's 50 percent. You can put a number on it. But crucially, that number is not the same kind of number as the risk that it'll come up tails if you bet heads.

54:27It is fundamentally different. You're fooling yourself when you put a number on it. You don't actually know the way you know the 50 percent with the coin flip. This unknowable outcome is what Frank Knight calls uncertainty. So risk is the coin flip. Uncertainty is will Russia devalue? And I think you can argue that the big mistake that long-term capital made was they confused risk and uncertainty. They thought the world was measurable, that risk could be modeled with math. And a lot of the world is measurable, to your point. Math is really powerful at predicting market outcomes. But there is still some amount of unquantifiable uncertainty.

55:13And if you're highly leveraged, if you borrowed a lot of money and made a lot of bets, sooner or later, that unquantifiable uncertainty will destroy you. And that is what happened to long-term capital management. Jacob, we love it when our listeners write in. We got a note from someone who talked about their seven-year-old who missed her dance class. Almost missed her dance class. Almost missed her dance class because she was listening to the Ice episode. And the daughter asked for a show about Crayola, about crayons. Please email us whatever age you are at businesshistory at pushkin.fm. Or you can find me on x at Jacob Goldstein or on LinkedIn.

55:57in. Robert, you're on Twitter at Radio Smith. Shout out radio. I am indeed. Our show today was produced by Gabriel Hunter Chang, engineered by Sarah Bruguer. Our video editor, yes, we're on YouTube, is Matt Nielsen. And our show runner and editor is Ryan Dilley. One quick note, we're going to be off, taking a little summer break for the next couple of weeks, but we're still making shows. We'll be back later in July. I'm Jacob Goldstein. I'm Robert Smith. Thanks for listening. You ain't heard about Moto Casino? Moto has real Vegas slots. Any game you can find on the floor in Vegas, you can play it on Moto.

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