Vagueness and Memory.

Vagueness.

Long Term Capital Management was one of the premier US investment funds during the 1990s. Run by experienced traders and academics with an edge for mathematics and statistics, the fund returned 40% pa during 1994-1997. Leading business publications such as Business Week touted its remarkable achievements, with any critics on the sustainability of the fund relegated as obstructionist or ignorant. One of the funds leading advisers, Myron Scholes (of Black-Scholes fame, the formula used to price most derivatives around the world) was reported to rebuke a critic in an investors meeting questioning how the fund could make such returns by saying “You’re the reason – because of fools like you we can”.

But there was more to it than that. The fund was reliant on borrowing from banks to take bets on the movement of stocks, bonds, currencies and commodities. The bets were based on the precision of the models based on the intellectual firepower of academics like Scholes. The models used historical assumptions to predict where these investments would end up a certain percentage of the time, and the fund would bet appropriately.

The major risks of the fund were two-fold. Firstly, it was using an incredible amount of leverage, so was dependent on the continued liquidity of the market and faith of their lenders to ensure it had enough cash to cover its bets. Secondly, it was operating in a vacuum of precision, with an assumption that the past would realistically continue in the future with absolute certainty.

The reality of such a flawed approach hit the fund during 1998 – this was the year of Russian and Argentinean debt crisis and the Asian currency crisis. According to the firms’ models, these events wouldn’t occur at the same time. But they did, and the fund lost 4bn dollars from its bets being in the wrong direction, wiping out its gains of the past 4 years.

The real danger was to the broader financial system - the same system that ensures credit flows to business and individuals. Because the fund had borrowed to fund its bets, and it hadn’t set aside anything for these bets going badly, the fund couldn’t pay back its lenders (which were the major US banks such as Goldman Sachs, Merrill Lynch, JP Morgan and Lehman Brothers). Failure to pay back the loans could create a crisis in confidence, freezing up the flow of credit.

Clearly, the banks and fund managers did not heed the warning of one of their academic peers, Kenneth Arrow, when he prophetically stated in 1992 - “Our knowledge of the way things work, in society or nature, comes trailing clouds of vagueness. Vast ills have followed a belief in certainty”.

In this situation, the protagonists were so precisely arrogant in their beliefs, and their repeated aversion to taking external, common sense advice created a potential catastrophe for financial markets.

Memory.

If this all sounds familiar, it is. This problem was essentially the same as the allegedly “unprecedented” credit and liquidity crisis of 2008. Banks made bad loans, didn’t understand the risks, and then threatened to refuse to lend each other because they didn’t know how badly exposed the other banks were.

The solution to the 1998 problem was somewhat different to 2008 – in 1998 a consortium of banks bailed out Long Term Capital Management, although this was facilitated by the New York Federal Reserve with the US Federal Reserve providing interest rate cuts to reduce the cost of the bailout to the banks. As in 2008, the solution was agreed quickly (to avoid impacts to financial markets) and the public were not consulted on this approach.

But the precedent was established. The US Government wouldn’t let a private institution with private interests’ fail that could threaten the stability of a financial system; despite the fact the private institution played a significant role in creating the broader systemic risk. The 2008 bail outs of AIG, Freddie Mac and Fannie Mae emerged in similar circumstances; although in 2008 US taxpayer funds were directly used. So an even more dangerous precedent has been established. Rather than a consortium of banks with some additional government assistance, the taxpayer is effectively underwriting substantial downside financial and systemic risks.

Why does the public accept underwriting these substantial risks? It appears to be a matter of trust and fear of the unknown.

Taxpayers quite rightly assume the government is acting in the public interests – if they ask for money, they must need it. If this is the agreed approach, the public also has an equal right to ask during the "normal" times that the risks taken are understood and managed appropriately. As the recent pushback for banking regulation and financial reform in America is showing us, this is proving to be quite a challenge.

We also appear to be so scared of the implications of a failure. But failure happens and we all need to understand and learn from the risks that caused the failure. What is dangerous is creating an environment that downside risks are neutralised – creating such precedents means we don't learn from mistakes, meaning it is more likely the problem (potentially larger) will recur.

In the modern world, memories are such a hard thing to hold onto, particularly if they fall into a vacuum of complex and often-conflicting explanations. Harold Pinter hit the nail on the head during his 2005 Nobel Prize for Literature Speech; although he was referring to our memories or war and conquest, it is equally relevant here –

“It never happened. Nothing ever happened. Even while it was happening it wasn't happening. It didn't matter. It was of no interest. It's a brilliant, even witty, highly successful act of hypnosis.”

It is very hard to fit skepticism and questioning into our fast paced lives, let alone remember history. But if we don't remember or understand, history risks a repeat.