Emerald Group Publishing Limited
Copyright © 2000, MCB UP Limited
The myth of money
The myth of money
Inventing Money: The story of Long-Term Capital Management and the legends behind it
By Nicholas Dunbar
The story of Long-Term Capital Management, its rise and demise, is a wonderful fable for our time and is very well told in this book. It is a story of how a Nobel prize for economics was won. It is a story of how the modern world of finance was created. It is a story which shows that, despite the extraordinary financial sophistication of our times, we still want to believe in myths.
Nicholas Dunbar is a solid author. The book takes in a history of trading and speculation. Isaac Newton turns up as a terrible warning of what is to come. Here was the equivalent Nobel laureate of his day, the man who discovered gravity and laid the foundations of the study of physics. But he too wanted to believe that a way had been found to make huge amounts of money without any risk. This was back in 1720. The dream then was called the South Sea Company and when it turned belly up and became the South Sea Bubble Newton had lost £20,000 which, back in the early eighteenth century, was a large amount of potatoes by anyone's standards.
So nothing is new under the sun. Anyone who thinks differently should read the shrewdest few pages on the topic, which are hidden away in JK Galbraith's novel, A Tenured Professor. But the human race has just as much of an appetite for myth as it has for reality, possibly more. It comes as no surprise that something like the LTCM disaster can occur in our own times.
With hindsight we can see it coming. Reading this book you rise up in the air and can see clearly that the juggernaught is heading for the cliff. But during the events you were down by the roadside and everything, though unlikely, was on track.
After all, LTCM had impeccable foundations. Robert Merton and Myron Scholes were on board. Back in 1973, when they were merely academics, Merton had published The Rational Theory of Option Pricing, and Scholes and another academic, Fischer Black who died in 1995, had published The Pricing of Options and Corporate Liabilities. These papers became the foundations of the options market and, along with the stunning advances in computing power, made the modern financial markets possible. And they, combined with the talents of a great financial barnstormer, John Meriwether, created LTCM some twenty years later.
Dunbar tells this story well. Immediately after his account of the events of 1973 he drops this paragraph in: 'Yet the Black-Scholes-Merton theory contains the seeds of its own destruction. The seeds lie buried deep in the small print of the theory in its underlying assumptions. The most important assumption is that the underlying market such as stocks functions properly. In the summer of 1998, this and other assumptions would break down.'
In the old days of 1973 brilliant academic work by three economists would simply have made their university careers for life. Or as Dunbar puts it: 'The young professors could relax in the congenial obscurity of an academic career, having established a name for themselves. End of story.'
But that wasn't the end. In 1992 Meriwether, Scholes and Merton founded LTCM. By early 1998 LTCM had a portfolio of well over $100 billion with swap positions commanding a notional value of $1.25 trillion. Every serious bank had a piece of the action via LTCM. Even the Italian government, frantic to control its national debt to enable it to hit the right targets to allow it to join the European Monetary Union, was using this miracle financial service. Even the communist-run Bank of China was a strategic investor. Then, triggered by volatility in the world's markets, it all turned pear-shaped. By late September in 1998 the biggest financial rescue the world has ever seen had to be instigated. It cost $3.65 billion to save LTCM from taking everything else down with it.
There are all sorts of reasons for LTCM's demise: sudden volatility in the world markets, disastrous decisions by Meriwether and a whole raft of events set in train by the LTCM culture itself.
But the real reasons would have been understood by anyone in history. The desire to believe in the idea that alchemists and wizards could have the power to find a way of turning reality on its head and producing riches beyond the dreams of avarice is as strong as ever.
Inventing Money is published by John Wiley at £17.99/ US$32.50 and is available from 0800 243407 (UK) or +44 1243 843294 (overseas).
Management the hedge fund name famous across the globe for the scale of its rise and fall. And, inevitably, the book that tells its story has now been published: Inventing Money, by Nicholas Dunbar. The author offers us a well-written and informative account of how the company's culture developed, and why LTCM plummeted so dramatically.