Crash

They seemed like the masters of the universe, the gods of investment banking. But with Long Term Capital Management's multi-billion dollar fall from grace, we are all being martyred for our banks' blind faith
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The Independent Culture
The financial markets are good at many things. One of them, it might seem from the last few weeks, is humbling the mighty. Predictions made in good times, many of them backed by large amounts of hard cash, have turned sour. Senior executives at UBS and IMG Barings have fallen on their swords; the thundering herd of redundancies on Tuesday at Merrill Lynch are only the front-runners for thousands of downsized jobs. The marketmeisters of New York and the economic overlords of Washington alike have been left with plenty of egg on their faces.

Sadly, there was little humility on show last week, as the International Monetary Fund and the World Bank convened their annual meetings. There was quite a bit of hurt pride and some back-stabbing, but a sense of failure amongst all those pin-striped suits and highly polished black Oxfords? Get real.

Being right is at the heart of financial market culture. It is a world where victory is everything, and there are no prizes for second place: that is the self-projected image of investment banking, and Long-Term Capital Management, the hedge fund based in small town Greenwich, Connecticut, which had to be bailed out in a $4bn US government-led lifeboat two weeks ago, was in many ways the epitome of that culture. Established by John Meriwether, a former Salomon's bond analyst who was regarded as little less than a deity by many, it traded on the microscopic differences that opened up between securities. A hedge fund like LTCM is trading for professionals: it is an esoteric business that carries allure and glamour, but also mystique. Its 150 employees were known as rocket scientists, a testimony to the mathematics which, in theory, they substituted for the less precise judgements of their peers. This was gambling as physics, and its protagonists had big balls and bigger brains. With their capital of $4bn as security they borrowed another $120bn, then used that to borrow around $1trillion - a sum roughly equivalent to the gross domestic product of China. If the myth behind LTCM was powerful while it was alive, then in death it has become even more resonant. Here is a classical tragedy, according to the Authorised Version: a company run by intellectual giants, reduced to nothing overnight by a sudden and incomprehensible earthquake in the markets.

There is something about the company that was very American. Its foundation was science, a kind of fundamentalist rationalism that placed ultimate faith in the fusion of science and markets. And it had a peculiarly American faith in its own judgements. This is a country that has not lost a war, which emerged into the world proclaiming itself to be a city on a hill, which saw its dominance underpinned by victory in the Second World War and then doubly underlined by the end of the Soviet Union. Putting up your hands and admitting that you got things wrong, that somehow you finished up on the losing side of an argument, is not part of the culture.

At its best, this translates into a fierce and vital optimism that disdains risk in the name of enterprise. At its worst, it is a fatal arrogance. Long-Term Capital Management - the very name tempts fate, with its solid,reliable promise of a safe pair of hands - was powered by arrogance. It gave out an aura of assurance that was, in its last months, almost its only asset. Its underlying premise was that science, mathematics plus economics, had discovered the secrets of the financial universe, the underlying truths that drove markets. If one security went up, it was a sure bet that another, linked one would go down. Of course, it was far more complicated than that. You wouldn't understand. Give us the money and we'll turn it into a fortune. Trust us. We are winners.

And winners they were: there were two Nobel prize-winners in economics on the board, for instance. Nobel prizes, for goodness sake! How can you go wrong?

In the first place, they weren't such wizards, even in the good times. They were returning around 30-40 per cent to investors, which sounds a lot until you look at what financial markets were doing during this period. That is about what you would have got if you had simply chucked your money into a fund tracking one of the big market indices and left it there. "With that sort of risk, you expect a better return," says one New York banker. In other words, all of that gravity-defying brilliance, the sheen of success, concealed a company which was basically pretty average. The spectacular feat which they managed was to make money when the market was going up and lose it when it went down. If these were rocket scientists, then God help Nasa.

And as it turned out, they were quite a lot worse than average. When the good times stopped very abruptly, things went horrendously wrong, but the Werner Von Brauns at LTCM apparently stuck to their rockets and their equations. These equations, as it turned out, were wrong. Economics describes events in the past and assumes that these relationships will persist into the future. When they don't, good economists pick through the evidence and try to work out what went wrong. A good economist, like any good theorist, tests assumptions against reality and discards theories when they don't fit the evidence. Long-Term Capital Management's Nobel laureates apparently couldn't manage that feat. When things went wrong they carried on regardless, stacking up the debt until no one would lend to them any more.

Of course, they weren't the only ones to botch the numbers. The economists at the IMF, too, thought they knew the future. Their equations told them that the vast flood of capital out of emerging markets simply could not happen. No matter that these equations were, at best, ten years old. What happened, in the IMF's view, was that some vast shift took place in the space-time continuum.

"Very large unprecedented movements," said Michael Mussa, the IMF's chief economist last week. "Ten standard deviations out in the distribution. That is why Long-Term Capital Management got into the difficulty it did. We had a millennial event; that is, something which the probabilistic model said would happen once in a thousand years happened in August, and it caught some people a bit off guard."

To hear everyone speak over the last week, you would think that we were discussing a medical prodigy. Everyone, led by the US Treasury Secretary, Robert Rubin, calls this "contagion." A bit like the Ebola virus. Except, of course, it wasn't. Markets are just big crowds of people interacting with each other, and for the last five years they have been attending a particularly lively rave off the M25. Then the ecstasy ran out and they rioted. The ring leaders were the people who helped shunt the capital around the world at the drop of a hat.

The bankers, in short, the chaps in the good suits and French cuffs at the Mayflower Hotel in Washington today were the rock throwers. And the guys from LTCM, who got blown up by their own Molotov cocktail.

As Paul Krugman, the leading US economist, put it in Slate, the online magazine, "A realistic assessment of risk should take into account the possibility of these large, low-probability events - in effect, should allow for the reality that now and then shit does indeed happen. But the wizards at LTCM, so the story goes, forgot about reality. They treated the statistical distributions found by their computers, based on data from a period when shit didn't happen, as if they represented the entire universe of possibilities.

"As a result, they greatly understated the risk to which they were exposing both their investors and those who lent them money." And in return, the Federal Reserve Bank of New York moved in and propped up LTCM, bullied some of its friends into buying the thing and dealing it with in gentlemanly fashion. No revolver and a glass of brandy for Mr Meriwether, just back to the nice house in the Connecticut countryside.

LTCM was too big to let it go, they said, too important.

Moral hazard is a technical term in banking to describe what happens when bad decisions get rewarded, and moral hazard is what is at stake in Washington. Long-Term Capital Management got bought out by the big American commercial banks, because it would have been too damaging to those same banks if it had been flushed down the toilet to join the thousands of smaller banks, shipyards, coal mines, corner shops and farms that have ended up in the cess pit of global capitalism in the past few years.

They were expendable; the men in the Mercedes weren't, because they lived in Connecticut, not Ulsan, Surabaya or Vladivostok. For heavens' sake! These are our friends, went the cry in Old Greenwich. That's David Mullins, who used to be at the Fed himself! Why, we had them over for cocktails just last week!

Maybe all of the bankers who put their own life savings into LTCM, and the banks which followed and then propped it up, were just being nice. Or maybe they were being dumb. Or maybe they knew that, in the end, Uncle Sam would always be there for them, if not for anyone else.

"Of course," says Mr Krugman, "if you believe that big, supposedly sophisticated players can be that foolish - or, for that matter, if you believe that they are not foolish but do foolish things because the government will always bail them out - you start to wonder whether our whole financial structure is as sound as we like to imagine. Did somebody say 'crony capitalism'?"

The argument of the last decade has been that markets are everything. You can't buck the market, because that is what defines the truth. If you believe that shares in Buckfast Broadcasting should be worth more than they are because the company is a miracle, and everyone else thinks differently,then you're wrong.

It doesn't matter whether your family have mined coal here for a hundred years, there's cheaper stuff around. The market is the only thing that defines the truth, the whole truth and nothing but the truth.

All hail the market. It is the moving finger which writes on the wall, and if you don't follow its dictates, then screw you. As it turns out, that does not apply to dumb people who messed up in Connecticut, if they went to the right colleges. It sounds bad, it looks bad, and it smells even worse.

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