By Erin Sherbert
By Erin Sherbert
By Leif Haven
By Erin Sherbert
By Chris Roberts
By Kate Conger
By Brian Rinker
By Rachel Swan
Risk trumped intellect. The fund collapsed.
To forestall a worldwide financial collapse, the U.S. government pressured New York banks to pony up $3.5 billion to keep the fund from going bankrupt.
Yet Merton and Scholes' 1973 calculations -- particularly those dealing with the wealth of information inherent in a company's stock price -- beat at the heart of computer models such as KMV's. Like Long Term Capital's calculations, KMV bases its projections on historical data, and on Merton and Scholes' ideas about handicapping risk.
Computer models shouldn't be blamed for putting the world at peril of financial disaster, says Cornell University derivatives professor Robert Jarrow. The math is sound, he says. "A crude analogy is fire. If you don't use it right, it burns things down," he says. "If you use it right, you can cook, heat, and provide comfort."
But it's hard to cook on a leaky gas stove without sparking a conflagration. And it's harder to predict the future when your computer model is threatened by everything from Boris Yeltsin's health and Hurricane Andrew, to the integrity of South Korean bankers and the vicissitudes of the Brazilian real.
The dizzying developments in international finance over the past decade have underscored the age-old idea of financial risk, which holds that the more unlikely your bet, the greater your potential reward. Tom Wolfe may have been facetious when he called his Bonfire of the Vanities characters "Masters of the Universe." But the fact is that a series of events during the past decade-and-a-half have colluded to turn a gaggle of financiers in New York, Paris, Amsterdam, Hong Kong, and San Francisco into the world's all-knowing, all-being masters of finance.
New York financiers lose confidence in the safety of Mexican treasury bills, spelling economic ruin for millions of Latin American families. Other traders get nervous about the Thai currency, and set the world's greatest industrial region back 10 years. And, perhaps, a San Francisco Internet stock fund manager's attack of cold feet will cause financial carnage to tear along the San Andreas fault.
"The way the world is now, a 24-year-old trader wakes up, he has a cup of latte, and he says, 'I want to destroy the Czech currency today,' " says Robert Theleen, head of Chinavest, a San Francisco group of investment funds. "And traders in Czechoslovakia will help him do it."
Traders bet against the currency, compelling the Czech government to raise interest rates. The standard of living for Czech families collapses, and members of the middle class move to the impoverished class. They will stay that way for a decade, until some other investor decides that the Czech Republic is a good place to park money, and pulls a few billion dollars out of, say, the Philippines, to bet on the Czech koruna.
Before making these decisions, the masters frequently turn to the new computer risk models. Banks spent millions of dollars during the 1980s buying high-powered computers, and hiring Ph.D.s in physics -- as opposed to business or accounting -- to crank out mile-long risk-analysis algorithms. These computers mix and match bonds and stocks in different markets, and in different countries. While humans make the decisions to move money, computer calculations form the basis for more and more of the assumptions these brokers trade on. Or, in perhaps easier-to-understand gambler-speak: It is new computer-risk models like KMV's that set the house rules.
International finance has been around for centuries, of course. Speculative bubbles followed by spectacular collapses are nothing new, either. Cycles of risk, reward, and catastrophe repeat every generation, as parents pass along greed, hubris, and an innate misapprehension of economic swings. Bookstores are full of tomes about the disastrous tulip craze in 17th-century Holland, and pretty much every financial column these days includes mention of 1929 or some other financially catastrophic date.
But the game really is different now. The failure of the fixed exchange-rate regime that governed the globe from the end of World War II to the mid-1970s, the collapse of the Berlin Wall in the 1980s, and the concurrent opening of economies in Latin America and Eastern Europe have created a different economic world.
Growing financial markets in Asia, Latin America, and Eastern Europe have given financiers more tables on which to play. The massive growth of mutual funds and 401(k)s has given them fantastically greater sums of money to bet. And the absolute lack of limits on where or when they can move this money has made the global economy more fragile than ever.
All decisions -- whether to buy government bonds denominated in Mexican pesos, sell debt pegged to the Thai baht, bet on the probability of movement in the Russian ruble, or buy shares of Amazon.com -- are based on individual acts of risk assessment. This can mean quantitative calculations, subjective assessments, ordinary hunches, spectacular leaps of faith, or, most commonly, a fanciful blend of all four.
But there's one thing that hasn't changed at all, even in the brave new world of financial-risk assessment. Nobody has proven able to predict financial collapses. The global economic disasters that used to roll around every generation -- and lately seem to happen every couple of years -- have always caught financiers unawares. Indeed, the masters seem most giddy in the moments before financial collapse.