When Economic Bombs Drop, Risk Models Fail
By TIMOTHY L. O'BRIEN
hen we examine banks, we expect them to have systems in place that take account of
outsized market moves."
-- Alan Greenspan, chairman of the Federal Reserve, in congressional testimony on Thursday
Ever play blackjack at your local casino?
Then the name Edward O. Thorp might be familiar. Thorp introduced blackjack fans to counting
cards in his 1962 best seller "Beat the Dealer," which gave gamblers an invaluable tool for trying to
beat the house.
Ever wonder where hedge funds come from?
An accomplished mathematician, Thorp started one of the first and most successful hedge funds,
now called Edward O. Thorp & Associates, in 1969. And he has few kind words for the Wall
Street professionals and Nobel laureates who helped bring Long-Term Capital Management, the
giant hedge fund in Greenwich, Conn., to its knees.
Thorp said he was invited to invest in Long-Term Capital when it was started in 1994, but he
declined.
"I didn't want to have anything to do with it because I knew these guys were just dice-rollers," he
said. "I didn't really see where these guys had an advantage they could exploit."
Many people on Wall Street clearly thought otherwise. Over the last four years, Long-Term Capital
attracted money from some of the world's savviest investors, and made a lot of money for them
during most of that period -- the salad days of the 1990s bull market.
But hedge funds are supposed to perform well even when markets hit rough patches, as they have
lately. And it is not clear whether the firm's fans had ever scrutinized Long-Term Capital's investment
strategy with hard times in mind.
"It was just a mutual admiration society at Long-Term," Thorp said, "and nobody was focusing
clearly enough on the model."
Aha. The model.
Nowhere, except perhaps within the walls of the Pentagon, the White House's Situation Room or the
National Weather Service, does "the model" hold as much sway as it does on Wall Street.
Some of the most profitable trading on Wall Street, especially within hedge funds, involves complex,
innovative products known as derivatives. Derivatives are financial hybrids born in the guts of a
computer and intended to protect users from disadvantageous economic shifts like currency
devaluations or interest-rate increases.
In short, each derivative, its value "derived" from an underlying asset like a stock, bond or currency,
is a little model.
And financial models are only as good as their makers.
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