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Michael Lewis
Fri, 02 Apr 1999, 1:44pm EST
Another Long-Term Capital Management Puzzle: Michael Lewis
Another Long-Term Capital Management Puzzle: Michael Lewis
(Michael Lewis, the author of ''Liar's Poker,'' ''The Money
Culture'' and ''Trail Fever,'' is a columnist for Bloomberg News.
The opinions expressed are his own and don't represent the
judgment of Bloomberg LP or Bloomberg News.)
New York, Feb. 2 (Bloomberg) -- I for one am still puzzled
by what happened in the financial markets last August and
September. In a short few weeks, a lot of very smart and very
well-informed investors abandoned markets that they themselves
had created, in what appeared to be a form of mass hysteria.
As a result, the risk premiums on everything from interest-
rate swaps to long-term equity options rose to new and surprising
levels. The movements in many of these markets was the
equivalent, statistically speaking, to a drop of several thousand
points in the Dow Jones Industrial Average.
This strange panic raises at least one big question. It is
widely believed, in any market, that the better informed its
players become the more efficiently that market will behave. And
up to a point, that is what has happened in the markets for
interest-rate swaps, mortgage bonds, long-dated equity options,
etc., etc. Over the past decade or so, they have ceased to be a
fat opportunity for arbitragers and become rationally priced.
They have taken on the traits we associate with mature markets.
Spreads have narrowed, liquidity has improved, and a lot of smart
people can plausibly claim to have a good notion of how these
things should trade.
But then, during six weeks beginning in late summer and
early fall, the markets for arcane securities behaved more
strangely than they ever have behaved, and to this day they have
been slow to recover their old sense of certainty.
Why should this be?
Three possibilities.
1) The panic last fall was perfectly rational. The Russian
default raised the specter of many more national defaults. This
in turn caused, say, sterling interest-rate swaps to become that
much riskier. That is, the markets were simply pricing in a new
piece of information: that governments were willing to renege on
their debts.
The trouble with this explanation is that the bizarre
behavior occurred in the financial markets of large and stable
countries. Does anyone really believe that the collapse of Russia
increased the possibility that the U.S. or U.K. governments will
default on their debt?
Rational Response
2) The panic was a perfectly rational response to the
presence of one preposterously large player -- Long-Term Capital
Management LP -- that became dangerously weakened. In the latter
stages of the panic, this was almost certainly the case, as the
belief that Long-Term Capital would be forced to liquidate its
trades led others to do it for them.
But this explanation mistakes cause for effect. Long-Term
Capital was weakened only after the markets panicked. And in any
case, the firm once had a larger share of these markets than it
did last August, and no one back then seemed to mind.
3) The panic was, indeed, irrational, in a way that
illustrates something more general about financial markets. Far
from causing markets to become more efficient, the presence of
many seemingly well-informed people channels into a financial
market a new, irrational force. People!
It is at least worth considering that markets cannot be
thought of simply as less efficient or more efficient. It seems
at least possible, in light of recent events, that they can
become at once more and less efficient.
When a market is new it tends to be mispriced, but in
somewhat predictable ways. When the Japanese government
introduced bond futures, for instance, the Japanese bond market
was roaring, and Japanese investors used the futures simply to
speculate. As a result, the futures were rich, and a lot of money
could be made buying the cash and selling the futures.
Analyzing the Herd
But once a market develops and comes to resemble an
anonymous, faceless mass, it acquires a new form of uncertainty.
This is the uncertainty of the cattle herd, when a lot of
creatures are thinking the same way about the world around them.
In the new, mature market, no model or formula can substitute for
judgments about the herd and the decisions the herd is likely to
make. The individuals that make up this newly developed market
suddenly understand that their fates are in each others' hands.
Prices are no longer driven by forces of simple ignorance but by
forces of informed fear and greed.
The stage is now set for a panic.
A market panic is a curious thing, and I do not pretend to
fully understand it. But I do wonder if the very forces that
cause a financial market to become incrementally more efficient
also create the conditions necessary for dramatic irrationality.
Is it possible that the ''smarter'' a market becomes, the
greater potential it has to behave stupidly?
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