A $4.5bn hole in the hedge

When two professors devised a mathematical model, one of the world's biggest financial disasters followed. Nicholas Dunbar reports

Just over a year ago, the global financial markets went into a tailspin. Three trillion dollars were wiped off the value of shares and other investments. At the heart of this crisis was a mysterious entity called Long-Term Capital Management - LTCM.

LTCM was a hedge fund that built up enormous market positions using complicated billion-dollar financial contracts. In the tangible, physical world, LTCM looked insignificant. It boasted three offices in London, Tokyo and Greenwich, Connecticut, and employed about 150 people.

But in the virtual world of modern finance, LTCM was awe-inspiring. It was the pinnacle of a 30-year revolution in economic and financial theory. A few academic visionaries had founded a vast financial infrastructure, which allowed traders to fling trillions of dollars between continents in the blink of an eye.

With catchphrases such as risk management and financial engineering, these visionaries were cherished by bankers for bringing the discipline of science to what had been a form of guesswork. Foremost among the visionaries were two professors, Robert C. Merton of Harvard Business School and Myron Scholes of Stanford University, who jointly won the economics Nobel prize in 1997 for their theory of option pricing.

Under the leadership of Wall Street's warrior king, trader John Meriwether, Merton, Scholes and several others founded LTCM in 1993. Joined by one of the world's foremost banking regulators, US Federal Reserve vice-chairman David Mullins, LTCM styled itself as a freelance police force of the markets, scouring the globe to remove inefficiencies from the system. It also generated billions of dollars in seemingly risk-free profits.

But in summer 1998, Merton and Scholes' theories failed. The world's 14 biggest investment banks faced disaster - saving themselves only by providing a $3.5 billion cushion to support LTCM while it was dismantled.

Half the world's financial markets seized up and US Federal Reserve chairman Alan Greenspan had to take emergency action and cut interest rates to get them working again. It was as if a country had gone bankrupt, but no one could see which.

The LTCM story began in academia, and will probably end there, as economists debate its significance. When Scholes and Merton (along with colleague, Fischer Black, who died in 1995) published their groundbreaking research in 1973, financial economics in the US was a minor discipline. So obscure did options - which give investors the right to buy an asset at a fixed price in the future - seem, that in his paper, Merton referred to them as "relatively unimportant contracts". Options are a type of financial derivative, so-called because they derive their value from something else, such as a share or the price of gold.

Black, Scholes and Merton's work relied on a key insight: derivatives can be replicated (see box right). The idea seemed radical at first and they struggled to publish their work. Many economists distrusted the mathematics required to understand the subject. It was not until the early 1980s that the markets discovered derivatives and financial economics became a hot discipline.

PhD students of Black, Scholes and Merton began the move to Wall Street around 1984. At many investment banks, the former professors were treated like boffins and placed in backrooms away from the trading floors. Nicknamed "quants" by traders, they priced options for a living. At the investment bank Salomon Brothers they were treated differently. John Meriwether, a top trader there, decided to conduct an experiment. He let the professors on the trading floor and gave them a chance to use their ideas to make money directly.

Meriwether's new group was wildly successful. By 1990, some of these former academics were earning annual bonuses of more than $20 million.

As investment banks used computers to gain a competitive edge, the derivatives markets grew rapidly. It turned out that Black, Scholes and Merton's theory resembled certain branches of theoretical physics such as quantum field theory. The skills needed to predict the paths of elementary particles could be transferred to option-pricing problems at investment banks. A second brain drain ensued, as physics and mathematics PhDs flocked to Wall Street and the City.

With Meriwether at the helm, Merton, Scholes and other leading academics as partners, and these former physicists and mathematicians as their white-collar workforce, LTCM was in the vanguard of this movement. From the late 1980s, Salomon Brothers regularly set up a recruitment booth at the December annual conference of the American Finance Association. In 1993, it attracted a throng of postgraduates and young lecturers.

Starting with $1 billion investor capital in 1994, the fund swelled to $7 billion by 1997. The partners saw their investment in LTCM grow from $150 million in 1994 to $1.6 billion in 1998. They retained their links with academia, as professors, faculty advisers and conference attendees. By 1997, when Scholes and Merton won their Nobel prizes, LTCM was at its peak. So confident were the partners that their theories would continue to prosper, that they returned $2.7 billion to investors. Then, in summer 1998, Russia defaulted on its government debt.

LTCM did not have major exposure to the Russian market, but many large investment banks and hedge funds did. Many dumped positions in other markets to cover Russian losses and LTCM suffered. On August 21 alone, the fund lost $550 million.

As the global turmoil worsened, a key flaw became apparent in the models used by LTCM and its competitors. In 1973, Scholes and Merton had been careful to include caveats to their theory. One assumption was that markets were "liquid", that there were always plenty of buyers and sellers constantly trading, who could agree on a price. LTCM was a victim of its success. Its size distorted the derivatives markets, invalidating the assumption. Rather than the thousands of investors required, only LTCM and a few investment banks were trading in these markets. The Russian default pulled the rug from under LTCM and its imitators. By the time of the bailout, the fund had lost $4.5 billion, wiping out the partners' personal wealth.

A year later, LTCM is being wound up by its creditors and an unrepentant Meriwether is starting a new hedge fund. The markets are as complex as ever, but traders are more wary about relying on what Greenspan called "mathematical models of human behaviour". The golden age of academic finance is over.

Nicholas Dunbar is technical editor of Risk magazine and author of Inventing Money: The Story of Long-Term Capital Management and the Legends Behind It (John Wiley), Pounds 17.99.