Merton and the wrong “real story”

LTCM’s real lesson: The Fed Chairman put

Oh dear. Bob Merton, one of the Nobel laureates that brought us LTCM and an almost a decade of “hedge funds are a plague” rhetoric is blame-shifting in The Financial Times today:

When the fund started to suffer losses, the counterparties did not behave as proponents of finance science - or rational markets - predicted. Instead, they sold assets in a seemingly indiscriminate panic, triggering market swings more violent than anything Prof Merton expected.

In that respect, the events were thus a brutal learning experience - not just for Prof Merton but Wall Street too. But that may also be a boon. “The real story is not what happened to LTCM in 1998 but what happened to Amaranth later—or rather, what didn't happen,” Prof Merton says.

The real story was, of course, that LTCM gave us reiterated the power of The Greenspan Put; the idea that the Federal Reserve Board would both prevent the failure of a major investment bank (or two, or three), and open the money spigot to get them back on their feet, thereby creating the greatest moral hazard in the history of finance. It delivered the final blow-off top of the 1990s tech bubble, and the covenant-lite financing of the current mergers and acquisitions/private equity boom.

And just because Greenspan’s finished the book, and is now pimping for The Bond King, nobody missed the subliminal message in successor Ben Bernanke’s speech on subprime lending late last week: “Don’t worry boys, we’ve got your back.” Get-out-of-debt-free cards after the jump.

LTCM as a learning experience [$$]
by Gillian Tett
The Financial Times May 21 2007

The appliance of financial science  [$$]
By Gillian Tett
The Financial Times May 21 2007

LTCM, panic and rational behavior
FT Alphaville May 22 2007

Comments

[dan collins]

I had the exact same reaction to seeing this story. In fact I forwarded it on to my publisher with the note "sometimes even nobel laureates fail to learn," prior to seeing your take on this.

Didn't anyone ever quote to Merton the old axiom, "The market is always right."

Every trading loss can be explained away with the logic Merton used in this story.