Bob Merton Sees No More Market Panics

Bob Merton was interviewed

by Gillian Tett in the FT yesterday. Merton was responsible

not only for inventing the Black-Scholes formula, but also for founding LTCM,

and his comments about the latter didn’t go down very well either at Alphaville

or at Naked

Shorts. Here’s the contentious passage:

The spectacular implosion of Long Term Capital Management in 1998 has come

to symbolise the perils of excessive speculation.

The causes of the hedge fund’s collapse, though, are widely misunderstood,

says Robert Merton. While some observers blamed events on the faith that the

fund placed in financial models – founded on a belief in rational markets

– Prof Merton says the real problem was the way that LTCM’s counterparties

behaved.

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.

"Just think about all the crises that haven’t happened, say with the

downgrade of General Motors and Ford or the collapse of Amaranth. Look at

how much more resilient the system is now – how institutions have adjusted

and we have learnt to deal with some of these crises which are not really

crises any more as a result."

I think Merton’s is being a bit half-baked here. He was to blame for LTCM’s

collapse. A good hedge fund must have a contingency plan for what it will do

in a market panic, and LTCM clearly didn’t have one.

The really worrying thing is that Merton seems to believe that panics can’t

or won’t happen any more, because certain events (Amaranth, the GM and Ford

downgrades) didn’t cause a panic. That’s silly. Panics come out of nowhere,

they don’t come in reaction to certain events. If the panic which caused the

meltdown of LTCM was really caused by the Russian default, then one would expect

that the much larger Argentine default would have caused a much larger panic.

But it didn’t.

Once more with feeling: News Doesn’t Matter. If a panic’s going to come, then

something will set it off. If Russia hadn’t defaulted, something else

would have left LTCM underwater. And the fact that there hasn’t been a similar

panic in the decade since LTCM went under means nothing. 10 years of relatively

efficient markets is nowhere near enough time to start announcing the end of

human behavior.