#Lukáš Kovanda, Ph. D.

I’m a Parasite?  They’re Taking Revenge on Me

“I think that we will feel the impact and consequences of the crisis for four to five years,” says MYRON SCHOLES, Nobel Prize Laureate in Economics and the co-author of the famous and abundantly used Black-Scholes Model of option valuation.

Lukáš Kovanda and Myron Scholes, Bratislava, Spring 2009.

For many years, you worked at the University of Chicago, the bastion of the free market.  Richard Posner, a major lawyer and in fact also an economist from the same university, calls the crisis a failure of capitalism.  He even called his newest book that.

I am also surprised.  In my opinion, capitalism did not fail.  The problem is that risk, as we understood it, was improperly evaluated and rated.  That led to enormous losses.  It is important to retain capitalism; it is bound up with the freedom of choice of every individual, with the freedom to make decisions.  If we bet on the other card, on government intervention, we will absolutely certainly lose innovation, growth, and creativity.  Our own problems can best be solved by ourselves, not by someone else.

Now you are at the head of Platinum Grove Asset Management hedge funds.  What do you recommend to invest in?

We are going through a generally very difficult period.  In stock trading, we combine speculations on rises and declines, trying to obtain genuine “alpha” (in financier-speak, that means, simply put, the measure of how clever an investor is: what his yield is with a view to the risk that he is taking to achieve it, note by L.K.).  Now we are definitely remaining in liquid sectors.  It is far more reasonable, because we are still not familiar with all of the consequences and impacts of the crisis on the entire economy.

In the autumn, you were forced to freeze the assets of the fund; your main fund lost 38 percent.  To many, that is reminiscent of the fall of the Long-Term Capital Management fund, with which you also were involved (see I Can’t Shake that Murder Rap…)

All risks have now been liquidated.  We paid out all of the clients who did not want to continue investing with us.  We are going on and I am satisfied.

What is your opinion of the Austrian School of economics (unmathematized, verbal economics, emphasising discrete human actions, which is, on the other hand, opposed to an excess of statistics, note by L.K.).  Some hold that its influence could increase due to the crisis, because mathematical risk models have failed.  But you yourself, it seems, are a representative of an entirely different stream.

Not entirely.  The Austrian School rightly emphasises the important role of undistorted prices as signals for human decision-making.  It realises that governments themselves can bring instability to the system through central banks, of which we should always be well aware.  It is based on a behavioural view of the world, from how we respond to stimuli, and how we get information from others for our own actions.  In line with that, many people today think that we should not prevent collapses and bankruptcies, but leave the economy to revive itself.

Economists from the Austrian School emphasise the risk of a monetary and credit expansion.  Many of them hold that the present pouring of money into the system will lead to enormous inflation.  Do you agree with that?

Yes.  The American central bank has printed (and continues to print) a significant amount of money; if it continues at this pace, it may be up to three trillion dollars pumped into the economy.  The Austrian theory of banking proclaims that we should rather use so-called commodity money – money underlain by a real value, and that the government should not participate in the process of its issuance at all.

Do you agree with that opinion, in particular?

I am not sure whether commodity money per say can function, because when the supply of a commodity changes, with it changes the basic unit of price measurement.  Many people from the banking sphere therefore rather propose that governments should increase the amount of money in the economy according to a pre-set stable plan.  The question of the day is how governments can get back the money that was pumped into the system.  That will be very difficult, much more difficult than pouring the money in.  That is why I think that presently there really is a risk of enormous inflation, because central banks have invested enormous sums of money into the system.

Last June, you said that the crisis would end this year, on 7 March.

(Laughs.)  You are right, I really did predict that.  And instead, the present bottom arrived at precisely that time.  Perhaps I should quit making forecasts.

In spite of that, do you think that the crisis is over, that we have already reached the very bottom?

No.  We will feel the consequences of this crisis for a really very long time.  The crisis is more profound than even I had predicted.  The prices of assets have gone down tremendously; people now have to work on making financing and investments more flexible.  Furthermore, they by no means want to risk as much as they did before the crisis.  So the recovery could really take a lot of time.

How long? Years?

I think that we will feel the consequences for four or five years.  But verify that: you know how my last tip turned out (laughs).

How will America cope with the crisis, and how Europe?

America depends on Europe, and Europe, in turn, on America.  The European economy is very inflexible at the moment, and European banks have not even announced in any credible way how much they will have to write off in bad assets.  European banks, for example those in Germany, still have lots of bad debt on their balances.  Write-offs will take a lot of time.

Myron Samuel Scholes (*1941)

A Canadian-born economist who received the Nobel Prize in 1997 for “discovering a new method to determine the value of financial derivatives”.  He earned his doctorate in 1969 at the University of Chicago where he studied – and later also lectured – together with other powerhouses of financial economics, Eugene Fama and Merton Miller.  In 1973, he published, together with Fischer Black, the revolutionary study The Pricing of Options and Corporate Liabilities, in which they first formulated what is today known as the Black-Scholes Model.  In 1981–1996, he worked at Stanford University, where he is now a professor emeritus.  Scholes was, however, also very active in practice.  From 1990 to 1994, he held senior posts in the investment bank Salomon Brothers (which became a part of Citigroup at the end of the decade).  In 1994, he co-founded the hedge fund Long-Term Capital Management (LTCM), whose collapse four years later nearly caused the collapse of the world financial system.  Since 1999, he has been the Chairman of the Platinum Grove Asset Management hedge fund, which he co-founded with Chi-fu Huang, a colleague of his from LTCM.  He drives an Audi S6, and does not have much time for his hobbies: golfing and skiing.

And what do you make of the steps taken by the US administration with respect to the crisis?  One of the assumptions of the Black-Scholes Model is that there are no restrictions with respect to speculation on declines.  The government, however, resorted to far-reaching restrictions on such speculation.  Was that necessary?

Personally, I would not prohibit speculation on declines.  It is the result of not understanding the whole process.  The result of the erroneous idea that people who get rid of assets cause the drop in their prices.  If there were real value behind the assets, people would surely buy them.  It is always good to have the most functional price mechanism possible, in which prices reflect information from the market without distortion, and hence, I do not agree with the bank.  I think that it was a politically motivated reaction.

Two years ago, you said that corporations, in the sense of publicly traded companies, would vanish if stock exchanges were to be increasingly regulated.  The consequence of the crisis will, however, probably be a further tightening of regulation – will all companies thus be private in the future (in the sense of not being traded on a stock exchange, note by L.K.)?

Every regulation increases costs.  In order for you to be able to cover those costs, in order for you to survive, you need an increasingly large organisational structure.  Mid-sized companies will always be at a disadvantage compared to large ones.  Every new regulation requires new lawyers, additional fixed costs, etc.  That chases smaller corporations, smaller companies out of the market.  But I think that most people applaud this, because it drives the competition out of the market.

Are you afraid of the present situation, when some large companies, for example banks, are essentially forming coalitions with governments?  For example, the bank Goldman Sachs is literally famous for the high posts in the administration at which it manages to place its former employees…

Naturally, one of the ways of recapitalising banks is to create a monopoly.  And that is precisely what is now happening.  Banks are again becoming profitable – but at the cost of reduced competition in the banking sector.  And I think that this will not change in the future.

Are you in favour of including fluctuations in the prices of assets (stock, real estate…) in the calculation of price level growth?

No.  That idea is based on the thought that assets are transformed into future consumer goods.  But we must look at real commodities and at how they are being consumed now.

What do you make of mark-to-market accounting (based on market prices, note by L.K.)?  That, too, is allegedly one of the causes of the crisis?

I am in favour.  I am in favour of accounting based on market prices.  Because if we increase the non-transparency of the market, we naturally also increase costs (from the point of view of investors).  The mark-to-market criterion is good – if we really believe that prices are where they should be.

Nassim Nicholas Taleb, your “court critic” and one of the few prophets of the present crisis, calls you a parasite: the Black-Scholes Model is useless according to him; its utility has been significantly inflated.

I do not want to say too much, with respect to that gentleman.  Let us leave him to his wishes and ideas.

Why such slurs?

It may be because one of the students of my colleague, Robert Merton, discovered a really gross error in Taleb’s academic work.  He is most likely driven by an attempt at revenge.

I Can’t Shake that Murder Rap…

Eleven years ago, Myron Scholes nearly destroyed the world financial system.  Yes, it is an exaggeration, but only slight.  More precisely speaking, Scholes was one of the key destroyers.  We can also include in that destructive gang Robert Merton, another Nobel Prize Laureate for Economics, as well as John Meriwether, a former head of bond trading at the investment bank Salomon Brothers.  All of them got together in 1994 and established the Long-Term Capital Management (LTCM) hedge fund.  On the basis of complex mathematical models, they prepared a trading strategy and both Nobel Prize Laureates – allegedly too proudly, people said – added an aura of the utmost prestige and uniqueness to the fund.  Investors were hungry to put not insignificant amounts into LTCM; in February 1994, the fund was able to start trading with funds in excess of a billion of dollars, and in the first years of its existence, it was making sky-high sums through so-called convergence trades.

Most convergence transactions concerned government bonds (of the US, Japan, and European countries).  LTCM bought cheaper, so-called off-the-run bonds (for example a 30-year US bond payable in 29 and three quarter years), and speculated on the drop in more expensive, so-called on-the-run bonds (for example a recently issued thirty-year US bond).  The difference in the price of the two kinds of bonds, from which LTCM profited in a series of transactions, was based on the fact that recently issued on-the-run bonds are more liquid.  Because the difference was truly small, however, the transaction had to be done in a very large volume to be really profitable.  LTCM therefore leveraged itself, which means that it speculated with borrowed funds.

In early 1998, the fund’s equity capital was 4.72 billion dollars, whereas its debt was more than 124 billion dollars.  Off its balance sheet, the fund also speculated with interest rate derivatives (financial contracts whose cash flows depend on the fluctuations of a given interest rate) and other assets, in a nominal sum of 1.25 trillion dollars.

The year 1997 was already problematic for LTCM, primarily in connection with the Asian financial crisis.  But the lethal blow came in the summer of 1998, when the Russian government declared insolvency.  Investors all over the world panicked, started to sell Japanese and European bonds, and only purchased the safer ones, i.e., US bonds.  Instead of the prices of bonds with a slightly different maturity date converging – on which the strategy of convergence transactions was built – they started to diverge in the chaos that followed.  But Scholes’ mathematical models had not anticipated that!  Because of the enormous leveraging of the fund, it was not profits that were multiplied in gigantic proportions now, but losses.  By the end of August 1998, LTCM had lost nearly two billion dollars in capital.  Because of the enormous leveraging, and also because of the tight connection with the largest banks and other financial institutions, a collapse threatened not only LTCM, but the entire global financial system.

The US central bank entered the situation, more precisely its New York branch, and together with the largest banking houses of the time – including Goldman Sachs, JP Morgan, Merrill Lynch, Morgan Stanley, UBS, and others, it gave the fund a bail out totalling over 3.6 billion dollars.  Only the investment bank Bear Stearns refused to participate in the rescue project.

“I feel like that woman whom people will forever connect with a single sentence from the news in a local paper: “Mrs. Jones, who was falsely accused of having killed her husband with an axe in 1994, recently held a garden party for ten”, says Myron Scholes, in trying to get over the fact that the general public will probably forever remember him as the proud Nobel Laureate who nearly destroyed the global financial system.  The fall of LTCM shows the fatal danger of enormous leveraging.  But in the same breath, we must add that in this regard, LTCM is rather the proverbial exception that proves the rule, a sort of an unfortunate “Titanic” of the financial markets.  Whereas it was leveraged up to 25 times, normal hedge funds invest with leveraging lower than a ten-times multiple of their equity capital, as economist Franklin Edwards states in his 1999 study Hedge Funds and the Collapse of Long-Term Capital Management.  According to the economists Barry Eichengreen and Bokyeong Park, and their 2002 study Hedge Fund Leverage Before and After the Crisis, at the time of the collapse of the LTCM, 74 percent of hedge funds invested with a leveraging that did not reach even a two-times multiple of their equity capital.

In spite of that, hedge funds are blamed – primarily by politicians – for the financial crisis.  They are a thorn in their eyes primarily because they are not too regulated.  “Watch carefully what I am saying: you will see tighter regulation,” said Poul Nyrup Rasmusen, the head of the Party of European Socialists, to the funds this June.  “Come out of your jungle.  What are you afraid of?  You can still make money even on thoroughly regulated markets.”

The interview, obtained in Bratislava, was published in the Týden No. 22 on 1 June 2009.

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