“Warren Buffett uses what he calls weapons of mass destruction,” says ROBERT MERTON, Nobel Prize Laureate in Economics and one of the men behind the fallen Long-Term Capital Management Fund.
John Meriwether, with whom you built the hedge fund Long-Term Capital Management in the Nineties (its collapse in 1998 nearly destroyed the world financial system, note by L.K.), is establishing another hedge fund. Are you planning to do something similar?
No. Don’t misinterpret it; I have nothing against hedge funds. But I am doing something completely different at the moment: I am trying to design an efficient pension system for future generations. It is intellectually demanding: it is a combination of an interesting and demanding task with a potentially large impact. Of course, if it is applied, I would have decent money from it.
Many politicians count hedge funds among the culprits of the present crisis. Last autumn, speculations on declines (See Dangerous “Shorting”) were banned in several countries, including the United States, which the funds used a lot. What do you think of that?
The ban on short sales was a very bad idea. It made markets inefficient. “Shorting” was, of course, abused here and there, but there is no reason to ban it altogether. When someone drives on the highway under the influence of drugs and is endangering others, does that mean that we will prohibit cars? Short sales make prices on the markets more precise and give them a greater telling value, in the sense that they better reflect the actual value of the given asset. Companies traded on the stock exchange are required by law to report negative news. But there is also news which is only negative in part, or whose negativity only becomes apparent later. If a “short” seller thinks that that will happen, and therefore considers the present prices excessive, he is taking on a risk in any event – he is betting on the news that the report will indeed turn out to be negative. And the “long” purchaser does the same – he is speculating on a rise. He is buying stock because he thinks that the news will not turn out to be negative or that other information will prove to be positive. Both speculators, on a decline and a rise, are risking – they are the reverse sides of the same coin. And if they have the right estimate and the stock indeed goes in the direction on which they are betting, they make money. Otherwise they lose.
CEOs ARE OFF. “Bank CEOs, managers, and the boards of directors of financial institutions do not understand derivatives or the risk connected to the securities,” says Robert Merton.
So why were short sales in particular banned?
Understandably, nobody is complaining about long purchases; speculation on a rise drives prices up. Large bankers simply got together and slammed their fists on the table: short sellers are sharply decreasing the stock of our banks! But those declines were not caused by speculators on a decline, but by the fact that the banks had assumed too great a risk, which continued to grow. In the end, it turned out that short sellers had estimated the situation correctly. “Shorting” does not cause a distortion in prices, as bankers had claimed, because the growth of stock prices would have been distorted just the same. But nobody minds that upward “distortion”, as I have already said.
For example, the ex-Prime Minister of Malaysia, Mohamad bin Mahathir, still accuses hedge funds of having caused the Asian crisis at the end of the 1990s by manipulating with the market and speculating on a decline. Is that possible?
Let us assume, entirely hypothetically, that several companies agreed to send prices down, for example by using a self-fulfilling prophecy – which is, by the way, a term coined by my father (the major sociologist Robert K. Merton, note by L.K.). But how to do it? When they artificially pull prices down, and that drop in price is not justifiable, buyers will naturally appear very quickly to buy the undervalued share. In the end, attempts to manipulate the market are very costly, as was shown in the past for example by the case of the Hunt brothers (Nelson and William; they bought silver in the Seventies to gain control over the world supply of the metal; in 1988, the first of them declared bankruptcy, note by L.K.). They did themselves in by trying to manipulate the silver market. Manipulating markets is not easy. They are large and there are many players.
Are you, therefore, against regulation and government intervention into financial markets?
No. I recognise three basic institutions: the government, the private sector, and the family. Take, for example, the “pension system”, which functioned well on the family basis, as long as people were living primarily in the countryside and worked on farms and in agriculture. They had many children, who took care of them in old age. But with the industrial revolution, with the move of people to cities, that became no longer possible, and institutions had to be adapted.
Do you agree with stricter regulation in response to this crisis, then?
Primarily, I do not put on ideological glasses in the style of: either the government or the market. People who go to extremes almost never find the right answer. On the other hand, Paul Samuelson, from whom I have learned a lot, used to say that the stock market can predict seven recessions out of five. Markets are simply unpredictable. Furthermore, militant proponents of regulation think that the regulator knows everything better than the market. But I think that the financial system does indeed need certain changes in regulation. But I am looking with hesitation at how the reform is being conducted.
What is it you mind?
Two things. I think that a lot of relevant regulation is being prepared in too much of a rush. One of the reasons is that politicians fear the deepening of the crisis and want to intervene quickly; the other is that they only want to show the world that they are doing something. When people are dismayed by a difficult economic situation and on top of that have the impression that politicians are not doing anything about it – even if doing nothing or only making slow, considered interventions were the best things to do – it does not look good in terms of the reputation of politics. But I am not saying that it is not understandable; I am only saying that new legislation is being done hastily.
Robert C. Merton (65)
“The Newton of modern finance” – that is what his teacher Paul Samuelson, one of the most significant 20th-century economists, calls Merton. Merton himself is a member of an elite club: in 1997, he, together with Myron Scholes, got the Nobel Prize in Economics. Only a year later, however, their names were mentioned with negative connotations – their Long-Term Capital Management hedge fund, whose trading strategies both of them helped create, painfully collapsed. Merton is the son of a famous sociologist of the same name, now deceased, who is the author of many concepts today used by economists (and others) – such as “self-fulfilling prophecy” and “unintended consequences”, and others. Merton drives an XJR Jaguar.
I also do not like that Congress determines very precisely, specifically and in needless detail what the rights and obligations of market players are. Markets are comprehensive systems, and very targeted legislation is usually not useful. It is better – only in principle – to formulate a certain intention and to appoint authorities to oversee the general efforts in that direction. If legislation is too specific, a problem arises with unintended consequences, which is, by the way, another broadly used term coined by my father. The problem is such that when lawgivers focus on resolving one specific shortcoming, they may find a specific solution, but the new legislation is influenced – often adversely – by a number of other areas that give rise to new shortcomings. That happened in the past and will continue to happen in looking for solutions to the present problems – it is inevitable. If you, for example, ban the so-called “shorting”, what will happen to the sale of call options or buying of put options? In principle, that is the same. Will you also ban them?
Are financial market derivatives (securities tied to the values of other securities, commodities, indices, or, for example, rates, note by L.K.) a weapon of mass destruction, as Warren Buffett says?
Let’s analyse it. First, Buffett has bitter experience with derivatives: one of the divisions of his insurance company subscribed long-term guarantees on derivatives years ago. He then tried to liquidate it, but it cost him lots of money. And Buffett himself issued derivatives worth billions of dollars in off-exchange sales; he subscribed put options. His Berkshire Hathaway uses derivatives; it has no problem with them. Second, he would probably, given that he himself subscribed billions of those securities, not say that Berkshire Hathaway is therefore using weapons of mass destruction.
Are they harmless, then? Some blame the crisis on them, in part – that is, on some kind of them.
No financial institution in the world, including central banks, can function without using derivatives. There are some 500 to 600 trillion dollars in derivatives all over the world today. They are like cars – the system cannot function without them. But it depends on how they are used. Can they be abused? Of course! Have there been abuses? Of course! Through them, however, banks can share the risk of interest rates, currency risk, and credit and commodity risks. They therefore contribute to a globally efficient distribution and transfer of risk. Without them, the financial market would not be functional.
Why are they connected to the crisis so much?
The problem is that the CEOs, senior managers, and boards of directors of financial institutions, and also regulators, do not understand derivatives in their full breadth. They do not understand the risks connected with them. When you then present analyses to them and they have to decide, they cannot see everything. These people often lack the required knowledge.
And their subordinates – brokers – are they more educated in this regard?
Specialised brokers certainly understand derivatives better. But that is not the kind of knowledge I am talking about – I do not mean brokers’ expertise. I will give another example. I have a portfolio of mortgages, mortgages which are being paid. So at first sight, everything is all right. But I can also see that real estate prices are going down, for example they have come down by ten or fifteen percent, and those real properties serve as collateral on those mortgages. Then I know, or rather I should know, two things: that the value of mortgages should go down, although they are still being repaid. And secondly, the risk involved in them is now higher than it used to be. That is the type of knowledge that senior managers often lack. They say: “People are paying their mortgages, everything is all right.” It is not. Not necessarily.
While we are on these managers: some economists argue that banks are now too large for it to be possible to manage them well.
That is another matter. I am talking about derivatives, and you are talking about a far broader problem. That is too general a conclusion; and if it is the case, their reduction, split-up into several parts, should not be determined by legislation.
Do you, however, not fear consolidation in the sector? The lucrative sphere of investment banking is now, due to the crisis, shared primarily by only two banks: Goldman Sachs and JP Morgan Chase.
In the short term, that is definitely the case – the profits of Goldman and JP Morgan are now due to several phenomena: the markets are reviving and hedge funds and other financial institutions – also large banks such as Morgan Stanley, UBS, Deutsche Bank – have to a large extent left those markets. Although in the short-term, the two banks will profit greatly, I do not believe that it will stay that way forever. Morgan Stanley and other institutions can get back into the business – they have simply decided to interrupt their engagement for some time due to a lack of capital. And besides, it is also possible to launch a hedge fund, for example, and compete with the two. What stands in the way of that?
For example the excellent connections that “the Goldmans’” have with the US administration, which are now frequently discussed.
Many think – I do not say that I entirely agree – that Goldman Sachs now has in fact fewer opportunities for further expansion. Last year, the institution became a bank, so it is subject to more restrictions than when it was an investment bank. For example, it is now subject to capital adequacy requirements, and others.
What do you make of the critics of the Black-Scholes Model (sometimes referred to as the Black-Scholes-Merton Model – a famous model of asset valuation that Merton helped develop, note by L.K.) such as Nassi Nicholas Taleb?
When you really focus on what Taleb proclaims, you will find out that he is not saying that much. The Black-Scholes equation is a very special case. It is elegant in the sense that it can be easily calculated. It has been used for forty years. Not in trading any more (for that, it is too simple) but still in accounting, for example. But it has always only been a symbol for the deeper “philosophy” that is behind it.
Bad models – including “yours” – are to blame for the crisis, says Taleb.
Every model, not only mathematical, is incomplete, because it is a simplification of reality that looks away from its complexity. That means that models have their limits. In order to be able to use them, one must be familiar with that limitation. I will give you another example. Last December, I was flying to Geneva. There was snow everywhere, but the landing was perfectly smooth, the aircraft simply touched down as if into a cushion. The pilot got out of the cockpit and told us: “I must admit that I had nothing to do with the landing, it was all controlled by the computer.” But: would I fly with that plane without a pilot – only controlled by a computer? Not a chance. The computer is only an incomplete model of what can happen. When something happens that a model is not expecting, something that is not programmed in the computer, the pilot must intervene. The pilot, therefore, must know precisely what is in the computer and what is not – he must know the limits of the model. People and models are communicating vessels, which cannot be separated. This also applies to models for the valuation of financial assets.
While we are on flying… I have heard that your first scientific paper was not on economics at all, but on literature – it dealt with a flying island.
That is true. I think that in 1966, I wrote an essay for the Journal of the History of Ideas, in which I analysed, from the point of view of physics, the impossibility of the existence of the flying island described in Swift’s classic – Gulliver’s Travels (laughs).
In September 2008, speculation on a decline (also called short sales, i.e., “shorting”; for example the sale of borrowed stock, on the assumption that it will be possible to buy it back in the future at a lower price and return it) was prohibited in many world markets (e.g., in the USA, Australia, and the United Kingdom), especially with financial titles. In doing so, regulators referred to the thesis that speculations on a decline accelerate the drop in stock prices, in particular those of financial companies.
For example, the US administration banned “shorting” on 799 selected stock-exchange titles last September. This was not the first time it did so. As Murray Rothbard describes in his 1963 book America’s Great Depression, the government went on a campaign against the “short” sellers of flour during the Great Depression, in 1931. “Speculators on a decline were accused of being the initiators of the price slides and erosion of faith in the markets,” he writes. “The intention of ‘profiting from the losses of others’, of which they were accused, is indeed curious, if we realise that there must be, for each short seller, a long buyer, that is, someone who is speculating on the increase of prices,” explains Rothbard. He adds that the government campaigns orchestrated by President Hoover in the end led to prices that were even lower than there would have been without the ban. This was due to the fact that the collecting of profits by short sellers (purchases of lower-price stock) is the key braking force at times of price declines.
The interview, obtained in Boston, was published in Týden No. 45 on 9 November 2009.