Inventing Money provides a short history of the Long Term Capital Management debacle, from the financial theories which gave it wings, to the financial markets which ripped those wings apart in 1998. Fischer Black, Myron Scholes, and Robert Merton (Jr) developed a quantifiable option pricing algorithm in the 70's. Previously, economists created useless algorithms which required some subjective valuation of market sentiment; this trio noticed that this sentiment indicator was superfluous, options could be priced by knowing the price volatility of the underlying asset, the riskless rate of interest, and the duration of the option (with future price volatility being estimated by historical volatility). Armed with this better pricing information, mathletic financial analysts started wiping the market floors with traders who were mis-pricing by "gut" instinct.

This pricing advantage was based on a significant barrier to entry, due to the requisite analysis. But, if the competition is mis-pricing assets, an above-average rate of return can be made by arbitraging the mis-price being offered and the more informed price, as the prices will converge at some point. This sparked an arms race between investment banks as they sought analytic talent to prevent their own mis-pricing and to take advantage of others' mistakes. In 1993, the original trio got together with John Meriwether (Wall Street trader) and started LTCM. The social stature of this group allowed LTCM to acquire a large investment base and, more importantly, enabled LTCM to borrow cash at lower rates than most of its competitors. This cheap cash fueled LTCM's lucrative arbitrage operations, as LTCM was able to cheaply leverage the returns on its investments. The bad thing about leverage is that if risks aren't managed, leverage can wipe out equity in a heartbeat (or two months for LTCM). In 1998, the global markets went ape because of Russia's sovereign debt default, and the Pacific Rim collapses (Thailand, S. Korea). This increase in global volatility forced a very large amount of LTCM's very leveraged investments to go against them, which triggered margin calls on their accounts, forcing them to sell assets at a loss. As the market volatility increased, LTCM was forced into a death spiral of sell-offs, which quickly ended in bankruptcy. The worst part of this was that they had seen the global market volatility rising drastically, but didn't maintain the cash reserves needed to weather the storm, instead they chose to use their cash reserves, believing that their intelligent trades could weather the storm.

Hard to believe that one bad call can vaporize $4B, but that's what happened.

Abraham Maslow has his hierarchy of needs, firms appear to have their own (no cute pyramids here):

Cash
Profits
Defensible Profits

Firms need cash to survive in the short run (LTCM); in the medium run, they need to have profits (dot-bombs); and in the long run, they need to be able to defend profits from other organizations that will attack their markets (Bell). Just like humans, firms need to be aware of where they are in terms of their needs.

Also, Nathan Walker's blogging. Nathan and I went through some bad hijinx in college, so now I'm relieved he's still writing and alive, even though I feel louche for thinking that, cause surely he'd be fine. Regardless, I'm happy to read his blog.

Randomized spam is fun; it reminds me of David Bowie's Behind the Music, where he's just mangling found phrases. My random spam winners are: "courtroom cowhand", "popularized boredom", and "bray postoffices". One of the best and worst things about humans is their ability to see patterns in anything.