WEBVTT - The Nobel Winners Who Almost Crashed the Economy 0:00:17.560 --> 0:00:21.479 Pushkin too quick. No, it's perfect push kid stuff. You 0:00:21.600 --> 0:00:33.200 got it. 0:00:35.000 --> 0:00:37.239 You can take me back to the nineteen nineties, baby, 0:00:37.440 --> 0:00:38.120 and then. 0:00:38.040 --> 0:00:39.840 The seventies and then the nineties. 0:00:40.920 --> 0:00:42.440 Okay, Robert Smith. 0:00:42.480 --> 0:00:44.360 This is a story about some of the smartest people 0:00:44.400 --> 0:00:47.960 in the world, incredibly successful in their fields. They decide 0:00:47.960 --> 0:00:50.880 to come together start a new thing, and they are 0:00:50.920 --> 0:00:54.760 so successful they make billions of dollars. They win the 0:00:54.800 --> 0:00:57.720 Nobel Prize as they are making billions of dollars, and 0:00:57.760 --> 0:01:02.600 then the next year they get destroyed, and in fact, 0:01:02.600 --> 0:01:04.800 they get destroyed so hard that they almost take the 0:01:04.840 --> 0:01:06.480 global economy down with them. 0:01:06.520 --> 0:01:10.240 I'm Jacob Goldstein, I'm Robert Smith, and this is Business. 0:01:09.440 --> 0:01:13.320 Sure, the history of business today on the show, the 0:01:13.479 --> 0:01:15.520 story of long Term capital Management. 0:01:15.680 --> 0:01:17.520 Wooh, you are so amped for this. 0:01:17.680 --> 0:01:20.680 The mid nineties, the Cold War has just ended, free 0:01:20.720 --> 0:01:23.759 market capitalism is triumphant, and the. 0:01:23.720 --> 0:01:27.480 Economy was fantastic in the nineteen nineties, best economy, my 0:01:27.560 --> 0:01:31.319 favorite economy. And the people who started Long Term Capital 0:01:31.360 --> 0:01:33.440 Management looked at the economy not just in the US 0:01:33.480 --> 0:01:35.200 but around the world, and they said, yes. 0:01:35.360 --> 0:01:38.480 Yes, this is the moment we've been waiting for. We 0:01:38.520 --> 0:01:42.520 are going to ride this global capitalism wave, and they did. 0:01:43.160 --> 0:01:45.600 What they did not know was that that wave was 0:01:45.640 --> 0:01:49.000 about to crash. Let's start before the nineteen nineties. Let's 0:01:49.360 --> 0:01:53.120 let's let's start in the nineteen eighties, the early eighties, 0:01:53.400 --> 0:01:55.480 Go Go Go all the street with. 0:01:55.400 --> 0:01:59.120 A bond trader named John Merriweather. Meriweather had grown up 0:01:59.760 --> 0:02:03.160 working class South side of Chicago, worked as a golf 0:02:03.200 --> 0:02:05.440 caddy as a kid that was like his you know, 0:02:05.640 --> 0:02:08.280 path up old school, got his MBA at the University 0:02:08.320 --> 0:02:10.920 of Chicago, and in the mid seventies he went to 0:02:10.959 --> 0:02:15.440 work at Solomons and Solomon Brothers was about to become 0:02:16.000 --> 0:02:20.120 the heart of nineteen eighties Masters of the Universe. Wall 0:02:20.160 --> 0:02:24.960 Street Bonfire the Vanities was based on Solomon Brothers. Michael 0:02:25.000 --> 0:02:27.440 Lewis and Liar's Poker wrote about Solomon Brothers. It was 0:02:27.440 --> 0:02:29.560 where he worked right out of college in the eighties. 0:02:29.840 --> 0:02:33.800 And a key thing to know is at this time 0:02:34.639 --> 0:02:38.640 the kind of legendary traders at Solomon Brothers were like, 0:02:38.919 --> 0:02:44.280 very rough, They were street smart. They ate cheeseburgers for breakfast. 0:02:44.360 --> 0:02:47.880 They traded, you know, based on their cheeseburger filled guts. 0:02:48.560 --> 0:02:51.640 And Michael Lewis wrote beautifully about these guys in Liar's Poker, 0:02:52.160 --> 0:02:56.400 most famously about a trader named Louis Raniery. Louis Raniery 0:02:56.440 --> 0:02:58.560 started out in the mailroom. He was from Brooklyn. He 0:02:58.600 --> 0:03:01.040 worked his way up and Robert, I want you to 0:03:01.080 --> 0:03:04.959 read one sentence from Liar's Poker that describes the life 0:03:04.960 --> 0:03:07.680 of a guy who worked with Ranier and just captures 0:03:07.720 --> 0:03:08.280 this culture. 0:03:08.680 --> 0:03:11.760 At Solomon Brothers, he traded bonds while being hollered at 0:03:11.800 --> 0:03:15.800 by six salesman, eating a morning cheeseburger, and watching Ranieri 0:03:15.919 --> 0:03:18.640 hold a big lighter under the balls of a fellow trader. 0:03:20.080 --> 0:03:21.160 I wasn't prepared for that. 0:03:23.480 --> 0:03:26.799 This, this is Slivin Brothers. At this time, you don't 0:03:26.840 --> 0:03:32.000 see the lighter coming. John Merriweather was not this kind 0:03:32.040 --> 0:03:35.040 of guy. He was working class, but he was calm. 0:03:35.120 --> 0:03:38.400 He was even tempered. He didn't yell, didn't hold big 0:03:38.480 --> 0:03:42.760 lighters under his colleagues balls, but he did love to 0:03:42.840 --> 0:03:46.000 take risks. He was a trader at heart, and he 0:03:46.080 --> 0:03:48.040 was really good at it. And he got promoted and 0:03:48.080 --> 0:03:51.080 he started running a desk, which meant he had to 0:03:51.200 --> 0:03:54.360 hire people to come work with him. Higher traders. And 0:03:54.440 --> 0:03:58.680 this is when he has his big idea. For the 0:03:58.680 --> 0:04:00.560 past decade or so. By this point, this is the 0:04:00.560 --> 0:04:04.680 early eighties, professors at places like MIT and the University 0:04:04.720 --> 0:04:09.640 of Chicago had been developing these really mathematical theories of 0:04:09.800 --> 0:04:11.320 finance about prices. 0:04:11.480 --> 0:04:11.640 Right. 0:04:12.000 --> 0:04:15.160 Some of this had filtered into Wall Street, but not much. 0:04:15.360 --> 0:04:18.239 It was an academic endeavor. They had found data sets 0:04:18.279 --> 0:04:19.960 and they were tracking the stock market, and they knew 0:04:20.000 --> 0:04:22.360 there was money involved, but they were doing it to 0:04:22.360 --> 0:04:25.839 pass their dissertations, not necessarily to like blow up the market. 0:04:25.960 --> 0:04:29.240 Yeah, and still the culture on Wall Street was this 0:04:29.480 --> 0:04:34.640 very kind of cheeseburgers for breakfast culture, not an academic culture. 0:04:35.400 --> 0:04:41.640 But Merriweather's idea was basically, oh, maybe these nerds know 0:04:41.760 --> 0:04:44.520 what they're talking about, you know, like maybe they could 0:04:44.560 --> 0:04:47.200 actually come to Wall Street. We could do a bunch 0:04:47.240 --> 0:04:50.400 of math and make money. And so he decides to 0:04:51.080 --> 0:04:54.360 test this theory, starts hiring a bunch of you know, 0:04:54.520 --> 0:04:57.520 guys with PhDs from a MIT and they come work 0:04:57.560 --> 0:04:58.799 with him at Solomon Brothers. 0:04:58.960 --> 0:05:00.920 He's like, stay away from the guy with a big light. 0:05:01.640 --> 0:05:05.279 Yeah, and it's unsurprising now now, if you have a 0:05:05.279 --> 0:05:08.640 PhD from MIT, the easiest thing to do is not 0:05:08.680 --> 0:05:10.360 to be a professor, but to go work at Jane 0:05:10.400 --> 0:05:11.000 Street or some. 0:05:11.240 --> 0:05:17.279 Quant Yeah, they're actually recruiting at MIT in Stanford and Harvard. 0:05:17.400 --> 0:05:21.120 A banker who worked with Merriweather said, these guys that 0:05:21.160 --> 0:05:26.040 Merriweather is bringing in, these academics, were considered freaks. Here's 0:05:26.080 --> 0:05:27.360 a line, those. 0:05:27.160 --> 0:05:29.680 Guys would be playing with their slide rules at Bell 0:05:29.800 --> 0:05:31.280 Labs if it wasn't for John. 0:05:31.839 --> 0:05:36.000 Slide rules, slide rules. Three things about that quote. Those 0:05:36.000 --> 0:05:38.159 guys would be playing with their slide rules at Bell 0:05:38.240 --> 0:05:41.480 Labs if it wasn't for John. One, it comes from 0:05:41.760 --> 0:05:46.679 Roger Lowenstein's book When Genius Failed, excellent excellent nonfiction book 0:05:46.720 --> 0:05:49.680 about the rise and fall of long term capital management, 0:05:49.720 --> 0:05:54.240 the key source for today's show. Two, slide rules were 0:05:54.279 --> 0:05:58.520 what people used to do complicated math before graphic calculators 0:05:58.560 --> 0:06:00.520 came along. Scientific calculators I had. 0:06:00.320 --> 0:06:03.000 One, Yeah you would like actually move little little slides? 0:06:03.000 --> 0:06:04.719 And yeah in a little little clear window. 0:06:04.880 --> 0:06:09.680 I love that. And Three Importantly, this quote was an 0:06:09.680 --> 0:06:12.480 anachronism even in nineteen eighty three, because if they would 0:06:12.480 --> 0:06:14.680 not have been playing with slide rules, they would have 0:06:14.760 --> 0:06:18.280 been playing with computers. The rise of the computer is 0:06:18.320 --> 0:06:21.599 what empowers these people to do real work. 0:06:21.680 --> 0:06:23.400 I'm going to give you a number four too, because 0:06:23.440 --> 0:06:25.840 we're starting to see the shift in the economy. In 0:06:25.880 --> 0:06:28.520 this quote, they're not at Bell Labs anymore. They're not 0:06:28.600 --> 0:06:33.400 working for American manufacturing, an American invention, They're working for 0:06:33.440 --> 0:06:36.080 American finance. This is when we're seeing this big shift 0:06:36.080 --> 0:06:36.760 in the economy. 0:06:36.880 --> 0:06:40.520 Yes, financialization, financialization, the rise of Wall Street. 0:06:40.600 --> 0:06:40.880 Yes. 0:06:41.040 --> 0:06:44.040 And in fact, it's no coincidence that Jim Simons, who 0:06:44.080 --> 0:06:45.440 you did a show about. 0:06:45.160 --> 0:06:47.600 Who is a math PhD, who is a math PhD. 0:06:47.360 --> 0:06:50.799 Is starting his fund Renaissance Technologies right around the same time. 0:06:51.480 --> 0:06:55.920 So Meriweather brings the nerds to Wall Street and they 0:06:55.960 --> 0:06:59.839 work with him on what's called the arbitrage desk. Robert Smith, 0:07:00.520 --> 0:07:04.560 what's arbitrage? Sweet sweet free money? 0:07:04.800 --> 0:07:08.440 Arbitrage is this very specific idea in finance, and it's 0:07:08.480 --> 0:07:11.560 this very big idea and very simple idea I would say, 0:07:11.600 --> 0:07:16.360 which is is, if you can buy and sell the 0:07:16.440 --> 0:07:19.800 same thing at different prices, you can make money with 0:07:19.960 --> 0:07:25.080 almost no risk. So let's say silver is trading in 0:07:25.120 --> 0:07:27.280 New York at one hundred dollars and is trading in 0:07:27.320 --> 0:07:29.480 London at one hundred and one dollars. 0:07:29.560 --> 0:07:32.000 It's a very high price for silver. It's very exciting moment. 0:07:32.200 --> 0:07:34.840 Yes, you could buy the silver in New York for 0:07:34.880 --> 0:07:37.520 one hundred dollars and simultaneously sell it in London for 0:07:37.560 --> 0:07:39.400 one hundred and one dollars. You know, you don't have 0:07:39.440 --> 0:07:42.640 to ship it, and then you make a dollar profit. Yes, 0:07:42.800 --> 0:07:43.640 no work whatsoever. 0:07:43.760 --> 0:07:47.520 Yes, Now, arbitrage is like this tend to be hard 0:07:47.520 --> 0:07:50.200 to find because people arbitrage them away. When you buy 0:07:50.240 --> 0:07:52.360 the cheap one and sell the expensive one, you cause 0:07:52.400 --> 0:07:54.160 the prices to converge at. 0:07:54.120 --> 0:07:55.480 One hundred dollars and fifty cents. 0:07:55.560 --> 0:07:59.480 So the kinds of arbitrage is that Merriweather and his 0:07:59.600 --> 0:08:02.240 nerds are finding are a little more subtle, but they are. 0:08:02.240 --> 0:08:05.160 But they exist in the world. And these guys come 0:08:05.160 --> 0:08:08.240 in and indeed start making money, a lot of money. 0:08:08.480 --> 0:08:11.800 In some years, they account for most of Solomon's profits. 0:08:12.800 --> 0:08:15.360 And that might have been the end of the story. 0:08:15.440 --> 0:08:18.320 They might have just got rich on Wall Street, but 0:08:18.480 --> 0:08:22.680 for one thing in nineteen ninety one. So they've been 0:08:22.720 --> 0:08:26.480 at this for a while. They're doing well. Merriweather gets 0:08:26.560 --> 0:08:30.640 in trouble because a guy who worked for him rigged 0:08:30.880 --> 0:08:34.000 Treasury bond auctions and actually told Merriweather about it, and 0:08:34.040 --> 0:08:36.800 Merriweather told his boss, but they didn't do anything. They 0:08:36.839 --> 0:08:39.680 said on it. Sorry comes out, they lose their jobs. 0:08:39.880 --> 0:08:40.640 We talked about this. 0:08:40.600 --> 0:08:42.760 In the Warren Buffett Show because Warren Buffett was a 0:08:42.839 --> 0:08:45.080 huge investor in Salomon Brothers had to come in and 0:08:45.120 --> 0:08:46.719 run the company from Omaha. 0:08:46.880 --> 0:08:48.000 Yes, with all of these. 0:08:47.840 --> 0:08:50.240 New York traders, just to fix the reputation. 0:08:50.440 --> 0:08:52.599 Yes, so Merriweather, I think he resigned under pressure. I 0:08:52.640 --> 0:08:54.959 don't think Ashley got fired, but he's out. He's out. 0:08:55.400 --> 0:08:59.120 So he decides not long after that he wants to 0:08:59.840 --> 0:09:03.400 get his band of nerds back together, but not working 0:09:03.480 --> 0:09:07.000 for somebody else, not at a Wall Street firm. He 0:09:07.080 --> 0:09:11.439 wants to start a hedge fine. Ooh, wasn't his reputation 0:09:11.559 --> 0:09:14.760 bat well? I will know he didn't get fired for 0:09:14.800 --> 0:09:18.680 losing money. Yes, that fired for unethical laps and making 0:09:18.720 --> 0:09:20.160 a lot of fun making a lot of money. So 0:09:20.480 --> 0:09:23.040 o contrare ethical laps plus making a lot of money. 0:09:23.679 --> 0:09:26.360 Perfect, And so he decided to start a hedge fund. 0:09:27.040 --> 0:09:29.920 In nineteen ninety three, hedge funds were not that popular, 0:09:30.280 --> 0:09:34.280 but there was this idea which was you could have 0:09:34.320 --> 0:09:37.840 a fund that was not correlated to the market, and 0:09:37.880 --> 0:09:41.400 this was very useful because you would make money on stocks, 0:09:41.440 --> 0:09:44.160 but you're worried about losing money, so you put a 0:09:44.200 --> 0:09:46.280 fraction of your wealth into a hedge fund and they 0:09:46.320 --> 0:09:49.720 would do sophisticated mathematical things to make sure that if 0:09:49.760 --> 0:09:52.319 the market were to crash, you wouldn't lose all your money. 0:09:52.360 --> 0:09:53.960 That was the hedge part. That's the hedge right. 0:09:54.000 --> 0:09:56.000 They make different kinds of bets, so it's not just 0:09:56.120 --> 0:09:58.160 market goes up, you make money. Market goes down, you 0:09:58.240 --> 0:10:00.840 lose money. This was the original idea. Hedge funds had 0:10:00.840 --> 0:10:03.280 been around for decades by this point. By the time 0:10:03.320 --> 0:10:05.240 Merriweather comes along and the Nine Days, not all hedge 0:10:05.240 --> 0:10:08.200 funds are even hedged. The main thing they are is 0:10:08.280 --> 0:10:12.720 special funds for rich people and institutions that charge high fees. 0:10:13.920 --> 0:10:18.000 And Meriweather decides he's going to launch the biggest hedge 0:10:18.000 --> 0:10:21.280 fund ever. And in order to launch the biggest hedge 0:10:21.280 --> 0:10:23.400 fund ever and to charge higher fees than usual, which 0:10:23.400 --> 0:10:26.600 is also part of his plan, he needs to nerd up. 0:10:26.800 --> 0:10:29.520 He needs to go even nerdier than before, and he 0:10:29.640 --> 0:10:34.199 goes and recruits two professors. Two super nerds who are 0:10:34.200 --> 0:10:37.319 going to make his dreams come true. They are Robert 0:10:37.400 --> 0:10:41.520 Merton and Myron Scholes. Merton was a Harvard professor who 0:10:41.640 --> 0:10:45.600 was sort of the father of the finance math nerds 0:10:46.160 --> 0:10:50.160 in Shoals. Scholes was at Stanford and hiring Shoals was like, 0:10:51.200 --> 0:10:53.600 I couldn't quite nail this one. It was like hiring 0:10:53.640 --> 0:10:57.280 doctor band aid for your hospital or I don't know it. 0:10:57.320 --> 0:11:01.920 Because Schole's name was on this famous equation that was 0:11:02.000 --> 0:11:04.640 widely used in finance. Shouls and another guy, Fisher Black 0:11:04.640 --> 0:11:07.800 had come up with Black Shoals, an equation that I 0:11:07.840 --> 0:11:08.840 know is dear to your heart. 0:11:09.080 --> 0:11:12.160 Yeah, if you know anything about finance, Matthew, you know 0:11:12.200 --> 0:11:15.800 the Black Shoals formula. And what they did was solve 0:11:15.960 --> 0:11:20.120 this classic problem in finance, which is how to price 0:11:20.559 --> 0:11:24.600 an option. So an option is a contract between two 0:11:24.640 --> 0:11:27.880 people that essentially says I have the right to buy 0:11:27.920 --> 0:11:30.840 something you own in the future at a certain price 0:11:30.880 --> 0:11:32.959 at a certain price. So Jacob's, you know, all in 0:11:33.280 --> 0:11:36.440 on SpaceX and I I'm a little bit wary, So 0:11:36.480 --> 0:11:39.640 I say to him, I want the right to buy 0:11:39.679 --> 0:11:43.200 SpaceX at two hundred dollars in six months. Okay, that's 0:11:43.200 --> 0:11:46.960 a normal contract. But how much should I pay Jacob 0:11:47.120 --> 0:11:49.160 for that right to buy it in the future, the right, 0:11:49.240 --> 0:11:52.400 but not the obligation right. And so people had used 0:11:52.400 --> 0:11:55.720 their guts, they essentially guessed what this was worth. And 0:11:55.840 --> 0:12:00.920 what Shoals and Black and Merton did was come up 0:12:00.960 --> 0:12:03.880 with this way to essentially price the future in the 0:12:03.920 --> 0:12:09.400 present by creating a little insurance portfolio. Theoretically, yeah, the 0:12:09.400 --> 0:12:12.400 way you predict future risk now is through essentially an 0:12:12.400 --> 0:12:16.760 insurance contract. So now Meriwether has Merton and Shoals. He 0:12:16.800 --> 0:12:18.640 also hires a guy who had worked at the FED. 0:12:18.760 --> 0:12:23.160 It's incredible team, and history, in a really profound way 0:12:23.920 --> 0:12:28.720 is on their side. Like, think about this moment. It's 0:12:28.960 --> 0:12:33.760 nineteen ninety three. Communism fell, you know, the Soviet Union 0:12:33.920 --> 0:12:37.400 just fell apart. The Cold War is over, and it's 0:12:37.480 --> 0:12:43.520 clear right free market capitalism one command and control communism lost. 0:12:43.880 --> 0:12:47.240 Even Russia at this point is becoming a market economy. 0:12:47.440 --> 0:12:50.400 And there's this famous, kind of controversial book that has 0:12:50.440 --> 0:12:52.080 just come out around this time that kind of nails 0:12:52.080 --> 0:12:54.199 this moment, a book with the title that people love 0:12:54.240 --> 0:12:57.640 to mock. The title was The End of History was 0:12:57.640 --> 0:13:00.480 by a professor named Francis Fukuyama, and let me just 0:13:00.520 --> 0:13:02.640 say he didn't actually mean the end of history the 0:13:02.640 --> 0:13:04.600 way people who mocket say. 0:13:04.640 --> 0:13:06.439 Things would still happen. Things would still happen. 0:13:06.480 --> 0:13:09.760 His argument was, there has been this long arc of 0:13:09.840 --> 0:13:13.560 humanity figuring out how to organized people in economies, you know, 0:13:14.080 --> 0:13:18.920 monarchical feudalism, and we had communist dictatorships, and now in 0:13:18.960 --> 0:13:22.680 the nineties we have arrived at a winner free market 0:13:22.679 --> 0:13:25.040 capitalism and liberal democracy. 0:13:25.240 --> 0:13:27.480 And if you think all the other countries in the 0:13:27.480 --> 0:13:31.479 world are going to become more like the US, more efficient, 0:13:32.160 --> 0:13:33.360 then you can make bets on that. 0:13:33.760 --> 0:13:36.319 This is the world that Merton and Shoals have been 0:13:36.360 --> 0:13:41.199 doing their math for the rational so called rational if 0:13:41.200 --> 0:13:44.200 you like, world where the market becomes more efficient, where 0:13:44.240 --> 0:13:47.400 prices more and more closely reflect fundamentals. 0:13:48.000 --> 0:13:51.160 This is their moment. The world is breaking their way. 0:13:51.400 --> 0:13:54.600 And so when Merton and Shoals and Meriwether go out 0:13:54.600 --> 0:13:59.240 to pitch their fund the world wants in. Italy's Central 0:13:59.280 --> 0:14:03.600 Bank invests, the biggest investment bank in Brazil invests. Money 0:14:03.640 --> 0:14:07.480 is coming in from Japan, from Taiwan, from Kuwait, from 0:14:07.559 --> 0:14:11.160 Wall Street. Phil Knight, founder of Nike invests Michael Ovitz. 0:14:11.400 --> 0:14:16.160 Avitz don't know Ovits Hollywood superagent invests. You know all 0:14:16.360 --> 0:14:22.200 Meriweather raises over a billion dollars, which was a hedge fund. Ever, 0:14:22.720 --> 0:14:26.520 and in February of nineteen ninety four they launch Long 0:14:26.600 --> 0:14:30.200 Term Capital Management becomes a thing. They got an office 0:14:30.520 --> 0:14:34.160 in Greenwich, Connecticut. Of course, they got like forty people, 0:14:34.240 --> 0:14:36.600 and they got a bunch of computers and they are 0:14:36.680 --> 0:14:40.280 ready to start making money. We're going to run an 0:14:40.320 --> 0:14:42.680 ad now. If you don't want to hear ads, you 0:14:42.680 --> 0:14:46.880 can join Pushkin Plus at pushkin dot fm, slash plus. 0:14:47.160 --> 0:15:09.840 We'll be back in a minute. 0:15:11.160 --> 0:15:14.240 The ads are over. We're going to talk about one 0:15:14.280 --> 0:15:17.040 of the first big trades they did at Long Term 0:15:17.040 --> 0:15:21.480 Capital because it explains the basic way that the firm worked. 0:15:22.200 --> 0:15:25.960 So the traders at the firm saw this gap, this 0:15:26.120 --> 0:15:31.000 price gap basically an arbitrage opportunity, and what it was 0:15:31.000 --> 0:15:34.960 was a gap in the price between newly issued thirty 0:15:35.040 --> 0:15:36.200 year treasury. 0:15:35.760 --> 0:15:37.920 Bonds fresh it could still smell the inc. 0:15:38.000 --> 0:15:42.120 Us government debt and thirty year treasury bonds that had 0:15:42.200 --> 0:15:45.360 been issued just a few months earlier. So this is 0:15:45.440 --> 0:15:50.840 basically the same thing. But there was an unusually large 0:15:50.920 --> 0:15:53.080 gap between the prices of the two of them for 0:15:53.240 --> 0:15:55.840 sort of kind of regulatory reasons about the way Wall 0:15:55.880 --> 0:15:58.240 Street had to work. The key thing is it was 0:15:58.320 --> 0:16:01.000 clear that this gap should close over time. It was 0:16:01.400 --> 0:16:04.920 bigger than made sense. So this is perfect for the nerds. 0:16:05.160 --> 0:16:08.680 It's an irrational gap on really safe assets. They don't 0:16:08.720 --> 0:16:11.240 have to bet on whether you know the treasury market 0:16:11.280 --> 0:16:13.360 is going to go up or down. They just have 0:16:13.440 --> 0:16:16.800 to bet that this irrational price gap is going to close, 0:16:16.920 --> 0:16:18.880 and it almost certainly will close. 0:16:19.000 --> 0:16:21.040 This is the age of rationality. Of course it's going 0:16:21.120 --> 0:16:23.040 to close, and they can help it do that. 0:16:23.520 --> 0:16:27.120 The only problem is that the gap between the prices 0:16:27.240 --> 0:16:30.120 was really small. It was like one and a half percent. 0:16:30.760 --> 0:16:33.800 So even if the gap closes entirely, and it might 0:16:33.840 --> 0:16:36.200 not do that, the most they could make is ish 0:16:36.720 --> 0:16:38.640 one and a half percent too low. 0:16:38.720 --> 0:16:39.360 That's too low. 0:16:39.440 --> 0:16:42.240 Yes, you're not starting this great hedgehunt with a billion 0:16:42.280 --> 0:16:44.640 dollars for a return like that. So you have an 0:16:44.680 --> 0:16:48.400 investment that you're very confident in, it's a smaller intern. 0:16:49.080 --> 0:16:49.600 What do you do. 0:16:50.240 --> 0:16:55.040 You lever up. You borrow money. You borrow massive amounts 0:16:55.040 --> 0:16:58.240 of money because when you borrow money, you can turn 0:16:58.320 --> 0:17:03.280 a tiny percentage increase into a large percentage increase. Yes, 0:17:03.600 --> 0:17:05.960 let's do the math. Okay, give it to me. Okay. 0:17:06.040 --> 0:17:09.639 So if I have a million dollars and it's going 0:17:09.679 --> 0:17:13.080 to return one percent, that's ten thousand dollars. 0:17:13.560 --> 0:17:13.879 Boom. 0:17:14.200 --> 0:17:16.360 No, that doesn't even buy me a Masarati. 0:17:16.720 --> 0:17:18.680 I want my Mazarin and buy you a bad car. 0:17:19.320 --> 0:17:21.280 So I take my one million dollars, I go to 0:17:21.359 --> 0:17:24.520 a bank and say give me nineteen million more dollars. 0:17:24.600 --> 0:17:29.840 Now I have twenty million dollars, same investment only. Now 0:17:29.960 --> 0:17:33.680 I make two hundred thousand dollars. I get my Masarati, 0:17:34.640 --> 0:17:37.240 and that's a twenty percent return. I pay back the 0:17:37.320 --> 0:17:42.439 nineteen million. Sure, and by borrowing that money, I can 0:17:42.520 --> 0:17:44.840 make myself rich even on tiny opportunities. 0:17:45.200 --> 0:17:46.399 This is the game. 0:17:47.160 --> 0:17:49.560 Still is the game. Still, this is not a historical thing. 0:17:49.760 --> 0:17:51.040 This is what happens today. 0:17:51.119 --> 0:17:54.840 So they do this, They borrow something like twenty five 0:17:55.200 --> 0:17:58.600 dollars for every dollar they have. Yes, and they make 0:17:58.760 --> 0:18:03.040 a billion dollar bet on this to treasury arbitrage play, 0:18:03.359 --> 0:18:06.520 and it works, and very quickly they make fifteen million 0:18:06.560 --> 0:18:09.320 dollars in profit, putting up very little of their own money. 0:18:09.840 --> 0:18:12.600 It's working. It's important to know that they're not the 0:18:12.600 --> 0:18:15.440 only ones who see this gap. You know, the quants 0:18:15.720 --> 0:18:18.320 are emerging by this point, there are lots of nerds 0:18:18.640 --> 0:18:22.119 following in their footsteps, and so as other traders are 0:18:22.119 --> 0:18:25.080 getting in on this kind of bet, the spreads are closing, 0:18:25.320 --> 0:18:28.920 and the traders at Long term Capital have to look 0:18:29.200 --> 0:18:31.760 farther out into the world and make bets that are 0:18:31.800 --> 0:18:34.720 a little bit more speculative. One big one they do 0:18:34.800 --> 0:18:37.040 early on is on Italian bonds. 0:18:38.800 --> 0:18:42.040 So I don't want to give a hard time to 0:18:42.080 --> 0:18:45.399 the Italian economy, but let's just say they've had a 0:18:45.400 --> 0:18:47.480 lot of problems, especially at this point, a lot of 0:18:47.520 --> 0:18:51.760 different governments, and so Italian bonds are a little bit 0:18:51.880 --> 0:18:55.520 riskier than the other countries of Europe or US bonds. Yes, 0:18:55.600 --> 0:18:58.040 and this is before the euro right, so even more so. 0:18:58.840 --> 0:19:00.960 But a trader at Long. 0:19:00.800 --> 0:19:05.840 Term Capital is convinced that the market is overestimating a 0:19:05.880 --> 0:19:08.760 particular risk. And again this isn't like some wild speculation. 0:19:09.000 --> 0:19:13.520 He thinks the market is overestimating the risk that Italian 0:19:13.800 --> 0:19:16.920 companies will default on their bonds relative to the risk 0:19:17.000 --> 0:19:20.679 that the Italian government will default. Right, So it's still 0:19:21.480 --> 0:19:24.840 a spread trade, right, a convergence trade. 0:19:24.960 --> 0:19:28.560 But you know, it's interesting that there is this principle 0:19:28.560 --> 0:19:34.919 in behavioral economics that says that people overestimate the odds 0:19:34.960 --> 0:19:36.080 that bad things will happen. 0:19:36.200 --> 0:19:37.000 Uh huh. 0:19:37.040 --> 0:19:39.400 So in the stock market, you hear news about all 0:19:39.440 --> 0:19:42.119 time highs or the stock market crashing. Most days, the 0:19:42.240 --> 0:19:45.200 stock market is boring. You know, the price at the 0:19:45.240 --> 0:19:46.520 end of the day is very similar to the price 0:19:46.560 --> 0:19:48.440 at the beginning of the day. You know, we worry 0:19:48.480 --> 0:19:51.800 about Italian bonds or Italian company bonds. Oh no, they're 0:19:51.800 --> 0:19:54.520 going to default, but most of the time they don't. 0:19:55.200 --> 0:19:58.200 But weirdly, as humans, we think about the bad thing 0:19:58.600 --> 0:20:01.320 that can happen, and that's the price we put on it. 0:20:01.480 --> 0:20:04.000 So Long Term Capital decides to take the other side 0:20:04.040 --> 0:20:06.760 of that bet to decide, no, the world is going 0:20:06.800 --> 0:20:09.520 to continue to just be faught. Yeah, to be boring. 0:20:09.680 --> 0:20:12.200 They make this bet. Italy in fact did not default, 0:20:12.240 --> 0:20:15.119 and Long Term Capital made something like six hundred million 0:20:15.200 --> 0:20:18.960 dollars in two years on that trade. So the firm 0:20:19.080 --> 0:20:22.520 is doing the thing that they said they would do. 0:20:23.119 --> 0:20:25.639 They're making these trades that profit, you know, whether or 0:20:25.680 --> 0:20:27.920 not the market goes up or down, that things will 0:20:27.960 --> 0:20:30.520 tend to converge over time. They're borrowing a lot of 0:20:30.520 --> 0:20:35.639 money to do it, and it works so well. It works, 0:20:36.480 --> 0:20:40.480 in fact, better than they thought it would. In nineteen 0:20:40.560 --> 0:20:45.080 ninety five, long Term Capital made a fifty nine percent return. 0:20:45.720 --> 0:20:47.320 They took a bunch of fees out of that, and 0:20:47.359 --> 0:20:51.600 they returned to their investors forty three percent in one year. 0:20:51.880 --> 0:20:55.919 Take all my money, Take all my money, acts, Yeah, yeah, please. 0:20:56.600 --> 0:21:00.720 And one interesting thing about this moment is the people 0:21:00.840 --> 0:21:03.800 running the firm, Merton and Cholls and the rest of them, 0:21:03.840 --> 0:21:06.560 they knew that this was extraordinary. This was more than 0:21:06.600 --> 0:21:09.720 they expected. And I don't just mean that in a 0:21:09.800 --> 0:21:11.760 kind of hand wavy way. They weren't like, oh, that's 0:21:11.800 --> 0:21:14.320 more and we expected. It was more than their math 0:21:14.560 --> 0:21:15.800 told them was likely. 0:21:16.000 --> 0:21:19.639 And at this point there are traders who are not 0:21:19.760 --> 0:21:22.680 PhDs in the firm, who are, you know, popping the 0:21:22.800 --> 0:21:26.119 champagne and saying we're geniuses. They're you know, they're like, 0:21:26.160 --> 0:21:28.000 we're we're going to do this again and again and again. 0:21:28.160 --> 0:21:30.080 But the math guys in the room are looking at 0:21:30.119 --> 0:21:33.600 this saying, this is off our calculations, this is better 0:21:33.640 --> 0:21:35.360 than we thought, which is just as bad as worse 0:21:35.400 --> 0:21:35.960 than we thought. 0:21:35.960 --> 0:21:39.520 It's not. It's not actually no mathematical perspective. So they 0:21:39.680 --> 0:21:42.480 they have done all them me And in fact, you know, 0:21:42.960 --> 0:21:46.520 all firms tell their their investors we might lose money, right, 0:21:46.560 --> 0:21:49.119 your lawyers make you say we might lose money. But 0:21:49.240 --> 0:21:53.280 there is this amazing investor letter. It's actually an addendum 0:21:53.400 --> 0:21:56.840 to the investor letter that the firm sends out. The 0:21:56.920 --> 0:22:00.920 addendum is written by Merton and Shoals. Lowenstein talks about 0:22:00.920 --> 0:22:03.560 this in his book. And they don't just say yes, 0:22:03.600 --> 0:22:07.280 our firm might lose money. They put numbers on how 0:22:07.359 --> 0:22:10.280 much they might lose. So, for example, they say, yes, 0:22:10.359 --> 0:22:13.720