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"Trillion Dollar Bet"

PBS Airdate: February 8, 2000
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NARRATOR: It was a brilliant discovery that revolutionized modern finance.

MERTON MILLER: When I saw the formula I knew enough about it to know that this is the answer. This solved the ancient problem of risk and return in the stock market. It was recognized by the profession for what it was as a real tour de force.

NARRATOR: An elegant mathematical formula that helped create a multi-trillion dollar industry.

STAN JONAS: Up until the time that they came up with their insight, the world was full of uncertainty and risk, uncontrollable and un-analyzable. And then in a moment of tremendous clarity they realized that two risky positions taken together can effectively eliminate risk itself.

NARRATOR: This bold idea shaped one of the most ambitious investment strategies in history - attracting the elite of Wall Street, until it confronted them with the biggest risk of all.

ROGER LOWENSTEIN: Markets began to act in ways that no one had seen before and they began to lose 100 million and more, day after day after day, until finally there was one day when they dropped half a billion dollars, 500 million in a single day.

NARRATOR: These money machines, driven by mathematical models, had earned fantastic sums. Now as they spiraled out of control, investors froze in terror.

BEN SCHWARTZ: Everyone in the marketplace thought the sky was falling and there was instant reaction. The fear was incredible. People thought, "Oh my God, what's going to happen next?"

NARRATOR: The crisis threatened to bring markets around the world to the brink of collapse. Could a global economic meltdown be avoided?

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NARRATOR: Since the dawn of capitalism there has been one golden rule: if you want to make money, you have to take risks. Then came one of the most ambitious intellectual endeavors of the century: the attempt to find a mathematical way to conquer risk, to turn finance into a science. If it worked, it would open new realms for the world's financial exchanges and forever change the way traders trade.

BEN SCHWARTZ: I've seen many people come and go. People come in with a good fresh attitude, but they just can't survive, they just can't handle the competition.

It's not for the meek; it's not for the weak. If you can't handle it you can't be there, and it's simple, otherwise people just take your money and they don't feel bad. Every day when I walk in to the Exchange I walk in with a clear mind, no emotion. The emotion builds up almost like a volcano, ready to explode, and when I walk in that pit it explodes. It's crazy. I communicate by going buy 20 from someone, sell you 20. Constant chaos, it's constant chaos. The market's always moving. Yelling, screaming, grabbing, whatever it takes to get people's attention, to make the market move. Constantly going, where am I, where am I, where am I, meaning what is my position, give me an exact total, give me an exact figure, what do I have to do to get out of position?

NARRATOR: Here at the Chicago Mercantile Exchange, the products that are traded are strange and complex things, like pork belly futures, interest rate swaps, and currency derivatives. Their prices are constantly fluctuating as market sentiment shifts. The job of the trader is to try to guess what these prices will be next year, next week, or in 10 seconds' time.

BEN SCHWARTZ: On any given day you can lose six figures, millions and millions of dollars exchange hands in these pits every day. Me personally? I've lost a lot of money, you know. On any given day, I'm not going to give you a figure, but you know it's not - you can lose a car, you know, put in - an apartment, a house, whatever, on any given day if you make a simple mistake.

NARRATOR: A successful mathematical model that could improve the trade-off between risk and reward would have to beat the instincts of an ordinary trader on the floor. It would also have to compete with the accumulated wisdom of an acknowledged expert, in his office high above the pit.

CLERK: Yeah.

LEO MELAMED: You see it.

CLERK: It's 6 even. I want to try 7 even. 6 even is last. The NASDAQ is unchanged.

LEO MELAMED: All right, get me out. I'll be back, don't hang up.

NARRATOR: Leo Melamed, one of the chief architects of financial futures, has been trading successfully for over 30 years.

LEO MELAMED: What I do is I pick up the phone to my clerk who is at the pit, she's at the edge of the pit, and she flashes in the order via a hand signal to the broker in the pit who handles my account and he then executes the order that I gave, gives her the confirmation of its execution. All of that is within seconds. Up here it's kind of still and quiet. I get other kinds of information they don't get, but I don't get what they get which is the screaming and the noise, and that noise level changes from time to time, and it also gives, provides information as does the, the fear in the eyes of the, of the traders around you. That too is information. I go in, in the morning and the day is before me and I have to figure out which direction any one of a dozen markets is going to go in. Additionally, you have to figure out from reading the newspapers for - from being a psychiatrist as it were of the public attitude which way they're going today, what are they going to do, is this, is this information going to make them bullish, is this information going to make them fear, and if I can figure that out, I can beat the market.

NARRATOR: Traders like Melamed are convinced that success in the markets involves human judgment, business savvy and intuition - qualities that could never be reduced to a series of equations. But, an important group of financial economists, who study the markets mathematically, believes that such success is largely a matter of luck.

ZVI BODIE: In flipping a coin, if you flip it long enough, there may be a long run of heads, which doesn't at all imply that the person flipping it had the ability to make it come up heads. It could just be the luck of the toss.

NARRATOR: This strange view arose from an unexpected discovery. After the stock market crash of 1929, economists decided to find out whether traders really could predict how prices moved by looking at past patterns. They decided to run a series of experiments. In one of them they simply picked stocks at random. They threw darts at the Wall Street Journal while blindfolded. At the end of the year this random choice out-performed the predictions of top traders. This was a revelation: prices must be moving totally at random, and although patterns came and went, they were there by chance alone and had no predictive value. The economists arrived at a devastating conclusion: it seemed just as plausible to attribute the success of top traders to sheer luck rather than skill.

ZVI BODIE: When some individual made a fortune in the stock market, we have a tendency to assume that that was because he knew something, and of course the individual himself is happy to reinforce that belief - yes, I was a genius, or I was very clever, or I always said Microsoft was going to make me rich. But what you don't see are the thousands, hundreds of thousands, perhaps millions of people who are going, I always said that ABC company was going to make me rich, and ABC company went bust.

MERTON MILLER: If there's 10,000 people looking at the stocks and trying to pick winners, well, one in 10,000 is going to score, by chance alone, a great coup, and that's all that's going on. It's a game, it's a chance operation, and people think they are doing something purposeful but they're really not.

NARRATOR: This view disgusted most traders and continues to do so today.

LEO MELAMED: Listen, academics as a rule make terrible traders, so for me to think that I'm going to listen to their theory about trading, I beg to differ.

NARRATOR: According to economists, when traders like Melamed dig up information and quickly act upon it, the resulting prices move to reflect that research. Ironically, the very act of predicting prices makes them less predictable. But economists knew that mathematics had been successfully used to study random phenomena before, from population growth to the weather. Using esoteric theories of probability, they could model market fluctuations in their quest to master risk.

MERTON MILLER: We can deal with random series in a way that to the layman may appear as just chaos, but no, no, no, no, no, once you tell me that the series is random and you've got probability distributions, we can use some of the apparatus of modern mathematical statistics to do analyses.

PAUL SAMUELSON: The hope that the mathematical theory of probability in statistics could be a skeleton key to help you understand the nature of chance, perhaps to predict it better, perhaps to control it, that was born at, at that time and the rest is, as they say, history.

NARRATOR: Unknown to the economists of the 1930s, a French graduate student at the turn of the century, Louis Bachelier, had already exploited the structure of randomness in his doctoral thesis titled, "The Theory of Speculation." He compared the behavior of buyers and sellers to the random movements of particles suspended in fluid, anticipating key insights later developed by Einstein and the mathematics of probability. But Bachelier's accomplishments would go unnoticed for decades.

PAUL SAMUELSON: In the early 1950s I was able to locate by chance this unknown book, rotting in the library of the University of Paris, and when I opened it up it was as if a whole new world was laid out before me. In fact as I was reading it, I arranged to get a translation in English, because I really wanted every precious pearl to be understood.

NARRATOR: Using a series of equations, Bachelier created the first complete mathematical model of stock market fluctuations. He too believed stock prices moved at random and that it was impossible to make exact predictions about them. But then Bachelier said he had found a way to control risk, through an obscure financial contract called an option. He realized options could protect investors from market fluctuations and made the first attempt to figure out how to price them. But his superiors were unimpressed. His academic career faltered.

PAUL SAMUELSON: After the discovery of Bachelier's work there suddenly came to the mind of all the eager workers the notion of what the Holy Grail was. There was the next step needed. It was to get the perfect formula to evaluate and to price options.

NARRATOR: Economists returned eagerly to the markets to investigate this strange contract which had so intrigued Bachelier. They discovered options were a form of insurance that allowed investors to buy or sell stock for a specific amount, the strike price, by a specific date. For example, if you buy a stock today the price could drop in the future and you could lose money. But if you buy an option, you have the right to sell the stock at some agreed price in the future. If the stock drops, you have insurance. If it rises, you profit. Options can be an effective way to control risk. But how much should an investor pay for such absolute peace of mind? The value seemed to depend on each individual's level of confidence in the market. No one could agree on a standardized way to price options. It was a bewildering problem that the economists were determined to solve. Throughout the 1960s they developed their mathematical models, based on what seemed to be a hopeless quest to describe mathematically the emotional state of the typical investor. They invented symbols for the level of satisfaction, for reasonableness and aggressiveness. Symbols for the guesses of other traders, for defensiveness, for safety. Soon they had a giant mathematical edifice, but would it work?

ZVI BODIE: The mathematical models that were being developed during the '50s and '60s depended on inputs that were completely unobservable in the real world, like expectations of investors which might differ very much from one investor to another, and how did you actually come up with a number, how could you come up with a number to input?

STAN JONAS: They would talk about people's utility structure, they would talk about people's risk aversion, and this made all the models seem more like psychotherapy than real science.

NARRATOR: By the end of the '60s, economists were no nearer to pricing options than they'd ever been. But this was about to change.

MYRON SCHOLES: From an early age I was very, very fascinated by uncertainty. My parents having lived in a gold mining part of the world, in Northern Canada, would be always buying penny stocks, or the family would tend to be buying stocks that had very low prices because there'd be some rumor that there'd be another gold find or a silver find and so the prices would shoot up and - or not shoot up. I mean, the family wasn't seen to be getting rich, though. That got me very interested in, why was it the case that these prices tend to fluctuate?

NARRATOR: In 1968 economist Myron Scholes and his colleague Fischer Black set out to tackle the problem of options.

MYRON SCHOLES: When I first discovered options, I became very excited about the possibilities that here was a contract that enabled you to only be able to take the upside of the returns and not the downside, and that being able to take the upside only had value and that was really exciting.

NARRATOR: It was a goal that had eluded the greatest minds in economics. They knew that every stock price constantly moved up and down. As it did so, the value of an option on a particular stock fluctuated too, but there was no predictable relationship. What they wanted was to find was a formula that would calculate the correct price of an option at any moment in time just by knowing the current price of the stock, but they couldn't see their way through the mass of equations they'd inherited.

MYRON SCHOLES: I read the literature, tried to see what others had done, and I became dissatisfied with the various models because they had assumptions that didn't seem to make that much sense to me.

NARRATOR: Then Black and Scholes decided to try something different. One by one they dropped any symbol which represented something un-measurable. Their loss didn't affect the calculations at all. Now for the first time Black and Scholes were left with the bare bones of the problem, the elements that everyone agreed were necessary to value an option: the stock price, its volatility, the strike price, the duration of the contract, the interest rate, and the overall riskiness of the option. They were all measurable except one - the level of risk.

MYRON SCHOLES: I could do that first part and then I got stuck.

NARRATOR: So Black and Scholes decided if they couldn't measure the risk of an option exactly, perhaps they could somehow make it less significant. The method they devised was to become one of the most important discoveries in economics in this century. They started with the old idea of hedging, in which gamblers hedged their bets by betting in the opposite direction. They created a theoretical portfolio, a mixture of stocks and options. Then whenever either fluctuated up or down, they tried to cancel the movement out by making another risky move in the opposite direction. Their aim was to keep the overall value of the portfolio in perfect balance. Since prices moved at random, at first they could cancel out only small fluctuations. But eventually, using complex mathematics and a mass of calculations, they found they could precisely balance out virtually any movement.

MYRON SCHOLES: After the fact we called this dynamic hedging. What that means, dynamically hedging, is you want to be able to eliminate the uncertainty of the movements in the stock.

NARRATOR: They soon discovered that dynamic hedging reduced risk by creating a perfect equilibrium in which fluctuations in the portfolio cancelled each other out. Black and Scholes had found a theoretical way to neutralize risk. Risk now dropped out of their equation. And without risk - the unmeasurable element - they finally had a mathematical formula which could give them the price of any option. They had solved the problem that had eluded generations of economists. It was a marvelous achievement. But there was a practical problem with their formula. It assumed that markets were always in equilibrium, that supply equals demand. In the fast-moving markets of the real world, their calculations for dynamic hedging might quickly be thrown out of kilter. What was needed was a way to instantly rebalance a portfolio of stocks and options to keep offsetting their fluctuations. Unbeknownst to Black and Scholes, someone had found a way.

ZVI BODIE: He was kind of a wunderkind. He was just recognized from the very beginning as an extraordinary intellectual talent. His creative powers, the power of the analytical techniques, mathematical techniques that he was bringing to bear on some age-old questions in economics. Savings behavior, investment behavior. It was just obvious that here was a guy who was going to make intellectual history in our field.

ROBERT MERTON: In college I started studying the stock market. I went down to the stock exchange, watched all the activity from the visitors' gallery, people running around, calling numbers, shouting, and all the paper flying and the bells ringing and of course that was exciting, and it seemed to lend itself to my analytical skills.

NARRATOR: Bob Merton had developed a reputation for using exotic mathematical methods to study financial contracts like options. He was the perfect person for Black and Scholes to meet.

MYRON SCHOLES: In the fall, I went over our ideas that we had with Bob and spent a lot of time arguing with him about whether our results were robust and exact or whether there was flaws in our methodology.

ROBERT MERTON: So I'm going to reframe, reformulate their problem in the context of my modeling that I had developed.

NARRATOR: In constructing his own complex mathematical models, Merton explored theories no one in finance had even heard of. Turning to rocket science, he studied the theories of a Japanese mathematician, Kiyosi Ito, who'd faced a similar problem to Black and Scholes. In order to plot the trajectory of rockets, you needed to know exactly where the missile was, not just second by second, but literally all the time. Ito had developed a way of dividing time into infinitely small parcels, smoothing it out until it became a continuum so that the trajectory could be constantly updated. Bob Merton adapted this idea to the Black-Scholes formula. Using the notion of continuous time, the value of the option could be constantly recalculated and risk eliminated continually.

ROBERT MERTON: And then I discovered they were right. By following their procedure, their dynamic trading strategy in the stock and cash, at least in the context of my model, they could eliminate all of the risk.

MYRON SCHOLES: Bob phoned me up one Saturday morning and said that, you know, he had an alternative proof to our particular model and was very - he was convinced that it did work. He had used technology that I hadn't been aware of and Fischer hadn't been aware of, called Ito calculus, to actually solve the problem in a more elegant way and a more robust way, I think, than Fischer Black and I had done.

NARRATOR: The formula that Black, Scholes and Merton unleashed on the world in 1973 was sparse and deceptively simple, yet this lean mathematical shorthand was the fulfillment of a 50-year quest.

MYRON SCHOLES: When we did get the final equation obviously that was, eureka.

ROBERT MERTON: This is great. I mean, it doesn't get much better than that. When you solve a problem, and you really know you've cracked it.

NARRATOR: Here was a formula that would enable investors, by dynamically hedging, to control risks by spreading them across individuals, financial markets, and through time. Academics marveled at its elegance and sheer audacity.

PAUL SAMUELSON: I know, and can take my hat off to what that accomplishment was, because I got near the North Pole, but near is no cigar.

MERTON MILLER: It exploded. Within a few years it was the most widely cited article in finance, even alas, outdoing some of my own articles.

NARRATOR: But barely had the academics time to celebrate their achievement when traders began to use the formula for real. In 1973, the Chicago Board of Options was launched. As options on financial securities exploded, traders desperately needed a benchmark for pricing them. Now they simply programmed the Black-Scholes formula into their calculators. By pressing a few buttons they could find the exact price of any option at any time. Soon men and women who had never heard of Bachelier, Ito, or continuous time were exploiting the novel formula to make money - lots of it. They even realized it could be applied to other financial transactions. By allowing them to hedge their risks constantly, the traders could feel safe enough to conduct business on a scale they had never dreamt possible. The risks in stocks could be hedged against futures, those in futures against currency transactions and all of them hedged against a panoply of financial derivatives - so called because they "derive" their value from some other security. Derivatives, which include options, swaps, and futures, took on new forms to exploit Black-Scholes - transferring risk from those who did not want to bear it to those who were prepared to take it on and earn a profit.

STAN JONAS: The basic dynamic of the Black-Scholes model is the idea that through dynamic hedging we can eliminate risk. Now what this means, ironically, is contrary to grandpa's wisdom, the more we trade the less risk we have. So we have a mathematical argument for trading a lot. What a wonderful thing for exchanges to hear. So we have to have more contracts, more futures exchanges, we have to be able to trade Nikkei futures in Japan. We have to be able to trade options in Germany. Basically in order to reduce risk, we have to trade everywhere and all the time.

NARRATOR: The application of mathematics to risk management would lead to the creation of a multi-trillion dollar derivatives industry. Finally, 25 years after they came up with their formula, the architects of this revolution received the ultimate accolade.

MYRON SCHOLES: My first reaction on being awarded the Nobel Prize was, actually, I thought of Fischer Black, my colleague. He unfortunately had passed away. And there was no doubt in my mind that if he were still alive, he would have been a co-recipient of the Nobel Prize.

ROBERT MERTON: And this is the medal. This is the Nobel medal, and on the back of the medal is the insignia for the Royal Academy of Sciences. Now there's nothing like it, not once in a lifetime, but once in many lifetimes.

MAN: Bob Merton. Bob.

NARRATION: At the very height of their careers, Merton and Scholes were already multi-millionaires. Five years earlier, John Meriwether, the legendary bond trader at Salomon Brothers, had enticed Scholes and Merton to join him and 13 other partners in a new company he was launching, Long Term Capital Management. In 1994, Business Week introduced the public to the "Dream Team" Meriwether had assembled.

ROGER LOWERSTEIN: They were immediately seen as a unique enterprise. They had the best minds. They had a former vice chairman of the Federal Reserve. They had John Meriwether, a somewhat obscure figure, but a lionized one, and they had Meriwether's team, or the heart of Meriwether's team from Salomon, which had made essentially all of the money that Salomon had made over the past eight, 10 years. So they were seen by individual investors, but particularly by banks and institutions that went in with them, as a ticket to easy street.

ZVI BODIE: I first heard about LTCM from Bob Merton at lunch. He didn't have a name yet, but he was describing some new contraption, you know it'd be, it would be the analogy of a rocket scientist describing some new rocket.

ROBERT MERTON: The idea of building something from scratch, but not a little prototype company, but something that would be quite large and on a global basis. It was too good to pass up.

MYRON SCHOLES: It was for me a way to see the application of ideas to practice.

NARRATOR: LTCM launched a giant hedge fund that promised to use mathematical models to make investors tremendous amounts of money. Meriwether's track record, along with Merton and Scholes' reputations, made it easy to raise capital. The most prestigious investors, banks, and institutions all competed to get in. The minimum investment allowed was $10 million, and it could not be withdrawn for three years.

STAN JONAS: It was as though the apostles had effectively come down to raise money in a bingo parlor. This was going to be the team of the century.

ROGER LOWENSTEIN: They went around institutions who were considering investing, and this was an enormously powerful calling card because many of the people making decisions had studied under Merton and Scholes. They'd all read their books. They felt as if they were meeting the high priests and almost as if they were honored to be asked to invest with them.

NARRATOR: Within months they had raised three billion dollars and were ready to start investing across the globe. They set up not on Wall Street but far away from ordinary traders, in Greenwich, Connecticut. From their headquarters they devised one of the most ambitious investment strategies in history. Its success depended on absolute secrecy. Not even their investors were allowed to know what they were doing. Analyzing historical data, they used probability to bet that key prices would move roughly as they had in the past. To protect themselves against unwanted risk, they relied on an insight of the Black-Scholes formula - dynamic hedging. In effect, offsetting risk by taking bets in the opposite direction. Supremely confident, LTCM placed vast sums of money on the markets.

MYRON SCHOLES: The broad strategy of LTCM was to figure out how to hedge out the risks of your position such that you can do a lot of it much more than you can do if you didn't hedge out the risks.

ROGER LOWENSTEIN: What they did was study the relationships between various markets all around the world, bond markets, eventually equity markets, interest rates, the rate at which those prices change themselves. And when the relationships between these various markets got out of whack, which is to say became different than what had been their historical norm, LTCM would place bets, the bets being that the historical relationships would re-assert themselves. And they did this all over the world.

NARRATOR: And it worked. LTCM was a spectacularly successful money machine. Merton and Scholes had proved that the science of finance could cut it in the real world, and they basked in their success.

ROGER LOWENSTEIN: LTCM started out with three truly fabulous years. The first year they made 20%, and that was after the partners had collected handsome fees. The second year they returned 43% to their investors, the third year another 41%.

MERTON MILLER: I asked him, what is it you guys are doing at LTCM, and Myron characterized it in that way of his. He said, well you know, one way is to think of us as a gigantic vacuum cleaner sucking up nickels from all over the world.

STAN JONAS: It was as though the world was behaving exactly the way it had been writ on the blackboard. Long Term Capital thought that they had discovered the path to Nirvana. Here they are doing their day-to-day activities, playing golf in lush Greenwich or attending hedge fund conferences in Bermuda, or raising funds in Cannes. And then slowly and totally unexpectedly, a change in the market dynamics began to become apparent.

LOWENSTEIN: The first hint of trouble was at 1997, LTCM's returns fell from 40-ish% to 17. There was a reason why the returns fell, which is that when someone discovers a good game on Wall Street, he's bound to be imitated after a while. And that had happened to LTCM, so there was less room for them to exploit these little market discrepancies where they were drawing their profits from. And at the end of 1997, they returned much of the partners' capital. However, they did not reduce the size of their assets, so that they now had the same level of assets and investments, but less capital. That meant that if there were trouble, the trouble would hurt them much more quickly.

NARRATOR: In the summer of 1997, across Thailand, property prices plummeted. This sparked a panic that swept through Asia. As banks went bust from Japan to Indonesia, people took to the streets - events so improbable they had never been included in anyone's models.

BEN SCHWARTZ: Everyone in the marketplace thought the sky was falling, and there was instant reaction. The market broke, then rallied, then broke, then rallied. We didn't know what to believe.

NARRATOR: As prices leapt and plunged as never before, the models traders used began to give them strange results, so they relied instead on their instincts. In a time of crisis, cash is king. Traders stopped borrowing and dropped risky investments.

LEO MELAMED: You've got to be able to get out while the getting out is good, but that's true for any investment you make. That's true for real estate, that's true in every sort of business. You can't ignore an error. Once you realize that you've made an error, the best thing is to get out of that error and start again fresh, and that's what a good trader does.

NARRATOR: But at LTCM, the models told them everything would return to normal soon. There was no reason to panic. After all, they were hedged. With enough time, their bets would converge. All they needed was patience. But their bets diverged. As LTCM lost money, its ratio of assets to liquid capital reached 30 to one. The fund's debts exceeded $100 billion.

STAN JONAS: If I have $100 billion of a position and I lose one percent, I've lost a billion dollars. And if all I have to start out with is three billion dollars, if I lose three percent on my portfolio, in aggregate I'm going to be wiped out.

NARRATOR: Despite its extreme leverage, LTCM could continue to hedge - as long as the economic upheaval in Asia did not spread.

LEO MELAMED: That's an old market rule: the market will test you and do what you don't expect it to do.

NARRATOR: In August, Russia suddenly and without explanation refused to pay all its international debts. LTCM's models had not accounted for this unprecedented event. As frantic investors all sought liquidity, LTCM could not unload its positions which continued to diverge.

MYRON SCHOLES: In August of 1998, after the Russian default, you know, all the relations that tended to exist in a recent past seemed to disappear.

.

MERTON MILLER: Models that they were using, not just Black-Scholes models, but other kinds of models, were based on normal behavior in the markets and when the behavior got wild, no models were able to put up with it.

ROGER LOWENSTEIN: Although their models told them that they shouldn't expect to lose more than 50 million or so on any given day, they began to lose 100 million and more, day after day after day till finally there was one day, four days after Russia defaulted, when they dropped half a billion dollars, 500 million in a single day.

NARRATOR: In Greenwich, LTCM faced bankruptcy, but if the company went down, it would also take with it the total value of the positions it held across the globe - by some accounts $1.25 trillion, the same amount as the annual budget of the US government. The elite of Wall Street would suffer heavy losses. The Federal Reserve Bank called upon the world's top financial regulators to discuss the crisis.

ROGER LOWENSTEIN: Suddenly they seemed to be staring at this nightmare where one firm linked up to every major firm on Wall Street was going to be seized up and markets might just stop working. That was the great fear.

NARRATOR: On Sunday, September 20th, officials of the Federal Reserve and US Treasury headed for Greenwich, Connecticut.

PETER FISHER: What really was the shock for me when we went up to Long Term Capital and the partners gave us an overview of their positions and the risks and the pressures they were under, was the extraordinary scope of the risks that they had taken on, the breadth of the portfolio, and yet how utterly their effort to diversify the portfolio had failed them, how - that this wide set of positions across all markets had all come in, were all behaving the same way. Everything had come up heads.

NARRATOR: Fearing a global economic collapse, the Federal Reserve organized a bailout of LTCM with Wall Street's biggest power brokers. 14 firms put up $3.6 billion to buy out the fund. This consortium would now oversee all trading and had power to veto decisions made by the partners. Meriwether, Merton, and Scholes lost millions. So did their investors. Then the public recriminations began.

BERNIE SANDERS: We expect that they're going to explain to the members of this Committee why the Federal Reserve has organized the $3.5 billion bail-out for billionaires, why Americans should be worried about the gambling practices of the Wall Street elite.

ALAN GREENSPAN: How much dependence should be placed on financial modeling which for all its sophistication can get too far ahead of human judgment?

ROBERT MERTON: It's like getting hit by a truck. I can't imagine anyone wouldn't feel very deep emotions of loss, of why? And I'm no different from that.

MYRON SCHOLES: Some people have asked me how I felt going through the LTCM experience and obviously I felt quite bad, badly for, you know, investors, for others who had worked with us for - generally, because it was the case that we had a great idea and a great franchise, a great application of these ideas to problem-solving, and essentially realizing that that was very difficult to effect.

PETER FISHER: Math doesn't drive financial markets, people drive financial markets, and people are not predictable. We do not yet have a universal theory of human behavior or human motivation. Given that that's so, we're not likely to have robust models of financial market behavior that will always work, and I think the hubris of the mathematician is to ignore that fact.

MYRON SCHOLES: Individuals suspect that the models were flawed and essentially that was the reason why LTCM ended up in its difficulties. I personally don't think that that's the reason. It could be inputs to the models, it could be the models themselves, it could be a combination of many things. And so just saying models were flawed is not necessarily the right answer.

NARRATOR: Out of the 16 original partners, only five have remained to work for Meriwether. Myron Scholes has embarked on a new on-line trading venture. Robert Merton has remained at Harvard and consults for JP Morgan. In December 1999, LTCM fully repaid the banks that had prevented its collapse. Weeks later, the fund was quietly closed down. Some investors are still sitting on losses. Meriwether has launched a new hedge fund that will employ similar investment strategies as LTCM. But were those strategies responsible for one of the largest financial collapses in history? Or was it simply colossal bad luck?

PETER FISHER: The question that I don't yet know the answer to, and I suppose what the partners of Long Term Capital, I can suppose what their answer would be, but I don't yet know the balance between whether this was a random event or whether this was negligence on theirs and their creditors' parts. If a random bolt of lightning hits you when you're standing in the middle of the field, that feels like a random event. But if your business is to stand in random fields during lightning storms, then you should anticipate, perhaps a little more robustly, the risks you're taking on.

NARRATOR: In complex financial markets, the Black-Scholes formula is now an essential tool - one that continues to be used millions of times each day by traders around the world. Like many mathematical models, it relies on inputs and assumes a functioning market. It is a powerful way to manage risk, but it's not a crystal ball.

STAN JONAS: When do you admit that you're wrong, start all over again, or when do you hang on and assume that the markets will turn around in your way? That's the biggest decision we all have to make. However, there's one thing that's clear. Over the last several hundred years we've been able to identify some people that can do it better than others. They don't necessarily go to MIT; they don't necessarily have degrees in mathematics, though that doesn't automatically rule them out. They're the kind of people that can make that judgment that says, some thing's different here, I'm going back to harbor until I figure it out. Those are the kind of people you want running your money.

PAUL SAMUELSON: There is a tempting and fatal fascination in mathematics. Albert Einstein warned against it. He said elegance is for tailors, don't believe in something because it's a beautiful formula. There will always be room for judgment.

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