"Because the System is Now More Stable, We'll Make It Less Stable"

Nobel prize winner Myron Scholes says periods of calm in financial markets don't last. Low risk time periods encourage risk taking which then undermines the stability that made the risk seem like a good bet in the first place:

Risk Manager, by Holman W. Jenkins Jr., Commentary, WSJ (free): What some called the "goldilocks" market got a sharp rap upside the head this week. Why can't things always be smooth and nice and predictable? Myron Scholes, operator of the hedge fund Platinum Grove Asset Management, says you wouldn't like it if they were.

You know him better as a winner of the Nobel Prize in economics. You may also recall him as a principal of the hedge fund Long Term Capital Management (LTCM), which went belly-up in the late 1990s. Indeed, to ... a certain type..., he'll always be the mad scientist who almost blew up the world. ...

Our conversation ... takes place just before the recent market gyrations ... "Right now," according to Mr. Scholes, "we're quiet because the lion is tame, and maybe it's the central bankers of the world who are keeping it tame." And thus, "Individuals will say, oh, things are now quiescent and will be forever, and they'll take more risk again."

He adds: "My belief is that because the system is now more stable, we'll make it less stable through more leverage, more risk taking." ...

But then another question is: Why must the corrections be so convulsive? One of Mr. Scholes's favorite words is "model"--as befits a man awarded a Nobel in 1997 for the famous Black-Scholes model for pricing stock options. In chaotic times, speculators ... doubt their models. They want to reassess. In today's ever more globalized and complex economy, "the information set is huge, it's gigantic." As a result, "decision time becomes elongated" and speculators hold back their capital just when their services are most in demand. The lack of liquidity itself then becomes a factor in asset pricing, leading to swift, sharp drops in values.

You may be tempted to slightly arch your eyebrows right now if you remember LTCM. Mr. Scholes expects as much. He's made his peace with it. He says he feels like the woman in the local paper who, whatever she does, will always be remembered for one thing: "Mrs. Jones, who was falsely accused of the ax murder of her husband in 1944, recently had a garden party for 10 of her friends." ...

Was the financial system ever in danger from LTCM's collapse, as widely predicated in press accounts at the time? I half-expected Mr. Scholes to pooh-pooh the worry as apocalyptic. Instead he pauses, finally saying: "I don't know the answer. ...

We'll never know. A phone call was made. The New York Fed agreed to intervene and organize a notorious "bailout" by the creditors to prevent a fire-sale liquidation.

Mr. Scholes was doubly marked for notoriety because he had just a year earlier been awarded the Nobel Prize, along with Mr. Merton, for their work on derivatives pricing. He readily acknowledges that the episode was financially and personally embarrassing: "In life you pay tuition, right? Sometimes you pay too much tuition. Sometimes learning is costly." ...

[In the debate over] ... executive compensation .... Mr. Scholes hears his name invoked constantly, since the Black-Scholes formula has become the basis for assigning a value to stock options dished out to ... senior management. He finds much of the criticism misguided, noting that executive compensation is a strategic matter for companies and no less subject to learning than other strategic considerations.

Many of the giant paydays that incense the media, he points out, came about because a company's share price, over a succession of years, greatly outperformed a board's reasonable expectations. As a board member, he says, "you might say the probability of the stock price going up 500 times is zero, so why do I have to write a contract" that protects the company from outsized payouts in such an unlikely circumstance? "But if that happens a few times, people will start writing" those protections into the contract. "So there's learning that occurs."

Ditto large severance payments for executives who were hired with manifest approval of the stock market and later fired when the shares underperformed. "People will fashion new contracts and new ways of doing things. Boards will learn. It doesn't mean you have to overturn the whole applecart..." ...

He's not saying that executive pay is correct, only that markets will learn -- eventually.