By Dr Michael Black
Did my uncle create the financial bomb that finally blew up the world economy in 2007–8? Put it this way: along with Myron S Scholes and Robert C Merton, Uncle Black (Fischer Black to everyone else) was credited in the early 1970s with formulating the mathematical model that led to derivatives.
To cite just one post-Lehman historian: “Without derivatives, leveraged bets on subprime mortgage loans could not have spread so far or so fast. Without derivatives, the complex risks that destroyed Bear Stearns, Lehman Brothers, and Merrill Lynch... could not have been hidden from view... Derivatives were the key; they enabled Wall Street to maintain its destructive run until it was too late.”
What is a derivative? In essence, it is a financial contract that derives its value from the performance of another entity such as an asset, index or interest rate. It is one of three categories of financial instrument, the other two being equities (stocks) and debt (mortgages and bonds).
Derivatives were made possible by a mathematical model of financial markets devised by Black and Scholes, from which a formula of financial valuation followed. The Black-Scholes model was first aired in their 1973 paper ‘The Pricing of Options and Corporate Liabilities’, published in the Journal of Political Economy.
Black-Scholes also allowed the financial valuation of a company – any company, of any sort, anywhere in the world – which is shown to be a function of the price of its options that are traded in the market (and vice versa). It became the E=MC2 of the world of finance, its Gold Standard.
The most important thing to bear in mind is that at the time, and for three decades, the theory was seen to be progressive as well as brilliant. Merton and Scholes received the Nobel Prize for it in 1998 (Fischer had died in 1996 and the Nobel Prize is not awarded posthumously).
Black-Scholes was accepted by academics, by analysts, by traders, by rating agencies and by virtually all investment institutions as a representation of financial reality. Black-Scholes is probably the closest the world has ever come to a universal standard of financial value.
The Black-Scholes idea of value reigned supreme... right up to the moment in 2007 when it didn’t. Almost overnight, the model became suspect and the world financial system ground to a halt. Investment portfolios from Darien to Düsseldorf became ‘toxic’ because the Black-Scholes presumptions were suddenly recognised as bogus and the ‘real’ value of assets purchased was consequently indeterminate.
One could choose to view the entire Black-Scholes ‘boom to bust’ life cycle as one instance of a much broader pattern of post-1945 capitalism in which government financial controls were gradually relaxed, but at the expense of stability. That’s a very synoptic view suggested by the newly-published Cambridge History of Capitalism.
However, that’s not what it seemed like half a century ago. Corporate finance was in its infancy and beamed with the sort of promise we associate with the eighteenth- century Enlightenment – applying reason and science to human problems previously left to luck and quackery.
Born in 1938, Uncle Black was a maths and science geek who went to Harvard. By the mid-1960s he stood at the very dawn of a world we have since taken (and still take despite 2007–8) for normal, with investment management by ‘scientific method’, as opposed to the sort of craft practice that had prevailed before.
But the supposedly universal quality of Black-Scholes was to prove its undoing. The failure of this measure of value was systematic: that is, it affected everyone, everywhere simultaneously precisely because it was employed universally, its collective wheel greased by technology. Modern financial theory was supposed to eliminate risk, yet it had done the reverse.
This self-defeating character of a universal measure of value then raises a second issue. Is an objective measure of corporate value possible to formulate even if it’s not universal; let’s say, for an industry or a sector?
A hint to the answer to this question comes through the experience of a classmate of mine at the Wharton Graduate School of Finance where we both did our MBAs. Michael Milken understood what many of us more prosaic types didn’t: that the real money in corporate finance didn’t lie in creating value but in defining it. After graduation, this is what he set about doing with great skill for almost two decades.
Milken developed a supposedly objective measure of value which purported to show that many smaller and less prestigious companies were being substantially undervalued. His new measure made CEOs happy because it confirmed their professional intuition that their companies were undervalued. It made second-tier investment banks happy because they had something to sell. It made the managers of emerging equity funds happy because they had something to buy. Thus the junk bond (or, if one prefers, the high yield investment) market was born.
It takes considerable political-sociological skill to maintain the credibility of a measure of value without serious academic backing. And Milken sailed not just close to the wind but through it in order to maintain the credibility of the measure in his dealings with investors and regulators. But just as Goldman Sachs’ valuation of mortgage derivatives were shown to be self-serving after the 2007 crash, Milken’s corporate valuations were finally unmasked. Faced with a long list of fraud charges in 1990, he pleaded guilty to a selected few and was sentenced to two years in jail with a personal fine of over $4 billion (which he paid with plenty left over to continue his considerable benefactions to medical charity).
So much for objectivity. But isn’t there some way to overcome the natural self- interest of management, a way to correct measurement bias through the analytical verification of corporate value? Actually there isn’t. This has to do with the nature of value itself. In philosophical terms: value is its own representation.
This rule of financial reality became clear to me through the rise (and once again fall) of an ex-McKinsey & Company colleague, Jeff Skilling. Based on his radical ideas for finance in the complex and notoriously risky business of natural gas, Skilling was hired in 1990 by his main client, Enron, in Houston, Texas. Eventually he became its CEO.
Skilling, like Black and Milken before him, created a new measure of corporate value for Enron. The measure itself was old hat to corporate finance pros, since it was based on one of its fundamental postulates: the real value of a commercial entity is its discounted expected future cash flows.
To compute the corporate value, he merely estimated the future flows of actual (not accounting) flows in and out of the company/project/contract and applied the appropriate discount rate year by year. The result is what is called Net Present Value (NPV), perhaps the most fundamental concept in corporate finance.
So Skilling had some solid theoretical basis for his method of valuation. And he created a ‘following’ in the financial industry, that tracked and promoted this value assiduously. He even convinced the now defunct auditing firm of Arthur Andersen to subordinate its entire accounting system to this NPV regime.
Through an otherwise insignificant technical error in one of the myriad subsidiaries, the NPV house of cards was revealed for what it was: a simulacrum of value based on overheated managerial dreams. Within a few months of the slip Enron was bankrupt. Skilling and most of his senior management were indicted for securities fraud and false accounting. Currently Skilling is serving his sentence in federal prison and may be eligible for parole in 2017.
The whole valuation of Enron had come to rest on a theory of value applied by Skilling. At one level a black comedy, Skilling still protests his innocence. In at least one sense he is right. Not excusing criminal behaviour, nonetheless he was also a victim of the culture of corporate finance.
And then there is Bernie Madoff and the well-known scandal that broke late in 2008 around his so-called Ponzi scheme.
I had come competitively head to head with this éminence grise of finance when I was appointed arriviste Managing Director International for the American Stock Exchange. Madoff was then the Chairman of the National Association of Securities Dealers (NASD) as well as head of his own highly successful firm for more than four decades.
So the shock of Madoff’s admission that he had been engaging in fraud for years was profound. Most commentators asked the question “How?” How could Madoff dupe the regulators and analysts? How could he maintain the pretence without cracking over all those years? But for me the central question – for Madoff but also the others – remains not “How?” but “Why?” Why would one of the most respected men in global finance commit such a dire sin?
The facile and common explanation is: egotistical arrogance. The market went wrong and Madoff couldn’t admit poor judgement. But this doesn’t mesh with my experience of the man. There is, for me, a less ignoble if no less harsh interpretation of events.
Liquidity – the ability to find funding for a business even in times of temporary setbacks – is a core presumption of financial theory. The freezing of markets – illiquidity – is the financial equivalent of the existence of black holes in astrophysics: all the normal rules are suspended; theory fails.
For someone as consistently successful as Madoff (or Milken, Skilling, and for that matter Uncle Fischer, Scholes and Merton), however, liquidity is more than a theoretical presumption. It is a substantial right, an effective norm, which has been earned by previous success and implied by financial theory. Madoff’s liquidity would have been jeopardised by proper accounting of his initial book losses (just as it would have been for Skilling and Milken).
Given their track records, each of these men in their own way could well have felt compelled, duty-bound by the logic of corporate finance, to protect their liquidity for the sake of, and even as an obligation to, their clients until ‘reason’ – the logic of corporate finance – returned to the markets: Madoff by essentially using funds from new clients to support the existing clients; Skilling by creating complex, impenetrable intra-company transactions; Milken by insider dealing with ‘arbitrageurs’ like Ivan Boesky; Black and Scholes by simply ignoring the consequences of the very real if theoretically inconvenient liquidity crises that regularly hit companies such as Bear Stearns, Lehmans or Northern Rock, not forgetting the $4.8 billion federal bailout of hedge fund Long-Term Capital Management in 1998, on whose board both Scholes and Merton sat.
To paraphrase John Maynard Keynes: “The market can stay irrational for a lot longer than you can stay liquid.” To a man, and they were all men, they were caught out by this irrationality. Their theories didn’t allow for it.
Excusing no criminal act, nonetheless their behaviour was consistent with the culture of corporate finance. This culture seems to be least visible, and therefore most obsessively compelling, to those engaged in it most intimately. In the Wealth of Nations in 1776, Adam Smith insisted, “It is fear of losing employment which restrains fraud and corrects negligence.” But this was before the rise of the corporation. Today the inverse is more probably true: fear of failure promotes fraud and deceit.
Dr Michael Black is the librarian at Blackfriars Hall, a Permanent Private Hall of the University, a Community of more than 20 Dominican Friars and a centre for the study of theology and philosophy.
Image by Oxford University Images/Job Sessions