Who is he?
Black (1938-95) was an American economist who, with Myron Scholes, invented a theory that almost brought the world’s financial system to its knees.
What’s the theory?
It all began with options. A way to control risk, options give the owner the right to buy or sell an asset for a pre-set price in the future. The question was, how to value them. Before Black and Scholes, it was guesswork. After Black and Scholes did their number crunching in 1973, it was as simple as applying a formula. The Black-Scholes Option Theory took the financial world by storm.
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Great. Everyone was happy.
Er, no. It all went wrong. Scholes won a Nobel Prize for Economics with Robert Merton, who refined the formula, and they joined the bond trader John Merriwether to set up Long Term Capital Management (LTCM) in 1994. It was spectacularly successful and highly secretive.
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So what was the problem?
LTCM was supposed to be an infallible investment vehicle. It wasn’t. It all came crashing down when the Russian Government defaulted on its bonds in August 1998. Investors panicked, the theory went to pieces and the full extent of LTCM’s hubris was revealed. It had used a mere $2.5 billion in capital as collateral for $125 billion in securities, which in turn affected about $1.25 trillion in securities. The US Federal Reserve feared that, had all LTCM’s lenders wanted their money at once, the global financial system would not have taken the strain. It made the banks cough up $300 million each for a $3.6 billion bail out.
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What happened to Black?
He died of lung cancer in 1995. But Scholes’s problems go on. A federal judge found LTCM guilty of using sham transactions to avoid tax. The whole story, says The Washington Post, is “the ideal parable for the idiocy of markets”.