The Difference Between Being Tested and Being Watched

In the autumn of 1998, a hedge fund called Long-Term Capital Management lost roughly $4.6 billion in about four months and had to be unwound by a consortium of banks assembled at the Federal Reserve’s request, for fear its collapse would take the rest of Wall Street down with it. The fund’s principals included two Nobel laureates in economics and a team that had, by any ordinary measure, done the math correctly. Their models of bond spreads were not naive. They had been checked, refined, and checked again. And they failed anyway — not because the arithmetic was wrong, but because the thing being modeled had started paying attention to the model. That sounds like a category error. Bond markets don’t pay attention to anything; they’re just prices. But by 1998 a great many trading desks were running strategies close enough to LTCM’s that when the fund needed to unwind its positions, it was selling into a market full of people who had learned, directly or by imitation, to think the way…