From the March 01, 2009 issue of Futures Magazine • Subscribe!

Panic: The Story of Modern Financial Insanity

Panic: The Story of Modern Financial Insanity

By Michael Lewis

W.W. Norton & Co.

352 pages, $27.95

Michael Lewis is a terrific writer and “Liar’s Poker” is still worth reading 20 years after publication. His tales of idiosyncratic traders and their bizarre behavior are believable and well rendered. Unfortunately, Lewis, who is credited with editing the book, wrote only six of the 55 essays. Almost all the essays were previously published, some more than 20 years ago. One is tempted to describe the work as a literary derivative.

The non-Lewis essays are generally interesting and well written, but lacking his sense of humor, with one unintentional exception. A Wall Street Journal article discusses the dot-com bubble and quotes at length from a former Nasdaq chairman by the name of Bernard Madoff. “It was insanity,” Madoff says. “This thing was getting out of control.”

These essays cover financial panics since the mid-1980s, and Lewis asserts these panics were different from those earlier panics because they were fueled by financial derivatives. His first two derivative panics are the 1987 stock market crash and 1997-1998 Asian currency collapse. But were those panics any different from earlier financial meltdowns, such as the 1973-1974 panic caused by the Six Day War, the Arab oil embargo and the Watergate crisis culminating in the resignation of President Nixon and the collapse of the stock market? Or the 1979-1980 panic caused by the Iranian hostage crisis, the Soviet invasion of Afghanistan and the Hunt Brothers’ attempt to corner the silver market, which drove silver from $6 per ounce to more than $50 as interest rates soared and stocks tanked?

A comparison of those four panics could lead to the conclusion that financial derivatives accelerate panics, as Lewis suggests, but because the corrections are so rapid, the derivative panics were actually shorter and less damaging. The markets recovered much more rapidly from the1987 crash and the 1998 Asian currency collapse than after the 1974 and 1980 panics.

Nonetheless, Lewis identifies the principle source of recent financial panics. Surprisingly, his villain is the Black-Scholes formula for pricing options. He claims the Black-Scholes model caused the recent subprime mortgage meltdown because it misled borrowers about the true risks of adjustable mortgage contracts, including millions of folks who had never heard of Black or Scholes, and this gave them “the excuse to risk the roof over their head.”

For 20 years I traded options in the pits of the Chicago Board of Trade using the Black-Scholes formula and its offspring. Blaming the formula for my losses would have been like blaming the thermostat when I was shivering. There were financial panics before Fisher Black and Myron Scholes were born, and there will be financial panics if Congress declares the Black-Scholes formula illegal tomorrow. Panics are caused by human herds, not by formulas.

At worst, the Black-Scholes formula is a symbol of the flaws of quantitative analysis. But bizarrely, one of the strongest defenses of quantitative analysis comes in Lewis’ own essay on Long Term Capital Management (LTCM). It is hard to reconcile that essay with his introduction to the book. Lewis says LTCM relied on mathematical models and the losses weren’t really LTCM’s fault because “the statistical probability” of what happened to LTCM was “1 in 50 million.”

Nonetheless, in his introduction Lewis discusses the writings of Nassim Nicholas Taleb, the author of “The Black Swan” and “Fooled by Randomness.” A perusal of Taleb’s website is entertaining, to say the least. Taleb is the Ann Coulter of financial writers. His opinions are never hedged by Black-Scholes or any other model. As Lewis reports, Taleb has demanded that the Nobel Committee revoke the Nobel Prize in Economics it awarded to Myron Scholes. The Black-Scholes formula, Taleb says, is bunk. One wonders what Taleb would say about Lewis’ essay on LTCM and his “1 in 50 million” claim.

Apparently when Lewis’ former boss, John Merriwether, relied on financial formulas and lost billions at LTCM, the markets acted irrationally. Now a few years later, Lewis cites Taleb for the claim that people act irrationally by relying on financial formulas.

One also wonders why Taleb has gone public with his startling discovery about the flaws in the Black-Scholes formula. Prices of options in the markets are still based on offspring of Black-Scholes. If the markets are systematically under-pricing risk, Taleb should buy options by the boatload. But as Lewis himself says, if authors on financial folly knew so much, “they’d spare themselves the trouble of making their living by writing books and articles about financial folly and open hedge funds.” Until Taleb opens the Nassim Taleb Hedge Fund, caution about his claims would seem to be indicated.

By way of contrast, one of the best essays in the book is on John Paulson and his anti-subprime hedge fund. Paulson saw the subprime meltdown coming and made billions. He has also written excellent articles on how Treasury should handle the bailout, all of which have been generally ignored by Treasury. As they used to say on the floor of the Board of Trade, money talks and baloney walks.

In any case, “Panic!” promotes these well written and edited essays for the benefit of charity, so what the heck, I give the book two thumbs up.

Frederic Townsend traded for 20 years in the pits of the Chicago Board of Trade, the Chicago Mercantile Exchange and the Sydney Futures Exchange. Reach him at

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