I came across an amusing quote from one of the most revered academics in finance this week. Robert Merton, the man who refined the legendary Black-Scholes option pricing formula, was speaking at the CFA Insitute event and was talking about his time at Long Term Capital Management. Whilst there he was fundamental to the process of setting up the risk management models that governed how LTCM should manage their funds that famously failed to predict the eventual downfall of the fund. Merton however seems to have displaced the blame onto everyone else. He is reported to have said that the fund was carefully managed from a risk perspective (!?!) but that it had been undermined by the unforeseen risk-averse behaviour of its counterparties. I may not have one tenth the mathematical genius of the great man, but it seems to me an odd way of explaining the debacle. Surely the risk models were too naive - not giving enough weight to the likelihood of a loss and not taking into account the correlated behaviours of previously uncorrelated markets. Participants today all realise that markets actually have much "fatter tails" (or in mathematical terms are leptokurtic) than the normal distribution appears to suggest and the all-too-human flight to liquidity that was triggered after the Russian default should clearly have been incorporated into the models. It does feel odd criticising a man who stands so tall in the pantheon of financial theory, but I just felt he seemed to be doing modern risk managers a disservice by suggesting that LTCM had cracked risk governance and that if fault were to be assigned to anyone it should be to LTCM's counterparties and not to LTCM.