Essay on Investment Theory: Continued
Uncontrollable Risk
Lying As A Profession
The same lackadaisical attitude about lying had been observed in Solomon Brothers, when John Meriwether took a soft approach on discovering that a subordinate had falsified statements to the U.S. Treasury Department.
Although this eventually ended Meriwether's career at Salomon Brothers, when the government learned of the lie, his apparent unconcern with strict standards of honesty did not bother others in the market who thought he had been unfairly treated, nor did it faze the investors who were to entrust Meriwether with $1.25 billion of their money in Long Term Capital Management.
The same lackadaisical attitude about lying was observed at Barings Bank with Nick Leeson as at Solomon Brothers with John Meriwether.
It had been two generations since the words, 'My Word Is My Bond' had blazed across the wall of the London Stock Exchange (the LSE is now electronic and there is no longer a trading floor).
The harsh moral code of John Pierpont Morgan, with connotations of duty and honor that earned respect in the nineteenth and early twentieth centuries had been long forgotten and could barely be grasped by a generation of Baby-boomers with MBAs from liberal colleges.
The fundamental nature of over-the-counter proprietary trading in securities, especially in the comparatively illiquid derivatives markets, is lying and deception.
It is not accidental that John Meriwether honed the skills of his trading staff with a game called Liar's Poker (7).
A lack of candor with counterparties and clients is considered essential to success by most market intermediaries.
The economists who boosted the derivatives markets seemed to be more sympathetic with Keynes' view that the objective of securities trading is 'to pass the bad, or depreciating, half-crown to the other fellow', than with the moral and ethical foundations of Adam Smith.
When Myron Scholes, in the Conseco incident, candidly revealed that the practical application of the Black-Scholes Model depended on taking advantage of fools, he unthinkingly touched on the greatest weaknesses in his theory – the assumption that markets were perfect and that prices reflected the considered judgment of rational, intelligent investors.
The Apex of Recklessness
In 1996, problems in the derivative market continued to make headlines. Sumitomo Corporation revealed a loss of $ 1.8 billion in copper derivatives, allegedly due to unauthorized trading by a single trader, Yasuo Hamanaka.
Again, the difficulty that supposedly sophisticated institutions were having in dealing with the risks of derivative trading was apparent.
In a market in which ethical training consists of playing Liar's Poker, it would seem to be the height of folly to wager the entire capital of major banks on verbal contracts, laced with errors and burdened by substantial disagreement between the parties.
Of particular concern should have been the fact that a large portion of the OTC derivative contract market is long-term, with obligations extending for more than one year.
The casualness and lack of precision with which major banks enter into derivative contracts is shocking.
Furthermore, the banks and dealers often operate out of different legal and regulatory jurisdictions and enforcement of international contracts, in the event of a major crunch, is problematical, as was the case in Indonesia in 1997.
To the common person accustomed to the caution and extensive formalities associated with obtaining a hundred thousand dollar home mortgage, the casualness and lack of precision with which major banks enter into multi-million dollar derivative contracts would be shocking.
Defenders of the OTC derivative markets, of course, claim that despite untidiness, these risky instruments play a vital role in protecting investors and business people against currency and interest rate fluctuations.
Besides, it is claimed, derivative trading by major banks provides liquidity in this essential market.
These arguments remind us of those justifying state lotteries as 'funding for education', or even the rationalization of racetracks as an incentive for breeding better horses – generations after the invention of the automobile.
The LTCM Bailout
In 1994, Long Term Capital Management suffered tremendous losses following defaults in Russian bonds.
The failure of LTCM would have reverberated throughout the world markets as counterparties raced to dump collateral and unwind positions.
LTCM promoters ran to the U.S. Federal Reserve Bank for assistance, although technically they were not under the jurisdiction of banking authorities.
The Federal Reserve twisted arms and got banks to put up depositors' money to bail out a speculative scheme.
The Federal Reserve gathered together fourteen major banks in its offices and used moral suasion to elicit $3.65 billion of depositors' and shareholders' money in a massive bail-out of the LTCM speculative scheme.
The contributors included famous Wall Street institutions like Bankers Trust, Bear Stearns, Chase Manhattan, Goldman Sachs, J.P. Morgan, Lehman Brothers, Merrill Lynch, Morgan Stanley Dean Witter, and Salomon Smith Barney.
The LTCM fiasco gave rise to some snickering and schadenfreude among those who were pleased to see the proud Nobel laureates get their comeuppance.
The LTCM Affair Is Forgotten
There was concern among policy-wonks that the involvement of the Federal Reserve was another case of the 'Too Big Too Fail' syndrome, giving further impetus to government sanctioned moral hazards in banking.
Despite investigations of LTCM, the government did little to reform the system
Charges of crony capitalism and political favoritism captured headlines for a while.
President Clinton even empanelled a multi-agency Working Group on Financial Markets to study the LTCM case, which issued a mild report in April 1999, while Congress, the Federal Reserve, the SEC, and the Treasury Department did little to reform the system.
The collapse of the world's largest hedge fund faded into history.
No Jail For The Professors
In some ways, the fall of LTCM was similar to scandals at Barings Bank, Orange County, and corporations that had unwisely invested in derivatives.
However, no one went to jail and suggestions of impropriety were muted.
LTCM executives demonstrated reckless abandon in managing the money of investors, but they never represented that they would do otherwise.
LTCM executives never suggested that they would invest with prudence.
The LTCM professors did understate the downside perils in management's October 1994 letter to investors, claiming unreasonably precise knowledge of the degree of risk (8) that was being assumed, but this was an honest mistake based on widely accepted financial theories soon to be blessed by the Nobel committee.
Besides, the promoters had two lucky breaks that protected investors.
- The first was having started the fund in 1994, in the depths of a violent collapse in the bond market. This helped the fund to show excellent results as markets recovered over the next two years.
- The second providential occurrence was the promoters' decision to return $2.7 billion to investors in 1997, thereby reducing equity and increasing leverage. Expecting that profits could be maintained, management thought that reducing equity would improve numerical returns on capital. This was in line with the 'asset-lite' philosophy that dominated American business. However, at the time, this tactic was not popular with LTCM shareholders who thought they were being forced out of a good deal.
When the fund collapsed in 1998, investors had little cause to complain. Most had gotten their money back with reasonable profit.
The banks were left holding the bag and had themselves to blame.
This left fourteen major banks and many market intermediaries holding the bag due to the excessive leverage that finally drove LTCM to the wall.
Banks had themselves to blame for failing to demand adequate collateral in dealing with LTCM.
These institutions, however, were not likely to make an outcry, since their weak credit policies and gullibility had gotten them in this mess.
Moreover, the largest banks were themselves important players in derivative trading; the Great Bubble was still underway.
The Epiphany that Never Was
The fatal flaws in the Black-Scholes Model, already noted by other economists, were now revealed in a real life experiment.
However, what should have been learned from the LTCM case had more to do with the behavior of bankers and investors, than with the mistakes of fund promoters or errors in financial theory.
The LTCM affair revealed how far large banks had departed from sound credit practices.
The collapse of LTCM exposed the degree to which large banks and the Federal Reserve had departed from sound credit practices, jumping into bed with wild speculators – inflating the pot for leveraged betting on derivative trading, while showing a tenuous grasp of the risks they were assuming.
To the extent that banks with derivatives trading desks existed solely to bet on rate changes in other markets, they had become the direct descendents of the bucket shops of the 1920s.
The fall of LTCM did not bring about an Epiphany.
There were few strident calls for reform in derivative trading.
A Quagmire of Uncertainty
Over the years, there were some highly publicized instances of financial mismanagement in derivative trading. However, these were seen as isolated examples of weak controls, malfeasance, or poor judgment – not systemic risk.
The seven thousand derivative contracts of LTCM had a notional value of about two percent of the global OTC derivative market, perhaps not enough to trigger widespread collapse, but then, nobody could be sure.
The Asian crisis had introduced a large measure of uncertainty in the elite's understanding of systemic risk.
Even more worrisome was the massive scope of involvement of banks in ventures of questionable social merit.
One aspect of the LTCM case that might have raised eyebrows and brought action from market regulators was that banks had used derivative markets to evade Federal Reserve Regulation T on margin loans.
What should have been even more worrisome was the massive scope of involvement of banks in ventures that had questionable social value other than providing speculative profits to a few rich people, giving some a disproportionate share of profits from money risked by so-called 'sophisticated institutions' that represented modest investors and pensioners.
The Stock Market Crash of 1987 was an early sign of systemic risk in derivative markets, as concentrated program trading linked derivatives markets with spot markets, suddenly drying up liquidity and crashing prices.
This was understood as a problem in trading methods of organized exchanges.
Rules were issued to curb excessive volatility in prices.
John Reed, the head of Citicorp and one of the last old-school bankers to run that prestigious institution, showed responsible leadership by encouraging financiers from around the world to join into a Group of Thirty that would address risks in international clearing and settlement.
By 2000, total notional value of the OTC derivatives market exceeded one hundred trillion dollars.
No equivalent effective reforms of the OTC market followed the fall of LTCM.
By the year 2000, the total notional value of global OTC market in derivatives exceeded one hundred trillion dollars, mainly interest rate and currency swaps, options, and forwards.
During the 1990s, the market had expanded five-fold, having become an integral part of the international financial system.
The involvement of so many banks in granting credit to LTCM showed how low loan concession standards had fallen during the years of the Clinton administration.
The LTCM case was a harbinger of scandals that rocked Enron, WorldCom, and other public companies when the Great Bubble finally burst.
The leaders of the world's largest financial institutions no longer understood the systemic risks in the vast, unregulated derivatives market.
In retrospect, it seems that the Federal Reserve engineered the bailout of LTCM when it dawned on the leaders of the world's largest financial institutions that they no longer understood the systemic risks in the vast, unregulated derivatives market – although no one said this for publication.
If the wisest of the wise in LTCM had proven they did not know what they were doing, how could ordinary bankers presume to know better?
In 1997, one year before the LTCM collapse, the International Monetary Fund, the World Bank, and the U.S. Treasury Department, along with the Finance ministers in Korea, Thailand, and Indonesia, had found how little they understood of global systemic risk, as economies of Asian nations tumbled like dominoes.
LTCM might have been a trigger to an even greater catastrophe – but no one knew for sure.
Unfathomable Complexity, Undefined Risk
Some trading in derivatives takes place on organized exchanges throughout the world, with distinct safeguards and prudent rules.
However, a large share of the market is over-the-counter, between proprietary trading desks of banks, brokers, and dealers.
The OTC market is non-standardized and has no central clearinghouse.
Trading is document intensive and error-prone.
OTC trading involves unwritten contracts, with delayed and often unacknowledged confirmation.
It is unknown how many traders are speculating and how many creating legitimate hedges for clients.
In March 2003, Milton Friedman, a famous economist, warned against the hazards in this market, but the financial establishment, led by the Wall Street Journal, hooted in derision, suggesting he return his Nobel Prize.
Nevertheless, bank derivative trading and speculation in non-diversifiable foreign exchange and interest rate contracts may someday lead to a situation that will unhinge the strongest economies.
Bank speculation in non-diversifiable foreign exchange and interest rate derivative contracts may someday unhinge the strongest economies.
Just because risks are unknown, it does not mean there is no cause to worry.
Although over-the-counter derivative markets were not a direct cause of the collapse of the Great Bubble of the 1990s, they represented a way of thinking that led to 'asset-lite' management techniques that encouraged over-reliance on debt financing.
Derivatives are symptomatic of a perception of risk that endorses the redemption of stock and led to an endemic shortage of equities.
In the new century, the hazards of a vast, unregulated derivatives market will present latent perils to the economic order – dangers that may loom over financial markets for decades.
A Threat To World Banking
Unregulated derivatives trading, rather than serving as a protection against variance in exchange and interest rates, is a risk-multiplier, especially when the largest banks bet a sizeable chunk of depositors' money on puts, calls, and swaps.
The largest banks bet a sizeable chunk of depositors' money on puts, calls, and swaps.
During the 1920s, weaknesses in banking culminated in the Crash of 1929.
In the twenty-first century, fault lines in the one-hundred-trillion dollar derivatives market may presage unwelcome consequences.
Large banks have already suffered billion dollar losses playing this market and further debacles are likely.
A 'perfect storm' in exchange or interest rates may yet tumble more than a single fund or bank.
Shaky Foundations of Equity Valuation
This brings us to the question of how equities are valued.
The LTCM failure revealed that the confusing economic theories that justified high stock prices during the Great Bubble were suspect and in need of revision.
The confusing economic theories behind the LTCM failure were from the same sources that justified high stock prices during the Great Bubble.
However the 1994 declaration of the Financial Economists Roundtable and the Federal Reserves economists' assertion in 2000 that 'Irving Fisher Was Right' in saying that stocks were under-valued in 1929, showed how deeply theories can become ingrained in the social structure of markets.
Generations may come and go before the thousands of articles propounding the teachings of today's financial economists are eaten by bookworms and turned to dust.
It certainly will take at least another two or three decades before the economists themselves pass on to the next world, leaving others to tutor the MBAs that will managed future financial institutions, issuers, and investors' funds.
Economic theories have great inertia and continue to influence behavior long after the circumstances under which they were proposed no longer exist.
September 6, 2020
Essay: end
Notes:
(1) 'When Genius Failed. The Rise and Fall of Long Term Capital Management', Roger Lowenstein, Random House Trade Paperbacks, New York, 2000.
(2) 'Closed for the Holiday: The Bank Holiday of 1933', Federal Reserve Bank of Boston.
(3) Op cit, page 33- 34. Roger Lowenstein cited this information as gained from an interview with Maxwell Bublitz, an investment official of Conseco.
(4) Swaps Monitor Publications, Inc., 2000.
(5) 'Central Bank Survey of Foreign Exchange and Derivatives Market Activity', Bank for International Settlements, Basle, 1999.
(6) See: SwapsMonitor.Com article of November 7, 2020, published on the Internet.
(7) 'Liar's Poker, Rising Through the Wreckage on Wall Street', Michael Lewis, W.W. Norton & Company, New York, 1989.
(8) LTCM , letter to investors, 'Addendum # 1, Volatility and Risk Characteristics of Investments in Long-Term Capital Portfolio L.P., October 10, 2020.
