Long Term Capital Management

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pages: 206 words: 70,924

The Rise of the Quants: Marschak, Sharpe, Black, Scholes and Merton by Colin Read

"Robert Solow", Albert Einstein, Bayesian statistics, Black-Scholes formula, Bretton Woods, Brownian motion, business cycle, capital asset pricing model, collateralized debt obligation, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, David Ricardo: comparative advantage, discovery of penicillin, discrete time, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, floating exchange rates, full employment, Henri Poincaré, implied volatility, index fund, Isaac Newton, John Meriwether, John von Neumann, Joseph Schumpeter, Kenneth Arrow, Long Term Capital Management, Louis Bachelier, margin call, market clearing, martingale, means of production, moral hazard, Myron Scholes, Paul Samuelson, price stability, principal–agent problem, quantitative trading / quantitative finance, RAND corporation, random walk, risk tolerance, risk/return, Ronald Reagan, shareholder value, Sharpe ratio, short selling, stochastic process, Thales and the olive presses, Thales of Miletus, The Chicago School, the scientific method, too big to fail, transaction costs, tulip mania, Works Progress Administration, yield curve

But everybody understood that this company was the most theoretically sophisticated investment house ever created. That was their calling card, and investors clamored to have Long Term Capital Management invest their wealth. These financial theorists understood one thing. Their models typically assume that there are zero transaction costs. We might consider a 180-person firm to be expensive to operate, but the initial funding of the firm represented more than $5 million invested per employee. 168 The Rise of the Quants Long Term Capital Management used the facilities of others, such as Bear Stearns and Merrill Lynch, and the company was registered in the Cayman Islands to reduce regulatory overhead and minimize tax consequences. So that they could avoid the regulation imposed on mutual funds, Long Term Capital Management was organized as a hedge fund, under the Investment Company Act of 1940, which imposes little oversight but allows the admission of only very well-heeled millionaires who understood the risks of a highly leveraged strategy and could afford to lose some money on occasion.

When there was price convergence for these longest-term bonds, and others began to take notice and to imitate Long Term Capital Management’s success, the company had to hunt for other mispricing opportunities and liquidity differentials. These increasingly aggressive trades may no longer have been of the form of price convergence arbitrage trades, and sometimes would not differ from the strategies that were employed by less theoretically motivated trading houses. They began trading traditional options and placed themselves in the position of acting as the insurer of funds operated by other trading houses through their options strategies. Of course, as AIG also discovered much later, every insurance scheme can be profitable so long as there are no claims. If prices rose as Long Term Capital Management predicted, the premiums it collected were simply pure profit. Long Term Capital Management’s strategy was very profitable so long as the market continued on a trajectory that had been maintained ever since the company’s inception.

The Federal Reserve Bank of New York, as the Federal District Bank responsible for the oversight of Wall Street, and its Chairman Allan Greenspan organized a bailout of almost $4 billion to save Long Term Capital Management out of concern that its failure would also bring down the other investment houses with which they subscribed as counterparties. The New York Fed assembled leaders of all the major investment houses in its conference room on September 23, 1998 to construct a plan for the bailout of the highest-flying investment house of the day. The talk resulted in an offer by AIG, Goldman Sachs, and Berkshire Hathaway to buy out the partners of Long Term Capital Management for $250 million and inject an additional $3.75 million into the fund, which they proposed would be absorbed into the Goldman Sachs trading department. The Nobel Prize, Life, and Legacy 171 The group gave John Meriwether and Long Term Capital Management an hour to decide whether they would accept the offer the New York Fed thought they could not refuse.


pages: 198 words: 53,264

Big Mistakes: The Best Investors and Their Worst Investments by Michael Batnick

activist fund / activist shareholder / activist investor, Airbnb, Albert Einstein, asset allocation, bitcoin, Bretton Woods, buy and hold, buy low sell high, cognitive bias, cognitive dissonance, Credit Default Swap, cryptocurrency, Daniel Kahneman / Amos Tversky, endowment effect, financial innovation, fixed income, hindsight bias, index fund, invention of the wheel, Isaac Newton, John Meriwether, Kickstarter, Long Term Capital Management, loss aversion, mega-rich, merger arbitrage, Myron Scholes, Paul Samuelson, quantitative easing, Renaissance Technologies, Richard Thaler, Robert Shiller, Robert Shiller, Snapchat, Stephen Hawking, Steve Jobs, Steve Wozniak, stocks for the long run, transcontinental railway, value at risk, Vanguard fund, Y Combinator

With any activity that involves both skill and luck, as investing clearly does, as skill and intelligence improve, luck or chance plays an increasing role in the outcome. Michael Mauboussin has written about this idea many times, and he calls it the paradox of skill. The takeaway is that there is a lot of skilled market participants; so, intelligence alone is not enough. Other skills are required. Genius and its limitations are exemplified in no better way than by studying John Meriwether and his band of Einsteins at Long‐Term Capital Management. John Meriwether founded Long‐Term Capital Management in 1994 and before that he enjoyed a legendary two‐decade career as head of the fixed‐income arbitrage group and vice chairman at Salomon Brothers. At Salomon, he surrounded himself with some of the brightest minds in the industry. Michael Lewis, who began his career at Salomon Brothers, wrote in the New York Times, “Meriwether was like a gifted editor or a brilliant director: he had a nose for unusual people and the ability to persuade them to run with their talents…Meriwether had taken it upon himself to set up a sort of underground railroad that ran from the finest graduate finance and math programs directly onto the Salomon trading floor.

Edward Chancellor, Devil Take the Hindmost (New York: Penguin, 1999), 339. 9. Lowenstein, When Genius Failed. 10. Loomis, “A House Built on Sand.” 11. Lowenstein, When Genius Failed, 94. 12. Ibid., 127. 13. Roger Lowenstein, “Long‐Term Capital Management: It's a Short‐Term Memory,” New York Times, September 7, 2008. 14. Lewis, “How the Eggheads Cracked.” 15. Chancellor, Devil Take the Hindmost, 339. 16. Peter Truell, “Fallen Star Manager,” New York Times, September 9, 1998. 17. Lowenstein, When Genius Failed, 120. 18. Ibid., 126. 19. Lowenstein, “Long‐Term Capital Management.” 20. Lowenstein, When Genius Failed, 180. 21. Ibid., 192. 22. Ibid., 80. 23. Quoted in Lowenstein, When Genius Failed, 64. 24. Nassim Taleb, Fooled by Randomness (New York: Random House, 2004), 242. 25. Jim Cramer, “Einstein Has Left the Building,” TheStreet.com, September 3, 1998.

Meriwether's goal was to outsmart everyone, and this advantage persisted for a long time. His band of wizards would became the most powerful, profitable group inside of Salomon Brothers. In a year in which John Gutfreund, CEO, earned $3.5 million, Meriwether was reportedly paid $89 million.4 But after a scandal at the Treasury rocked the bank, Meriwether was forced to resign. Shortly thereafter, his loyal protégés would follow. Meriwether launched Long‐Term Capital Management with two giants of financial academia at his side, who would both later become Nobel Laureates. One was Robert Merton, who earned a bachelor of science in engineering mathematics from Columbia University, a master of science from the California Institute of Technology, and his doctorate in economics from MIT. Prior to joining Salomon Brothers, Merton taught at the MIT Sloan School of Management until 1988, before moving to Harvard University.


pages: 584 words: 187,436

More Money Than God: Hedge Funds and the Making of a New Elite by Sebastian Mallaby

Andrei Shleifer, Asian financial crisis, asset-backed security, automated trading system, bank run, barriers to entry, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Bonfire of the Vanities, Bretton Woods, business cycle, buy and hold, capital controls, Carmen Reinhart, collapse of Lehman Brothers, collateralized debt obligation, computerized trading, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency manipulation / currency intervention, currency peg, Elliott wave, Eugene Fama: efficient market hypothesis, failed state, Fall of the Berlin Wall, financial deregulation, financial innovation, financial intermediation, fixed income, full employment, German hyperinflation, High speed trading, index fund, John Meriwether, Kenneth Rogoff, Kickstarter, Long Term Capital Management, margin call, market bubble, market clearing, market fundamentalism, merger arbitrage, money market fund, moral hazard, Myron Scholes, natural language processing, Network effects, new economy, Nikolai Kondratiev, pattern recognition, Paul Samuelson, pre–internet, quantitative hedge fund, quantitative trading / quantitative finance, random walk, Renaissance Technologies, Richard Thaler, risk-adjusted returns, risk/return, Robert Mercer, rolodex, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical arbitrage, statistical model, survivorship bias, technology bubble, The Great Moderation, The Myth of the Rational Market, the new new thing, too big to fail, transaction costs

Rosenfeld, Harvard Business School presentation. See also Perold, “Long-Term Capital Management.” 20. For example, at the time of the Bank of China party, LTCM’s leverage was about nineteen to one—extraordinarily high relative to most other hedge funds. But, according to the firm’s calculations, LTCM’s value at risk was $720 million, and its $6.7 billion in capital was more than enough to absorb that. See Perold, “Long-Term Capital Management.” 21. Many hedge funds borrowed cheaply by financing positions in the repo market with overnight money. Long-Term was willing to pay more in order to lock the money up for six to twelve months. It also arranged a three-year loan and a standby credit. Rosenfeld presentation; Perold, “Long-Term Capital Management.” 22. Having done its best to lock up capital in these ways, LTCM calculated the residual liquidity risk, gaming out scenarios in which its brokers changed the terms of their lending.

But by 1988, when Asness arrived in Chicago, Fama was leading the revisionist charge: Along with a younger colleague, Kenneth French, Fama discovered non-random patterns in markets that could be lucrative for traders. After contributing to this literature, Asness headed off to Wall Street and soon opened his hedge fund. In similar fashion, the Nobel laureates Myron Scholes and Robert Merton, whose formula for pricing options grew out of the efficient-markets school, signed up with the hedge fund Long-Term Capital Management. Andrei Shleifer, the Harvard economist who had compared the efficient-market theory to a crashing stock, helped to create an investment company called LSV with two fellow finance professors. His coauthor, Lawrence Summers, made the most of a gap between stints as president of Harvard and economic adviser to President Obama to sign on with D. E. Shaw, a quantitative hedge fund.9 Yet the biggest effect of the new inefficient-market consensus was not that academics flocked to hedge funds.

In 1994, the Federal Reserve announced a tiny one-quarter-of-a-percentage-point rise in short-term interest rates, and the bond market went into a mad spin; leveraged hedge funds had been wrong-footed by the move, and they began dumping positions furiously. Foreshadowing future financial panics, the turmoil spread from the United States to Japan, Europe, and the emerging world; several hedge funds sank, and for a few hours it even looked as though the storied firm of Bankers Trust might be dragged down with them. As if this were not warning enough, the world was treated to another hedge-fund failure four years later, when Long-Term Capital Management and its crew of Nobel laureates went bust; terrified that a chaotic bankruptcy would topple Lehman Brothers and other dominoes besides, panicked regulators rushed in to oversee LTCM’s burial. Meanwhile, hedge funds wreaked havoc with exchange-rate policies in Europe and Asia. After the East Asian crisis, Malaysia’s prime minister, Mahathir Mohamad, lamented that “all these countries have spent 40 years trying to build up their economies and a moron like Soros comes along with a lot of money to speculate and ruins things.”10 And so, by the start of the twenty-first century, there were two competing views of hedge funds.


pages: 467 words: 154,960

Trend Following: How Great Traders Make Millions in Up or Down Markets by Michael W. Covel

Albert Einstein, Atul Gawande, backtesting, beat the dealer, Bernie Madoff, Black Swan, buy and hold, buy low sell high, capital asset pricing model, Clayton Christensen, commodity trading advisor, computerized trading, correlation coefficient, Daniel Kahneman / Amos Tversky, delayed gratification, deliberate practice, diversification, diversified portfolio, Edward Thorp, Elliott wave, Emanuel Derman, Eugene Fama: efficient market hypothesis, Everything should be made as simple as possible, fiat currency, fixed income, game design, hindsight bias, housing crisis, index fund, Isaac Newton, John Meriwether, John Nash: game theory, linear programming, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, market fundamentalism, market microstructure, mental accounting, money market fund, Myron Scholes, Nash equilibrium, new economy, Nick Leeson, Ponzi scheme, prediction markets, random walk, Renaissance Technologies, Richard Feynman, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, shareholder value, Sharpe ratio, short selling, South Sea Bubble, Stephen Hawking, survivorship bias, systematic trading, the scientific method, Thomas L Friedman, too big to fail, transaction costs, upwardly mobile, value at risk, Vanguard fund, William of Occam, zero-sum game

He also noted that Campbell had been long bonds and short a number of global stock index futures contracts ahead of the attack because of established trends.23 Their entries into positions were not triggered by actions on September 11. Their decisions to be in or out of the market were set in motion long before the unexpected event of September 11 happened. Although Enron, the California energy crisis, and September 11 are vivid illustrations of the zero-sum game with trend followers as the winners, the story of Long-Term Capital Management in the summer of 1998 may be the best trend following case study. Event #3: Long-Term Capital Management Collapse Long-Term Capital Management (LTCM) was a hedge fund that went bust in 1998. The story of who lost has been told repeatedly over the years; however, because trading is a zero-sum game, 151 152 Trend Following (Updated Edition): Learn to Make Millions in Up or Down Markets exploring the winners was the real story. LTCM is a classic saga of the zero-sum game played out on a grand scale with trend followers as winners.

., Jr, 62 Kerkorian, Kirk, 111 Killian, Mike, 125 Kingman, Dave, 143, 183-184 Klingler, James, 107 Klopenstein, Ralph, 39 Knapp, Volker, 393 Knoepffler, Alejandro, 273 Koppel, Ted, 117 Kovner, Bruce, 62, 282, 285, 289 Kozloff, Burt, 16 Kroc, Ray, 377 Kurczek, Dion, 393 kurtosis (statistics), 228 Lange, Harry, 111 Lao Tsu, 195 “law of small numbers,” 195 Le Bon, Gustave, 201 leadership traits, 201 “Learning to Love Non-Correlation” (research paper), 112 Lector, Hannibal, 221 Lee Kuan Yew, 205 Lee, Sang, 125 Leeson, Nick, 124-125, 168-172 Lefevre, Edwin, 91 Legg Mason, 285-286 Leggett, Robert, 241 Lehman Brothers, 153 Leonardo da Vinci, 242 leverage, decreasing returns and, 281-282 Levine, Karen, 203 Lewis, Michael, 184, 188 Liechtenstein Global Trust, 156 limitations of day trading, 272 linear versus nonlinear world, 224-229 Litner, John, 86 Little, Grady, 188-189 Little, Jim, 69, 71, 151, 253, 261 Litvinenko, Alexander, 199 Livermore, Jesse, 22, 90-93, 131, 236 Lo, Andrew, 271 Lombardi, Vince, 65, 176 Long Island Business News, 375 Long Term Capital Management (LTCM), xix, 118, 151-164, 272, 280, 293 long volatility, defined, 422 losers averaging, 235, 237-238 winners versus, 123-125 losing investment philosophies, 4-6 losing positions, when to exit, 262-263 losses. See also drawdowns handling, 22-23, 195-196 Long-Term Capital Management (LTCM) collapse, 156 zero-sum trading, 114-120 lottery example (risk and reward), 250-251 Lowenstein, Roger, 259 Lueck, Martin, 29 lumber trading, 134 Lynch, Peter, 110 Madoff, Bernard, 22, 223 The Man Group, 15, 29, 148, 157-158, 287 Managed Account Reports, 376 Mandelbrot, Benoit B., 228 manias, prospect theory, 194-199 Marcus, Michael, 19, 60, 62, 285 Marino, Dan, 261 market defined, 3-4 inefficiency of, 288-290 role of speculation in, 6 market price.

Part II 74 78 85 90 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 95 3 Performance Data . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 97 Absolute Returns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 98 Fear of Volatility and Confusion with Risk . . . . . . . . . . . . . . . . . . . . . . . . . . . . 99 Drawdowns . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 106 Correlation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 111 Zero Sum Nature of the Markets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 114 George Soros and Zero Sum . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 116 4 Big Events, Crashes, and Panics . . . . . . . . . . . . . . . . . . . . . . . . . . . . 123 Event #1: 2008 Stock Market Bubble and Crash . . . . . . . . . . . . . . . . . . . . . . 126 Day-by-Day Analysis . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 136 Event #2: 2000–2002 Stock Market Bubble . . . . . . . . . . . . . . . . . . . . . . . . . . 138 Event #3: Long-Term Capital Management Collapse . . . . . . . . . . . . . . . . . . . 151 Event #4: Asian Contagion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 164 Event #5: Barings Bank . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 168 Event #6: Metallgesellschaft . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 172 Final Thoughts . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 175 The Always “New” Coming Storm . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 178 5 Baseball: Thinking Outside the Batter’s Box . . . . . . . . . . . . . . . . . . . . 181 The Home Run . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 182 Moneyball and Billy Beane . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 185 John W.


pages: 257 words: 64,763

The Great American Stickup: How Reagan Republicans and Clinton Democrats Enriched Wall Street While Mugging Main Street by Robert Scheer

banking crisis, Bernie Madoff, Bernie Sanders, business cycle, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, facts on the ground, financial deregulation, fixed income, housing crisis, invisible hand, Long Term Capital Management, mega-rich, mortgage debt, new economy, old-boy network, Ponzi scheme, profit motive, Ralph Nader, Ronald Reagan, too big to fail, trickle-down economics

Bush administration as private, profit-driven pursue subprime, Alt-A, mortgages Gramm, Phil as antiregulatory, free-market ideologue background blames economic collapse on victims responsible for CFMA with ties to Enron as UBS executive weakens CRA standards for poor consumers Gramm, Wendy Lee background as deregulation activist exempts Enron from regulatory restraints as head of CFTC under Reagan, targets regulatory system tries to unseat Bush’s CFTC commissioner Gramm-Latta budget of 1981 Gramm-Leach-Bliley Act Grayson, Alan Great Depression Greenberger, Michael Greenspan, Alan on bailout of Long-Term Capital Management -Clinton agreement defines economic policy declares free markets as self-regulating on growth of OTC derivatives insists derivatives will self-regulate on irrational exuberance of economy opposes Born’s derivatives study, stance profiled, praised, in media in territorial rivalry with Rubin GSEs. See Government sponsored enterprises Hedge funds and AIG Geithner’s reliance on managers Long-Term Capital Management Paulson’s description to G. W. Bush receiving banks’ toxic holdings regulations prevented by Summers Hendrickson, Jill M. Hillebrand, Gail Hirsh, Michael Housing affordability as original purpose of GSEs bubble denied by Raines Fannie Mae, Freddie Mac, fail due to greed, corruption flipped in hot market and Goldman’s toxic derivatives not prime agenda of Fannie Mae, Freddie Mac Howard, J.

Born, who a decade later would begin to be seen as a modern-day Cassandra, recognized the problem immediately, as she would recall in a 2003 interview for Washington Lawyer magazine: “I became concerned about it once I got to the commission and began to learn about the OTC market. The more I learned, the more I realized we didn’t know.” She understood clearly that U.S. and international markets were facing great danger. She referred to Alan Greenspan himself, who said one of the reasons the Federal Reserve Board had supported the bailout of Long-Term Capital Management (a large hedge fund) was that they were “afraid it would have profound worldwide economic repercussions.” A Wall Street Journal article by Michael Schroeder and Greg Ip published December 13, 2001, five years after Born’s appointment, explained the escalating tension: “[Born’s] comments in speeches and in a discussion paper about the need for more oversight and regulation of OTC derivatives triggered an uproar among derivatives dealers—from J.

In dramatic fashion, according to the Wall Street Journal, she was summoned in June 1998 from the hospital bed of her daughter, who had undergone knee surgery, by Representative James Leach, chair of the House Committee on Banking and Financial Services, to an emergency meeting in which “regulatory staff and lawmakers berated Ms. Born for more than two hours in a fruitless effort to persuade her to stop her campaign.” Three months later, the collapse of Long-Term Capital Management led Leach to offer a grudging acknowledgment that Born wasn’t crazy. “You are welcome to claim some vindication,” he said at a congressional hearing. Born was still alive and kicking. Yet she had already aroused the extreme hostility of an army of corporate advocates—especially the formidable DC lobbying machine of Enron, which was “fanatical about preventing any hint of derivatives regulation” according to the Wall Street Journal reporters’ sources.


pages: 701 words: 199,010

The Crisis of Crowding: Quant Copycats, Ugly Models, and the New Crash Normal by Ludwig B. Chincarini

affirmative action, asset-backed security, automated trading system, bank run, banking crisis, Basel III, Bernie Madoff, Black-Scholes formula, business cycle, buttonwood tree, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, collective bargaining, corporate governance, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, delta neutral, discounted cash flows, diversification, diversified portfolio, family office, financial innovation, financial intermediation, fixed income, Flash crash, full employment, Gini coefficient, high net worth, hindsight bias, housing crisis, implied volatility, income inequality, interest rate derivative, interest rate swap, John Meriwether, Kickstarter, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, low skilled workers, margin call, market design, market fundamentalism, merger arbitrage, Mexican peso crisis / tequila crisis, Mitch Kapor, money market fund, moral hazard, mortgage debt, Myron Scholes, negative equity, Northern Rock, Occupy movement, oil shock, price stability, quantitative easing, quantitative hedge fund, quantitative trading / quantitative finance, Ralph Waldo Emerson, regulatory arbitrage, Renaissance Technologies, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, Sam Peltzman, Sharpe ratio, short selling, sovereign wealth fund, speech recognition, statistical arbitrage, statistical model, survivorship bias, systematic trading, The Great Moderation, too big to fail, transaction costs, value at risk, yield curve, zero-coupon bond

“FHFA’s First Anniversary and Challenges Ahead.” FHFA Speech, July 30, 2009. Long-Term Capital Management. “Long-Term Capital, Ltd. Private Placement of Ordinary Shares.” Confidential Private Placement Memorandum #225, October 1, 1993. Lowenstein, Roger. When Genius Failed. The Rise and Fall of Long-Term Capital Management. Random House, 2000. Luce, Edward. “Bank of Italy Governor Defends LTCM Position.” Financial Times, October 5, 1998. Lux, Thomas. “Herd Behavior, Bubbles, and Crashes.” The Economic Journal, July 1995. Macauley, Frederick. Some Theoretical Problems Suggested by the Movements of Interest Rates, Bond Yields and Stock Prices in the United States since 1856. NBER, 1938. MacKenzie, Donald. “Long-Term Capital Management and the Sociology of Arbitrage.” Economy and Society, 32:349–380, August 2003.

Chincarini looks at the financial crises of the past 15 years—starting with a comprehensive analysis of the Long-Term Capital Management crisis in 1998 and ending with the Euro-debt crisis of 2012—and argues convincingly that the central risk in these crises was accentuated from within the financial system rather than from external economic forces (it includes the best analysis I have read on the LTCM crisis). This bold new theory has important implications for both industry practices as well as for new regulations. It is essential that we learn the lessons from the past (or else we will repeat the same mistakes). Chincarini’s book should be required reading for anyone who wants to understand and help prevent financial crises.” —Eric Rosenfeld, Co-Founder of Long-Term Capital Management and JWM Partners “Chincarini connects the dots between LTCM, mispriced risk, the 2008 financial crisis, the flash crash, and the Greek debt crisis.

The story begins in 1998 with Long-Term Capital Management’s fascinating collapse and tries to explain the ways in which crowds and leverage demolished one of the most successful hedge funds in history. The failure of LTCM had many lessons for the financial community and for society at large, but no one paid much attention—perhaps because disaster was ultimately averted. Ignored lessons formed a large part of the basis for 2008’s financial disasters, only this time with more leverage, more participants, and a series of policy mishaps. PART I The 1998 LTCM Crisis All human beings are interconnected, one with all other elements in creation. —Henry Read The 2008 financial crisis really began 10 years earlier, with the collapse of the famous hedge fund Long-Term Capital Management (LTCM). LTCM was not an ordinary hedge fund.


pages: 289 words: 113,211

A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation by Richard Bookstaber

"Robert Solow", affirmative action, Albert Einstein, asset allocation, backtesting, beat the dealer, Black Swan, Black-Scholes formula, Bonfire of the Vanities, butterfly effect, commoditize, commodity trading advisor, computer age, computerized trading, disintermediation, diversification, double entry bookkeeping, Edward Lorenz: Chaos theory, Edward Thorp, family office, financial innovation, fixed income, frictionless, frictionless market, George Akerlof, implied volatility, index arbitrage, intangible asset, Jeff Bezos, John Meriwether, London Interbank Offered Rate, Long Term Capital Management, loose coupling, margin call, market bubble, market design, merger arbitrage, Mexican peso crisis / tequila crisis, moral hazard, Myron Scholes, new economy, Nick Leeson, oil shock, Paul Samuelson, Pierre-Simon Laplace, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk tolerance, risk/return, Robert Shiller, Robert Shiller, rolodex, Saturday Night Live, selection bias, shareholder value, short selling, Silicon Valley, statistical arbitrage, The Market for Lemons, time value of money, too big to fail, transaction costs, tulip mania, uranium enrichment, William Langewiesche, yield curve, zero-coupon bond, zero-sum game

HG4530.B66 2007 332.64'524—dc22 2006034368 Printed in the United States of America. 10 9 8 7 6 5 4 3 2 1 ffirs.qxd 3/1/07 3:33 PM Page v In memory of my son, Joseph Israel Bookstaber ffirs.qxd 3/1/07 3:33 PM Page vi ftoc.qxd 3/1/07 3:34 PM Page vii CONTENTS Acknowledgments ix About the Author xi CHAPTER 1 ~ Introduction: The Paradox of Market Risk 1 CHAPTER 2 ~ The Demons of ’87 7 CHAPTER 3 ~ A New Sheriff in Town 33 CHAPTER 4 ~ How Salomon Rolled the Dice and Lost 51 CHAPTER 5 ~ They Bought Salomon, Then They Killed It 77 CHAPTER 6 ~ Long-Term Capital Management Rides the Leverage Cycle to Hell 97 CHAPTER 7 ~ Colossus 125 CHAPTER 8 ~ Complexity, Tight Coupling, and Normal Accidents 143 CHAPTER 9 ~ The Brave New World of Hedge Funds 165 CHAPTER 10 ~ Cockroaches and Hedge Funds 207 CHAPTER 11 ~ Hedge Fund Existential Conclusion: Built to Crash? Notes 261 Index vii 271 255 243 ftoc.qxd 3/1/07 3:34 PM Page viii flast.qxd 3/1/07 3:34 PM Page ix ACKNOWLEDGMENTS N early a decade ago I made a presentation to the Institute for Quantitative Research in Finance on the origins of market crisis.

He is the author of a number of books and articles on finance topics ranging from option theory to risk management, and has xi flast.qxd 3/1/07 3:34 PM Page xii ABOUT THE AUTHOR received various awards for his research, including the Graham and Dodd Scroll from the Financial Analysts Federation and the Roger F. Murray Award from the Institute of Quantitative Research in Finance. He received a Ph.D. in economics from MIT. xii ccc_demon_001-006_ch01.qxd 2/13/07 1:44 PM Page 1 CHAPTER 1 INTRODUCTION: THE PARADOX OF MARKET RISK W hile it is not strictly true that I caused the two great financial crises of the late twentieth century—the 1987 stock market crash and the Long-Term Capital Management (LTCM) hedge fund debacle 11 years later—let’s just say I was in the vicinity. If Wall Street is the economy’s powerhouse, I was definitely one of the guys fiddling with the controls. My actions seemed insignificant at the time, and certainly the consequences were unintended. You don’t deliberately obliterate hundreds of billions of dollars of investor money. And that is at the heart of this book—it is going to happen again.

But in the frenzy of the crisis, the liquidity premium of the on-the-run bond had gotten totally out of hand, and no one cared or took the time to notice that such a subtle relationship had been broken. The Salomon gang bet that once the market cooled the normal physics would reemerge, pick up on this mispricing, and reestablish the relationship, which indeed occurred. Between this and several similar trades they picked up more than $100 million. (Ironically, 11 years later this same team, having left Salomon and riding high at Long-Term Capital Management, would trigger a market crisis that would lead to a far more egregious mispricing between various 30-year bonds. By then I would be sitting at Salomon arguing at a risk management committee meeting for the firm to take on a similar position. But with its trading spirit dulled by the Citigroup merger, Salomon would pass on the opportunity.) The damage to the stock market was accentuated by the fact that many large institutions had increased their stock holdings on the premise that portfolio insurance would protect them from losses.


pages: 471 words: 124,585

The Ascent of Money: A Financial History of the World by Niall Ferguson

Admiral Zheng, Andrei Shleifer, Asian financial crisis, asset allocation, asset-backed security, Atahualpa, bank run, banking crisis, banks create money, Black Swan, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, BRICs, British Empire, business cycle, capital asset pricing model, capital controls, Carmen Reinhart, Cass Sunstein, central bank independence, collateralized debt obligation, colonial exploitation, commoditize, Corn Laws, corporate governance, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, Daniel Kahneman / Amos Tversky, deglobalization, diversification, diversified portfolio, double entry bookkeeping, Edmond Halley, Edward Glaeser, Edward Lloyd's coffeehouse, financial innovation, financial intermediation, fixed income, floating exchange rates, Fractional reserve banking, Francisco Pizarro, full employment, German hyperinflation, Hernando de Soto, high net worth, hindsight bias, Home mortgage interest deduction, Hyman Minsky, income inequality, information asymmetry, interest rate swap, Intergovernmental Panel on Climate Change (IPCC), Isaac Newton, iterative process, John Meriwether, joint-stock company, joint-stock limited liability company, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, knowledge economy, labour mobility, Landlord’s Game, liberal capitalism, London Interbank Offered Rate, Long Term Capital Management, market bubble, market fundamentalism, means of production, Mikhail Gorbachev, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, mortgage debt, mortgage tax deduction, Myron Scholes, Naomi Klein, negative equity, Nelson Mandela, Nick Leeson, Northern Rock, Parag Khanna, pension reform, price anchoring, price stability, principal–agent problem, probability theory / Blaise Pascal / Pierre de Fermat, profit motive, quantitative hedge fund, RAND corporation, random walk, rent control, rent-seeking, reserve currency, Richard Thaler, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, seigniorage, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, spice trade, stocks for the long run, structural adjustment programs, technology bubble, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Thomas Bayes, Thomas Malthus, Thorstein Veblen, too big to fail, transaction costs, undersea cable, value at risk, Washington Consensus, Yom Kippur War

., p. 159. 78 Nicholas Dunbar, Inventing Money: The Story of Long-Term Capital Management and the Legends Behind It (New York, 2000), p. 92. 79 Dunbar, Inventing Money, pp. 168-73. 80 André F. Perold, ‘Long-Term Capital Management, L.P. (A)’, Harvard Business School Case 9-200-007 (5 November 1999), p. 2. 81 Perold, ‘Long-Term Capital Management, L.P. (A)’, p. 13. 82 Ibid., p. 16. 83 For a history of the efficient markets school of finance theory, see Peter Bernstein, Capital Ideas: The Improbable Origins of Modern Wall Street (New York, 1993). 84 Dunbar, Inventing Money, p. 178. 85 Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (New York, 2000), p. 126. 86 Perold, ‘Long-Term Capital Management, L.P. (A)’, pp. 11f., 17. 87 Lowenstein, When Genius Failed, p. 127. 88 André F.

., 17. 87 Lowenstein, When Genius Failed, p. 127. 88 André F. Perold, ‘Long-Term Capital Management, L.P. (B)’, Harvard Business School Case 9-200-08 (27 October 1999), p. 1. 89 Lowenstein, When Genius Failed, pp. 133-8. 90 Ibid., p. 144. 91 I owe this point to André Stern, who was an investor in LTCM. 92 Lowenstein, When Genius Failed, p. 147. 93 André F. Perold, ‘Long-Term Capital Management, L.P. (C)’, Harvard Business School Case 9-200-09 (5 November 1999), pp. 1, 3. 94 Idem, ‘Long-Term Capital Management, L.P. (D)’, Harvard Business School Case 9-200-10 (4 October 2004), p. 1. Perold’s cases are by far the best account. 95 Lowenstein, When Genius Failed, p. 149. 96 ‘All Bets Are Off: How the Salesmanship and Brainpower Failed at Long-Term Capital’, Wall Street Journal, 16 November 1998. 97 See on this point Peter Bernstein, Capital Ideas Evolving (New York, 2007). 98 Donald MacKenzie, ‘Long-Term Capital Management and the Sociology of Arbitrage’, Economy and Society, 32, 3 (August 2003), p. 374. 99 Ibid., passim. 100 Ibid., p. 365. 101 Franklin R.

Perold’s cases are by far the best account. 95 Lowenstein, When Genius Failed, p. 149. 96 ‘All Bets Are Off: How the Salesmanship and Brainpower Failed at Long-Term Capital’, Wall Street Journal, 16 November 1998. 97 See on this point Peter Bernstein, Capital Ideas Evolving (New York, 2007). 98 Donald MacKenzie, ‘Long-Term Capital Management and the Sociology of Arbitrage’, Economy and Society, 32, 3 (August 2003), p. 374. 99 Ibid., passim. 100 Ibid., p. 365. 101 Franklin R. Edwards, ‘Hedge Funds and the Collapse of Long-Term Capital Management’, Journal of Economic Perspectives, 13, 2 (Spring 1999), pp. 192f. See also Stephen J. Brown, William N. Goetzmann and Roger G. Ibbotson, ‘Offshore Hedge Funds: Survival and Performance, 1989-95’, Journal of Business, 72, 1(January 1999), 91-117. 102 Harry Markowitz, ‘New Frontiers of Risk: The 360 Degree Risk Manager for Pensions and Nonprofits’, The Bank of New York Thought Leadership White Paper (October 2005), p. 6. 103 ‘Hedge Podge’, The Economist, 16 February 2008. 104 ‘Rolling In It’, The Economist, 16 November 2006. 105 John Kay, ‘Just Think, the Fees You Could Charge Buffett’, Financial Times, 11 March 2008. 106 Stephanie Baum, ‘Top 100 Hedge Funds have 75% of Industry Assets’, Financial News, 21 May 2008. 107 Dean P.


Trend Commandments: Trading for Exceptional Returns by Michael W. Covel

Albert Einstein, Bernie Madoff, Black Swan, business cycle, buy and hold, commodity trading advisor, correlation coefficient, delayed gratification, diversified portfolio, en.wikipedia.org, Eugene Fama: efficient market hypothesis, family office, full employment, Lao Tzu, Long Term Capital Management, market bubble, market microstructure, Mikhail Gorbachev, moral hazard, Myron Scholes, Nick Leeson, oil shock, Ponzi scheme, prediction markets, quantitative trading / quantitative finance, random walk, Sharpe ratio, systematic trading, the scientific method, transaction costs, tulip mania, upwardly mobile, Y2K, zero-sum game

When Kernen asked about trend followers purportedly pushing markets further than they should be fundamentally, did that mean he had a way to determine the correct price level of all markets at all times? 3. When Kernen brought up Long Term Capital Management in attempt to compare Harding to its demise, did he not understand that Harding did not believe in efficient markets? Had he ever looked at a monthly up and down track record of Harding or any trend follower? 4. Why ask a trend following trader for “picks”? 5. When Kernen asked Harding if he would come back with the same moniker and title, was he implying that he believed Harding would blow up soon and be back on CNBC under some reformulated firm name—like what the proprietors of Long Term Capital Management did after their blowup? Has he ever asked Warren Buffett that question? I can easily see some painting this interview differently: “Harding set himself up for the LTCM tie-in by framing himself as a computer science shop looking at data and being black box.”

., 228 Jones, Paul Tudor, 15, 143-144 judgment, 30 Kahneman, Daniel, 118 history of trend following, 221-231 Kernen, Joe, 215-218 Hite, Larry, 15 King of the Hill (television program), 147 “home runs,” 81-82 Index Kovner, Bruce, 5, 15 Krakower, Susan, 162 LTCM (Long Term Capital Management), 101-102, 216 Krispy Kreme, 34 luck versus skill in trend following, 189-190 L Lynyrd Skynyrd, 211 “law of small numbers,” 118 M learning from others, 143-144 Lebeau, Charles, 60 Leeson, Nick, 4, 91 Lefèvre, Edwin, 223 Livermore, Jesse, 79, 223, 227-228, 239 long, defined, 12 long only, defined, 12 Long Term Capital Management (LTCM), 101-102, 216 Madoff, Bernard, 81 Magee, John, 226 Man Group, 15 Man Investments, 5 managed futures, defined, 11. See also trend following manipulation of monetary policy, 181-183 Marcus, Michael, 15 Longstreet, Roy, 239 market crashes, trend following during, 97-98 losers and winners market gurus, 147-148 crowd mentality, 117-120 during market crashes, 97-98 Efficient-Markets Hypothesis, 101-102 market predictors, 165-167 contradictions in predictions, 175-178 trend following versus, 194 hatred of trend following, 109-110 market price, importance of, 51-52 unexpected events, 91 market theories zero-sum game, 95 losses avoiding averaging, 79 271 fundamental analysis, 33-35 technical analysis, 35-36 markets drawdowns, 69-70 change in, 45 exit strategies, 75-76 entering, 73 what to trade, 65-67 272 Index McCain, John, 182 media, market predictions by, 177 Merton, Robert, 101 Miller, Merton, 101 origins of trend following, 221-231 Ostgaard, Stig, 221 P Paulson, John, 109 misleading information, spreading, 169-170 Pelley, Scott, 175 monetary policy, government manipulation of, 181-183 performance statistics for trend following, 15-23 money, capitalism and, 113-115 Picasso, Pablo, 88 money management, importance of, 61-62 players, types of, 205 morality of trend following, 109-110 Popoff, Peter, 166 pliability, 30 moving average, defined, 13 portfolio diversity, example of, 65-67 Mulvaney, Paul, 22 position sizing, 61-62 Munger, Charlie, 157 Prechter, Robert, 225 N–O predictions about market, 165-167 Nasdaq market crash (1973-1974), 151 net worth of trend following traders, 15 New Blueprints for Gains in Stocks and Grains (Dunnigan), 230 avoiding, 47-48 contradictions in, 175-178 trend following versus, 194 predictive technical analysis, 35 Nicklaus, Jack, 120 presidents, approval ratings based on economy, 181-182 Nikkei 225 stock index, 151 price action Obama, Barack, 182 optimism in trend following, 201-202 entering markets, 73 importance of, 51-52 profit targets, avoiding, 75-76 Index Profits in the Stock Market (Gartley), 226 Prospect Theory, 118 prudence, 30 Pujols, Albert, 138-139 Q–R quants, defined, 12 quarterly performance reports, 105-106 273 S S&P 500, defined, 13 Sack, Brian, 183 Schabacker, Richard W., 226 Schmidt, Eric, 47 Scholes, Myron, 101 scientific method in trend following, 134-135 Seidler, Howard, 20 Ramsey, Dave, 91 Seinfeld (television program), 161 Rand, Ayn, 113 selecting trading systems, 59-62 reactive technical analysis, 36 self-regulation, 124 “Reminiscences of a Stock Operator” (Lefèvre), 223 self-reliance, 30 repeatable alpha, defined, 12 Seykota, Ed, 15, 62 Rhea, Robert, 225 Shanks, Tom, 21 Ricardo, David, 223 Sharpe ratio, 137 risk assessment, 55-56 sheep mentality, 117-120 risk management, 61-62 short, defined, 12 Robbins, Anthony, 208 Simons, Jim, 135 Robertson, Pat, 166 The Simpsons (television program), 110 robustness of trend following, 85 Rogers, Jim, 23 Roosevelt, Franklin D., 114 Rosenberg, Michael, 201 rules of trend following, 201-202 Serling, Rod, 26 skill versus luck in trend following, 189-190 Smith, Vernon, 26 Social Security, 181 Sokol, David, 158 Soros, George, 189 274 Index speculation qualities of, 30 role of, 29-30 Speilberg, Steven, 208 spreading misleading information, 169-170 statistics in trend following, 137-140 Stone, Oliver, 29 story, fundamental analysis as, 33-35 Studies in Tape Reading (Wyckoff), 226 sunk costs, 118 Sunrise Capital, 5 drawdowns statistics, 70 performance statistics, 22 Technical Traders Guide to Computer Analysis of the Futures Markets (Lebeau), 60 Ten Years in Wall Street (Fowler), 224 three-phase systems, 60 Trader (documentary), 143 traders, investors versus, 29-30 trading gold, 173 trading systems, selecting, 59-62 “Trading With the Trend” (Dunnigan), 229 Transtrend, 5, 15 Trend Commandments (Covel) content of, 6 people written for, 9 trend following Swensen, David, 187 advantages of, 235-236 systematic global macro, defined, 12 compared to black box, 187 systematic trend following.

They flatten, reverse, or crash.4 To do that means you must have a portfolio with enough exposure to diverse global markets to allow you to make the crazy money during the big events. And there will inevitably be more surprise events with headline-generating losers taking the perp walk in the press, with the winners going unknown. That is a prediction worth betting on. This page intentionally left blank “Could you be on a desert island and make money trading?” That is the question to answer.1 Inefficient Markets The hedge fund Long Term Capital Management (LTCM) went bust in 1998, and that event is more relevant today than ever. It laid the foundation for government induced bubble/bailout schemes still employed daily. LTCM promised to use complex mathematical models to make investors wealthy beyond their wildest dreams. It attracted elite Wall Street investors and initially reaped fantastic profits with secret money-making strategies.


pages: 374 words: 114,600

The Quants by Scott Patterson

Albert Einstein, asset allocation, automated trading system, beat the dealer, Benoit Mandelbrot, Bernie Madoff, Bernie Sanders, Black Swan, Black-Scholes formula, Blythe Masters, Bonfire of the Vanities, Brownian motion, buttonwood tree, buy and hold, buy low sell high, capital asset pricing model, centralized clearinghouse, Claude Shannon: information theory, cloud computing, collapse of Lehman Brothers, collateralized debt obligation, commoditize, computerized trading, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, Doomsday Clock, Edward Thorp, Emanuel Derman, Eugene Fama: efficient market hypothesis, fixed income, Gordon Gekko, greed is good, Haight Ashbury, I will remember that I didn’t make the world, and it doesn’t satisfy my equations, index fund, invention of the telegraph, invisible hand, Isaac Newton, job automation, John Meriwether, John Nash: game theory, Kickstarter, law of one price, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, merger arbitrage, money market fund, Myron Scholes, NetJets, new economy, offshore financial centre, old-boy network, Paul Lévy, Paul Samuelson, Ponzi scheme, quantitative hedge fund, quantitative trading / quantitative finance, race to the bottom, random walk, Renaissance Technologies, risk-adjusted returns, Robert Mercer, Rod Stewart played at Stephen Schwarzman birthday party, Ronald Reagan, Sergey Aleynikov, short selling, South Sea Bubble, speech recognition, statistical arbitrage, The Chicago School, The Great Moderation, The Predators' Ball, too big to fail, transaction costs, value at risk, volatility smile, yield curve, éminence grise

Fama and French cranked up: The paper was called “The Cross Section of Expected Stock Returns,” published in the June 1992 edition of Journal of Finance. One day in the early 1980s: Nearly all of the details of Boaz Weinstein’s life and career come from interviews with Weinstein and people who knew and worked with him. In 1994, John Meriwether: A number of details of LTCM’s demise were taken from When Genius Failed: The Rise and Fall of Long-Term Capital Management, by Roger Lowenstein (Random House, 2000), and Inventing Money: The Story of Long-Term Capital Management and the Legends Behind It, by Nicholas Dunbar (John Wiley & Sons, 2000). 6 THE WOLF On a spring afternoon in 1985: The Liar’s Poker account is taken from The Poker Face of Wall Street, by Aaron Brown (John Wiley & Sons, 2006), as well as interviews and email exchanges with Brown. The Culver Spy Ring sprang up: “Setauket: Spy Ring Foils the British,” by Tom Morris, Newsday, February 22, 1998.

But they always loomed like a bad memory in the back of their minds, and were from time to time thrust to the forefront during wild periods of volatility such as Black Monday, only to be forgotten again when the markets eventually calmed down, as they always seemed to do. Inevitably, though, the deadly volatility returns. About a decade after Black Monday, the math geniuses behind a massive quant hedge fund known as Long-Term Capital Management came face-to-face with Mandelbrot’s wild markets. In a matter of weeks in the summer of 1998, LTCM lost billions, threatening to destabilize global markets and prompting a massive bailout organized by Fed chairman Alan Greenspan. LTCM’s trades, based on sophisticated computer models and risk management strategies, employed unfathomable amounts of leverage. When the market behaved in ways those models never could have predicted, the layers of leverage caused the fund’s capital to evaporate.

It was a sleepy business, and few traders even knew what they were or how to use the exotic swaps—or had any idea that they represented a new front in the quants’ ascendancy over Wall Street. Indeed, they would prove to be one of the most powerful weapons in their arsenal. The quants were steadily growing, moving ever higher into the upper echelons of the financial universe. What could go wrong? As it turned out, a great deal—a four-letter word: LTCM. In 1994, John Meriwether, a former star bond trader at Salomon Brothers, launched a massive hedge fund known as Long-Term Capital Management. LTCM was manned by an all-star staff of quants from Salomon as well as future Nobel Prize winners Myron Scholes and Robert Merton. On February 24 of that year, the fund started trading with $1 billion in investor capital. LTCM, at bottom, was a thought experiment, a laboratory test conducted by academics trained in mathematics and economics—quants. The very structure of the fund was based on the breakthroughs in modern portfolio theory that started in 1952 with Harry Markowitz and even stretched as far back as Robert Brown in the nineteenth century.


pages: 322 words: 77,341

I.O.U.: Why Everyone Owes Everyone and No One Can Pay by John Lanchester

asset-backed security, bank run, banking crisis, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black-Scholes formula, Blythe Masters, Celtic Tiger, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, diversified portfolio, double entry bookkeeping, Exxon Valdez, Fall of the Berlin Wall, financial deregulation, financial innovation, fixed income, George Akerlof, greed is good, hedonic treadmill, hindsight bias, housing crisis, Hyman Minsky, intangible asset, interest rate swap, invisible hand, Jane Jacobs, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Meriwether, Kickstarter, laissez-faire capitalism, light touch regulation, liquidity trap, Long Term Capital Management, loss aversion, Martin Wolf, money market fund, mortgage debt, mortgage tax deduction, mutually assured destruction, Myron Scholes, negative equity, new economy, Nick Leeson, Norman Mailer, Northern Rock, Own Your Own Home, Ponzi scheme, quantitative easing, reserve currency, Right to Buy, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, South Sea Bubble, statistical model, The Great Moderation, the payments system, too big to fail, tulip mania, value at risk

The gap in price would last only for a couple of seconds, and in that gap Barings would buy low and sell high—a guaranteed, risk-free profit.) The complexity of the mathematics involved in derivatives can’t be exaggerated. This was the reason John Meriwether, a famous bond trader, employed Myron Scholes—he of the Black-Scholes equation—and Robert Merton, the man with whom he shared the 1997 Nobel Prize in Economics, to be directors and cofounders of his new hedge fund, Long-Term Capital Management.* The idea was to use these big brains to create a highly leveraged, arbitraged, no-risk investment portfolio designed to profit no matter what happened, whether the market went up, down, or sideways or popped out for a cheese sandwich. LTCM quadrupled in value in its first four years, then imploded in the chaos that followed Russia’s default on its foreign-debt obligations in 1998. The fund had equity of $4.72 billion, which would have been pretty healthy if it were not for the fact that it was exposed, thanks to the miracles of borrowing, leverage, and derivatives, to $1.25 trillion of risk.

By June 2008, the International Swaps and Derivatives Association, or ISDA—the association of companies dealing in this stuff—was estimating the total size of the market as $54 trillion, close to the total GDP of the planet and many times more valuable than the total number of all the stocks and shares traded in the world. The underlying value of the risks being insured was much lower than the notional value, of course—but the lesson of Long-Term Capital Management was that when such deals blow up, they leave huge holes in the markets because of the sheer number of counterparties holding contracts with notional exposure to the risk. It’s like a game of pass-the-parcel, in which nobody knows who’s actually holding the parcel, much less what’s going to be found inside it when it’s unwrapped. So this tool, the CDS, which had been invented as a way of making lending safer, turned out to magnify and spread risks throughout the global financial system.

A “3-sigma event” is something that is supposed to happen only 0.3 percent of the time, i.e., about once every three thousand times something is measured. Quants use these measures of probability all the time. According to the models in use by the quants, the Black Monday crash of 1987 was a ten-sigma event. Translated into English, that meant that, in the words of Roger Lowenstein’s book When Genius Failed: The Rise and Fall of Long-Term Capital Management: Economists later figured that, on the basis of the market’s historical volatility, had the market been open every day since the creation of the Universe, the odds would still have been against its falling that much in a single day. In fact, had the life of the Universe been repeated one billion times, such a crash would still have been theoretically “unlikely.” The defiance of common sense here is flagrant.


pages: 349 words: 134,041

Traders, Guns & Money: Knowns and Unknowns in the Dazzling World of Derivatives by Satyajit Das

accounting loophole / creative accounting, Albert Einstein, Asian financial crisis, asset-backed security, beat the dealer, Black Swan, Black-Scholes formula, Bretton Woods, BRICs, Brownian motion, business process, buy and hold, buy low sell high, call centre, capital asset pricing model, collateralized debt obligation, commoditize, complexity theory, computerized trading, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, cuban missile crisis, currency peg, disintermediation, diversification, diversified portfolio, Edward Thorp, Eugene Fama: efficient market hypothesis, Everything should be made as simple as possible, financial innovation, fixed income, Haight Ashbury, high net worth, implied volatility, index arbitrage, index card, index fund, interest rate derivative, interest rate swap, Isaac Newton, job satisfaction, John Meriwether, locking in a profit, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, Marshall McLuhan, mass affluent, mega-rich, merger arbitrage, Mexican peso crisis / tequila crisis, money market fund, moral hazard, mutually assured destruction, Myron Scholes, new economy, New Journalism, Nick Leeson, offshore financial centre, oil shock, Parkinson's law, placebo effect, Ponzi scheme, purchasing power parity, quantitative trading / quantitative finance, random walk, regulatory arbitrage, Right to Buy, risk-adjusted returns, risk/return, Satyajit Das, shareholder value, short selling, South Sea Bubble, statistical model, technology bubble, the medium is the message, the new new thing, time value of money, too big to fail, transaction costs, value at risk, Vanguard fund, volatility smile, yield curve, Yogi Berra, zero-coupon bond

Chapter 5 The perfect storm – risk mismanagement by the numbers 1 Tanya Styblo Beder ‘The Great Risk Hunt’ (May 1999) The Journal of Portfolio Management, p. 29. 2 Peter Bernstein (1998) Against the Gods: The Remarkable Story of Risk; John Wiley, New York. 3 See ‘The Jorion-Taleb Debate’ (April 1997) Derivatives Strategy, 25. 4 Roger Lowenstein (2002) When Genius Fails: The Rise and Fall of Long-Term Capital Management; Fourth Estate, London, p. 15. 5 For details of Salomon’s Treasury Bond trading scandal, see Nicholas Dunbar (2000) Inventing Money; John Wiley & Sons, Chichester, pp. 110–112; and Roger Lowenstein (2002) When Genius Fails: The Rise and Fall of Long-Term Capital Management; Fourth Estate, London, pp. 19–22; Frank Partnoy (2004) Infectious Greed; Owl Books, New York, pp. 97–109. 6 Quoted by Merton Miller in ‘Trillion Dollar Bet’ (8 February 2000) Nova PBS. 12_NOTES.QXD 17/2/06 4:43 pm Page 323 Notes 323 7 LTCM’s 1997 return is somewhat in dispute.

Chapter 5 The perfect storm – risk mismanagement by the numbers 1 Tanya Styblo Beder ‘The Great Risk Hunt’ (May 1999) The Journal of Portfolio Management, p. 29. 2 Peter Bernstein (1998) Against the Gods: The Remarkable Story of Risk; John Wiley, New York. 3 See ‘The Jorion-Taleb Debate’ (April 1997) Derivatives Strategy, 25. 4 Roger Lowenstein (2002) When Genius Fails: The Rise and Fall of Long-Term Capital Management; Fourth Estate, London, p. 15. 5 For details of Salomon’s Treasury Bond trading scandal, see Nicholas Dunbar (2000) Inventing Money; John Wiley & Sons, Chichester, pp. 110–112; and Roger Lowenstein (2002) When Genius Fails: The Rise and Fall of Long-Term Capital Management; Fourth Estate, London, pp. 19–22; Frank Partnoy (2004) Infectious Greed; Owl Books, New York, pp. 97–109. 6 Quoted by Merton Miller in ‘Trillion Dollar Bet’ (8 February 2000) Nova PBS. 12_NOTES.QXD 17/2/06 4:43 pm Page 323 Notes 323 7 LTCM’s 1997 return is somewhat in dispute. Different sources give different returns for the fund – 17% (see Phillipe Jorion ‘How Long Term Lost Its Capital’ (September 1999) Risk, 31–36, p. 32) or 27% (see Nicholas Dunbar ‘Meriwether’s Meltdown’ (October 1998) Risk 32–36, p. 33). 8 Roger Lowenstein (2002) When Genius Fails: The Rise and Fall of Long-Term Capital Management; Fourth Estate, London, p. 147. 9 Roger Lowenstein (2002) When Genius Fails: The Rise and Fall of Long-Term Capital Management; Fourth Estate, London, pp. 161, 162. Chapter 6 Super models – derivative algorithms 1 The phrase ‘best and brightest’ is attributed to David Halberstam (1993) The Best and the Brightest; Ballantine Books, New York. 2 Emmanuel Derman (2004) My Life as a Quant; John Wiley, New Jersey. 3 Douglas Adams (1979) The Hitchhiker’s Guide to the Galaxy; Pan Books, p. 75. 4 Fischer Black and Myron Scholes ‘The Pricing of Options and Corporate Liabilities (1973) Journal of Political Economy 81, 399–417. 5 Robert Merton ‘The Theory of Rational Option Pricing’ (1973) Bell Journal of Economics and Management Science 28, 141–183. 6 John Maynard Keynes (1937) The General Theory of Employment, Interest and Money; MacMillan, London, p. 298. 7 Emmanuel Derman (Winter 2000) The Journal of Derivatives, p. 62. 8 See Robert Merton, Nobel Lecture (9 December 1997).

Chapter 7 Games without frontiers – the inverse world of structured products 1 Leo Melamed, Press Briefing (August 2004) quoted in FOW, p. 58. 2 Frank Partnoy (1999) FIASCO; New York, Penguin, p. 163. 3 Testimony before Senate Committee on Local Government Investment (17 January 1995). 4 See ‘Triple Currency Bonds’ IFR (29 March 1986), 615. Chapter 8 Share and share alike – derivative inequity 1 Roger Lowenstein (2002) When Genius Fails: The Rise and Fall of Long-Term Capital Management; Fourth Estate, London, p. 35. 2 The description of the LTCM – UBS option transaction is based on: David Shireff ‘Another Fine Mess at UBS’ (November 1998) Euromoney, 41–43; Nicholas Dunbar ‘Meriwether’s Meltdown’ (October 1998) Risk, 32–36, p. 34; Nicholas Dunbar (2000) Inventing Money; John Wiley & Sons, Chichester, pp. 168–175; Roger Lowenstein (2002) When Genius Fails: The Rise and Fall of Long-Term Capital Management; Fourth Estate, London, pp. 92–94. 12_NOTES.QXD 20/2/06 324 4:11 pm Page 324 Tr a d e r s , G u n s & M o n e y Chapter 9 – Credit where credit is due – fun with CDS and CDO 1 CDO litigation (including the Barclays – HSH and Bank of America – Banca Popolare di Intra litigation) is described in: Nicholas Dunbar ‘Barclays Fights CDO Lawsuits’ (October 2004) Risk, 10, 12; Nicholas Dunbar ‘BoA in Litigation Firing Line’ (March 2005) Risk, 13; Nicholas Dunbar ‘The Curious Incident of the Disputed CDO’ (July 2005) Risk, 22–24; Rachel Woolcott ‘NatWest Rattles Sabre in Law Firm Claim’ (August 2005) Risk, 11.


pages: 385 words: 128,358

Inside the House of Money: Top Hedge Fund Traders on Profiting in a Global Market by Steven Drobny

Albert Einstein, asset allocation, Berlin Wall, Bonfire of the Vanities, Bretton Woods, business cycle, buy and hold, buy low sell high, capital controls, central bank independence, commoditize, commodity trading advisor, corporate governance, correlation coefficient, Credit Default Swap, diversification, diversified portfolio, family office, fixed income, glass ceiling, high batting average, implied volatility, index fund, inflation targeting, interest rate derivative, inventory management, John Meriwether, Long Term Capital Management, margin call, market bubble, Maui Hawaii, Mexican peso crisis / tequila crisis, moral hazard, Myron Scholes, new economy, Nick Leeson, oil shale / tar sands, oil shock, out of africa, paper trading, Paul Samuelson, Peter Thiel, price anchoring, purchasing power parity, reserve currency, risk tolerance, risk-adjusted returns, risk/return, rolodex, Sharpe ratio, short selling, Silicon Valley, The Wisdom of Crowds, too big to fail, transaction costs, value at risk, yield curve, zero-coupon bond, zero-sum game

As a result, spreads between the benchmark U.S. government bonds and all other risk assets widened dramatically, leading the world to its next financial crisis: Long Term Capital Management. 150 145 Yen per Dollar 140 135 130 125 Yen Carry Trade Goes Bad 120 115 FIGURE 2.12 The Dollar/Yen Carry Trade, 1997–1998 Source: Bloomberg. -9 8 -9 8 De c No v 8 Au g98 Se p98 Oc t-9 8 98 l-9 Ju -9 8 nJu M ay 8 -9 r-9 8 ar Ap b98 Fe M 7 98 nJa 97 -9 v- De c No 97 7 t-9 7 Oc pSe 7 l-9 g9 Au Ju Ju n- 97 110 24 INSIDE THE HOUSE OF MONEY Long Term Capital Management 1998 Although Long Term Capital Management (LTCM) was not a global macro fund, it is worth mentioning for several reasons. For one, the arbitragefocused fund drifted into global macro trades and its subsequent unwind had ramifications for global macro markets.Two, it offers insights into what can go wrong at a hedge fund, as well as shed light on such important issues as liquidity, risk management, and correlations.

Indeed, efforts to take advantage of such misalignments force prices into better alignment and are soon emulated by competitors, further narrowing, or eliminating, any gaps. No matter how skillful the trading scheme, over the long haul, abnormal returns are sustained only through abnormal exposure to risk. Source: Testimony of Chairman Alan Greenspan before the Committee on Banking and Financial Services, U.S. House of Representatives, on PrivateSector Refinancing of the Large Hedge Fund, Long Term Capital Management, October 1, 1998. that they were in LTCM’s portfolio. In other words, their models didn’t provide for the LTCM liquidity premium. LTCM was a reminder of the notion that there is no such thing as a risk-free arbitrage. Because the arbitrage positions they were exploiting were small, the fund had to be leveraged many times to produce meaningful returns.This put them at risk to their lenders’ financing fees as well as general market liquidity.The problem with liquidity is that it is never there when really needed.

Markets are going to go where they’re going to go.Yes, sure, on one or two days when I was liquidating, it pushed it down, but the moment I stopped selling, it went where it was going to go. 80 INSIDE THE HOUSE OF MONEY 250 Yen per Pound 225 200 Siva-Jothy Liquidating Sterling/Yen Position 175 150 No v9 Ja 3 n94 M ar -9 M 4 ay -9 Au 4 g9 Oc 4 t-9 De 4 c9 M 4 ar -9 M 5 ay -9 Ju 5 l-9 Oc 5 t-9 De 5 c9 Fe 5 b9 Ap 6 r-9 Ju 6 l-9 Se 6 p9 No 6 v96 Fe b9 Ap 7 r-9 Ju 7 n9 Se 7 p9 No 7 v97 Ja n9 M 8 ar -9 Ju 8 n9 Au 8 g98 125 FIGURE 5.2 Sterling/Yen, 1993–1998 Source: Bloomberg. Markets are immense but if people know there’s a big position out there that is being liquidated, they’ll go for it. Nick Leeson at Barings Singapore and Long Term Capital Management are the classic cases. The market sniffed their unwinding and traded against them. Did the sterling/yen experience prove useful later on? Yes, definitely. The 1998 LTCM/Russia episode for me was the reverse. The firm didn’t have a great 1998, but the prop group did and I attribute it to the lessons learned in 1994. In 1998, GS had a risk arbitrage group that was set up a few years earlier.


pages: 419 words: 130,627

Last Man Standing: The Ascent of Jamie Dimon and JPMorgan Chase by Duff McDonald

bank run, Blythe Masters, Bonfire of the Vanities, centralized clearinghouse, collateralized debt obligation, conceptual framework, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Exxon Valdez, financial innovation, fixed income, G4S, housing crisis, interest rate swap, Jeff Bezos, John Meriwether, Kickstarter, laissez-faire capitalism, Long Term Capital Management, margin call, market bubble, money market fund, moral hazard, negative equity, Nelson Mandela, Northern Rock, profit motive, Renaissance Technologies, risk/return, Rod Stewart played at Stephen Schwarzman birthday party, Saturday Night Live, sovereign wealth fund, statistical model, Steve Ballmer, Steve Jobs, technology bubble, The Chicago School, too big to fail, Vanguard fund, zero-coupon bond, zero-sum game

Though Dimon wasn’t around to enjoy the fruits of his labor, the unit was up to a $1 billion run rate by late 1999.) The unwinding of the fixed income unit’s positions contributed to the market’s instability that summer, especially at Long-Term Capital Management (LTCM), which, having been founded by Salomon veterans, had on its books many of the same positions that Salomon was now vigorously selling. In fact, Dimon recalls, the Salomon arbitrage unit had only 10 material trading strategies it played around with. “With all the bullshit around it, there were just 10 trades,” he recalls. “And they were the same 10 trades that LTCM had.” (LTCM, in fact, was jokingly referred to by the Travelers crowd as “Salomon North.”) Long-Term Capital Management wasn’t just any old hedge fund. Through the magic of leverage, it had turned $5 billion of capital into a $100 billion giant, and its sudden shakiness posed a threat to the entire market.

Greenspan also later came to be known for the “Greenspan put.” (A put option gives the buyer the right, but not the obligation, to sell an asset at a predetermined “strike” price. If prices rise, you don’t sell. If they fall, you sell at the strike price and minimize your losses.) With aggressive interest rate cuts in the event of any kind of crisis—the Mexican crisis, the Asian currency crisis, the Long-Term Capital Management crisis, the bursting of the Internet bubble, or 9/11—his Federal Reserve created the impression that investors essentially had a “put option” on asset prices, and in the process arguably encouraged excessive risk-taking. His successor Ben Bernanke continued the tradition, resulting in the notion of the “Bernanke put.” The financial crisis in 2007–2009 ended any thoughts that these puts actually existed.

A scathing 1995 piece by Suzanna Andrews in New York magazine made the case that Maughan had been in over his head at Salomon yet had a tendency to say things like, “I am the hardest-working man at Salomon Brothers.” Most top executives also thought he put politics ahead of the interests of the firm, a conclusion arrived at after he seemingly forced the star trader John Meriwether out of Salomon—Meriwether had gone on to found Wall Street’s hottest hedge fund at the time, Long-Term Capital Management. A stream of talented partners had also left during Maughan’s tenure. Then there was the issue of Maughan’s wife, Va. A onetime Pan Am reservation agent who had changed her name from Lorraine Hannemann, Va Maughan was a gossipmonger’s dream. Stories floated around that it was she, and not Maughan, who had negotiated his pay packages at Salomon. She reportedly once refused to allow a Salomon executive the use of her car and driver to take his sick baby to the hospital, and she also was said to have bragged about a relative in the Japanese mafia.


pages: 350 words: 103,270

The Devil's Derivatives: The Untold Story of the Slick Traders and Hapless Regulators Who Almost Blew Up Wall Street . . . And Are Ready to Do It Again by Nicholas Dunbar

asset-backed security, bank run, banking crisis, Basel III, Black Swan, Black-Scholes formula, bonus culture, break the buck, buy and hold, capital asset pricing model, Carmen Reinhart, Cass Sunstein, collateralized debt obligation, commoditize, Credit Default Swap, credit default swaps / collateralized debt obligations, delayed gratification, diversification, Edmond Halley, facts on the ground, financial innovation, fixed income, George Akerlof, implied volatility, index fund, interest rate derivative, interest rate swap, Isaac Newton, John Meriwether, Kenneth Rogoff, Kickstarter, Long Term Capital Management, margin call, market bubble, money market fund, Myron Scholes, Nick Leeson, Northern Rock, offshore financial centre, Paul Samuelson, price mechanism, regulatory arbitrage, rent-seeking, Richard Thaler, risk tolerance, risk/return, Ronald Reagan, shareholder value, short selling, statistical model, The Chicago School, Thomas Bayes, time value of money, too big to fail, transaction costs, value at risk, Vanguard fund, yield curve, zero-sum game

First eBook Edition: July 2011 ISBN: 978-1-4221-7781-5 For T Contents Copyright Foreword Introduction: The Siren Song of the Men Who Love to Win ONE The Bets That Made Banking Sexy Introduction to derivatives. Long-term actuarial approach versus the market approach to credit. Goldman Sachs sees opportunity in default swaps. The market approach vindicated by Enron’s bankruptcy. TWO Going to the Mattresses The advent of VAR and OTC derivatives. The collapse of Long-Term Capital Management (LTCM). A fatal flaw is exposed. The wrong lesson is learned. THREE A Free Lunch . . . with Processed Food A new market for collaterized debt obligations (CDOs). Risky investments, diversification, and the role of the ratings agencies. Barclays finds investors for its CDOs, only to fall out with them. FOUR The Broken Heart Syndrome J.P. Morgan and Deutsche Bank dominate the European CDO market.

He was a lanky Texan whose off-the-rack suits and homespun manner personified the hate-to-lose commercial banker. After we’d talked, I was taken to meet the bank’s chief credit officer, Robert Strong, who talked about his memories of the 1970s recession and how cautious he was about lending. I knew why Chase was selling me this line so hard. A few months earlier, it had lent about $500 million to the massive hedge fund Long-Term Capital Management (LTCM), which was on the brink of bankruptcy and threatened to bring much of Wall Street down with it until a consortium of banks (including Chase) bailed it out. At the time, Chase was mocked for being so careless with its money, and Shapiro was keen to signal that this had been a one-off. That same trip, I went to J.P. Morgan’s headquarters on Wall Street, where it had been based for a century.

And if markets were efficient—in other words, if people like Meriwether did their job—then the prices of futures contracts should be mathematically related to the underlying asset using “no-arbitrage” principles. Bending Reality to Match the Textbook The next leg of my U.S. trip took me to Boston and Connecticut. There I met two more Nobel-winning finance professors—Robert Merton and Myron Scholes—who took Miller’s idea to its logical conclusion at a hedge fund called Long-Term Capital Management (LTCM). Scholes had benefited directly from Miller’s mentorship as a University of Chicago PhD candidate, while Merton had studied under Paul Samuelson at MIT. What made Merton and Scholes famous (with the late Fischer Black) was their contemporaneous discovery of a formula for pricing options on stocks and other securities. Again, the key idea was based on arbitrage, but this time the formula was much more complicated.


pages: 290 words: 83,248

The Greed Merchants: How the Investment Banks Exploited the System by Philip Augar

Andy Kessler, barriers to entry, Berlin Wall, Big bang: deregulation of the City of London, Bonfire of the Vanities, business cycle, buttonwood tree, buy and hold, capital asset pricing model, commoditize, corporate governance, corporate raider, crony capitalism, cross-subsidies, financial deregulation, financial innovation, fixed income, Gordon Gekko, high net worth, information retrieval, interest rate derivative, invisible hand, John Meriwether, Long Term Capital Management, Martin Wolf, new economy, Nick Leeson, offshore financial centre, pensions crisis, regulatory arbitrage, Sand Hill Road, shareholder value, short selling, Silicon Valley, South Sea Bubble, statistical model, Telecommunications Act of 1996, The Chicago School, The Predators' Ball, The Wealth of Nations by Adam Smith, transaction costs, tulip mania, value at risk, yield curve

The Federal Home Loan Mortgage Corporation, ‘Freddie Mac’, had been in business for three decades and had earned a second nickname, ‘Steady Freddie’, until in 2003 it announced it would have to restate earnings by $4.5 billion because of incorrect accounting in its derivatives portfolio.38 Another government-sponsored mortgage finance company, ‘Fannie Mae’, said it would have to restate previous years’ earnings – by $9 billion according to some estimates – because of incorrect accounting on its derivatives book.39 Its regulator, the Office of Federal Housing Enterprise Oversight, said this raised ‘serious doubts’ about ‘the overall safety and soundness of the business’; the company contested this view but made management changes.40 Even the experts can get it wrong, as we saw when Long-Term Capital Management’s sophisticated investment bankers, Nobel Prize-winning economists and rocket-scientist traders, lost nearly all their clients’ money in 1998. The losses came from several sources. Complex derivatives are hard to understand and hard to value. Frequently there is no external market in which to test valuations and holders can be surprised when they try. Misrepresentation was behind many derivatives losses.

Throughout the firm small businesses developed where specialized trading and investment skills and the ability to risk a certain amount of partnership capital gave the firm an edge.’14 It’s there again – that word ‘edge’ – although in the post-Spitzer era not many firms would have been quite so ‘refreshingly candid’ in their hours of interviews with Lisa Endlich.15 Proprietary trading went underground in 1998 at many firms: ‘By the late 1990s, almost every investment bank on Wall Street had, to some degree, gotten into the game. Most had separate arbitrage desks, with traders specifically assigned to look for opportunities in every nook and cranny of the business.’16 However, the Long-Term Capital Management crisis of that year persuaded many of the banks that specialist proprietary trading units were dangerous and they wound them down. Most dramatically, Citigroup’s Sandy Weil, having just bought Salomon Brothers, kings of the trading jungle, ordered the closure of proprietary trading at the firm. However, the closure of some arbitrage desks on Wall Street and ring fencing at others did not mean that proprietary trading went away: it is embedded into customer market-making by the very nature of the business.

VAR is not foolproof but it did provide the investment banks with a number that managers could focus on. Around it they were able to put in place a structure of committees and teams of risk experts to monitor and manage risk. For the first time since 1987 the investment banks appeared to be in control of the risks that they were running. This sense of security was shaken in September 1998, the month ‘when genius failed’ and Long-Term Capital Management, a high profile hedge fund, collapsed. The firm had about $5 billion of its own capital and borrowed getting on for $100 billion to leverage its trades. Under the leadership of John Meriwether, still then a legend for his time at Salomon Brothers, and with the expertise of a group of highly qualified arbitrageurs, professors and two Nobel Prize winners, the fund had a four-year winning streak of 40 per cent per annum and its models seemed infallible.


pages: 354 words: 118,970

Transaction Man: The Rise of the Deal and the Decline of the American Dream by Nicholas Lemann

Affordable Care Act / Obamacare, Airbnb, airline deregulation, Albert Einstein, augmented reality, basic income, Bernie Sanders, Black-Scholes formula, buy and hold, capital controls, computerized trading, corporate governance, cryptocurrency, Daniel Kahneman / Amos Tversky, dematerialisation, diversified portfolio, Donald Trump, Elon Musk, Eugene Fama: efficient market hypothesis, financial deregulation, financial innovation, fixed income, future of work, George Akerlof, gig economy, Henry Ford's grandson gave labor union leader Walter Reuther a tour of the company’s new, automated factory…, index fund, information asymmetry, invisible hand, Irwin Jacobs, Joi Ito, Joseph Schumpeter, Kenneth Arrow, Kickstarter, life extension, Long Term Capital Management, Mark Zuckerberg, mass immigration, means of production, Metcalfe’s law, money market fund, Mont Pelerin Society, moral hazard, Myron Scholes, new economy, Norman Mailer, obamacare, Paul Samuelson, Peter Thiel, price mechanism, principal–agent problem, profit maximization, quantitative trading / quantitative finance, Ralph Nader, Richard Thaler, road to serfdom, Robert Bork, Robert Metcalfe, rolodex, Ronald Coase, Ronald Reagan, Sand Hill Road, shareholder value, short selling, Silicon Valley, Silicon Valley ideology, Silicon Valley startup, Social Responsibility of Business Is to Increase Its Profits, Steve Jobs, TaskRabbit, The Nature of the Firm, the payments system, Thomas Kuhn: the structure of scientific revolutions, Thorstein Veblen, too big to fail, transaction costs, universal basic income, War on Poverty, white flight, working poor

After last-minute attempts to save the firm were unsuccessful, the Fed decided it had to organize a rescue: it would extend credit to a group of big banks that would enable them in turn to buy low-priced ownership stakes in Long-Term Capital Management. This worked in the sense that, although it didn’t save Long-Term Capital Management, it did save the banks that were its major lenders. Hedge funds were unregulated because they were supposed to represent private investment arrangements between wealthy, sophisticated parties who were prepared to absorb whatever losses they suffered; what this episode showed was that government and taxpayers may have had no power to monitor hedge funds, but they could wind up with the responsibility for covering their losses. Especially because it came at a time when the question of the government’s regulating the derivatives markets was in play, the fall of Long-Term Capital Management got people’s attention in Washington. James Leach held hearings, and a group of liberal Democratic members of Congress commissioned an investigation by the General Accounting Office.

A couple of weeks later, Elmendorf wrote Yellen to say that he was going to tell one of Rubin’s deputies that her view was that “on balance, more regulation could, and probably should, occur.” But in the spring of 1999, when the Working Group on Financial Markets issued its report on the collapse of Long-Term Capital Management, it called only for what Rubin, in a memo to Clinton describing the report, described as “indirect regulation”—mostly requirements that hedge funds disclose more information to their lenders. The report did not, Rubin went on, recommend “direct regulation” of hedge funds and derivatives dealers, or government supervision of the general financial condition of investment banks. By contrast, the GAO’s report on Long-Term Capital Management, published a few months later, took a harder line. It said that the Working Group had not proposed enough regulation, especially of investment banks, and that more was needed to ensure the safety of the financial system.

Clinton Library, 2010-0673-F—President’s Working Group on Financial Markets, Box 4, Folder 1. “on balance, more regulation”: Doug Elmendorf, memorandum to Janet Yellen, December 21, 1998, 1. Clinton Library, 2010-0673-F, Box 1, File 2. “indirect regulation”: Robert Rubin, memorandum to the president, April 22, 1999. Clinton Library, 2010-0673-F—President’s Working Group on Financial Markets. GAO’s report on Long-Term Capital Management: General Accounting Office, “Long-Term Capital Management: Regulators Need to Focus Greater Attention on Systemic Risk,” October 1999. “Larry thought I was overly concerned”: Robert Rubin with Jacob Weisberg, In an Uncertain World: Choices from Wall Street to Washington, Random House, 2004, 288. Another marcher in the skimpy parade: See Edward Gramlich, Subprime Mortgages: America’s Latest Boom and Bust, Urban Institute Press, 2007. 5.


pages: 461 words: 128,421

The Myth of the Rational Market: A History of Risk, Reward, and Delusion on Wall Street by Justin Fox

activist fund / activist shareholder / activist investor, Albert Einstein, Andrei Shleifer, asset allocation, asset-backed security, bank run, beat the dealer, Benoit Mandelbrot, Black-Scholes formula, Bretton Woods, Brownian motion, business cycle, buy and hold, capital asset pricing model, card file, Cass Sunstein, collateralized debt obligation, complexity theory, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, discovery of the americas, diversification, diversified portfolio, Edward Glaeser, Edward Thorp, endowment effect, Eugene Fama: efficient market hypothesis, experimental economics, financial innovation, Financial Instability Hypothesis, fixed income, floating exchange rates, George Akerlof, Henri Poincaré, Hyman Minsky, implied volatility, impulse control, index arbitrage, index card, index fund, information asymmetry, invisible hand, Isaac Newton, John Meriwether, John Nash: game theory, John von Neumann, joint-stock company, Joseph Schumpeter, Kenneth Arrow, libertarian paternalism, linear programming, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, market bubble, market design, Myron Scholes, New Journalism, Nikolai Kondratiev, Paul Lévy, Paul Samuelson, pension reform, performance metric, Ponzi scheme, prediction markets, pushing on a string, quantitative trading / quantitative finance, Ralph Nader, RAND corporation, random walk, Richard Thaler, risk/return, road to serfdom, Robert Bork, Robert Shiller, Robert Shiller, rolodex, Ronald Reagan, shareholder value, Sharpe ratio, short selling, side project, Silicon Valley, Social Responsibility of Business Is to Increase Its Profits, South Sea Bubble, statistical model, stocks for the long run, The Chicago School, The Myth of the Rational Market, The Predators' Ball, the scientific method, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Thomas Kuhn: the structure of scientific revolutions, Thomas L Friedman, Thorstein Veblen, Tobin tax, transaction costs, tulip mania, value at risk, Vanguard fund, Vilfredo Pareto, volatility smile, Yogi Berra

Shiller, The New Financial Order: Risk in the 21st Century (Princeton: Princeton University Press, 2003), 1–2, 5. 20. “Roundtable: The Limits of VAR,” Derivatives Strategy (April 1998): www.derivativesstrategy.com/magazine/archive/1998/0498fea1.asp. 21. The subsequent account of Long-Term Capital Management’s fall is, except where otherwise attributed, taken from the two books: Nicholas Dunbar, Inventing Money: The Story of Long-Term Capital Management and the Legends Behind It (New York: John Wiley & Sons, 2000); Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (New York: Random House, 2000). 22. Joe Kolman, “LTCM Speaks,” Derivatives Strategy (April 1999): www.derivativesstrategy.com/magazine/archive/1998/0499fea1.asp. 23. Robert Litzenberger speech, Society of Quantitative Analysts. 24. Richard Bookstaber, A Demon of Their Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation (Hoboken, N.J.: John Wiley & Sons, 2007), 97. 25.

The approach was similar to Ed Thorp’s, but with bonds instead of stocks and a lot more swashbuckling. Rosenfeld lured Merton on board in 1988 as a “special consultant to the Office of Chairman.” Scholes joined up two years later as a consultant to and later cohead of Salomon’s derivatives business. When Meriwether and Rosenfeld launched the most famous (and soon most infamous) hedge fund of the 1990s, Long-Term Capital Management, Merton and Scholes signed on as partners. Merton usually justified his presence in terms of the advice he could give about tradeoffs between risk and return. Scholes was less circumspect. During a road show to pitch the fund in 1993, a young trader at an insurance company scoffed, “No way you can make that kind of money in Treasury markets.” According to the trader, Scholes replied, “You’re the reason.

That put downward pressure on the prices of those other securities, which in turn threatened to start the cycle over again. Just as selling by portfolio insurers trying to protect their clients from price declines had driven down prices yet further in 1987, VaR had the potential to exacerbate a downturn. “Our activities may invalidate our measurements,” Taleb said early in 1998. “All…markets go down together.”20 THE SAGA OF LONG-TERM CAPITAL Management, or LTCM, offers so many cautionary tales that it’s hard to keep track of all of them. Listen to one of the former partners, or read the two fascinating books that chronicle the fund’s downfall, Roger Lowenstein’s When Genius Failed and Nicholas Dunbar’s Inventing Money, and one comes away shaking one’s head at the many hazards of hubris, of wealth, of leverage, of trusting one’s bankers, of trying to make decisions in a partnership.21 The hedge fund’s fall might be evidence that markets are efficient: Its market-beating returns were the result of taking excessive risks.


pages: 543 words: 157,991

All the Devils Are Here by Bethany McLean

Asian financial crisis, asset-backed security, bank run, Black-Scholes formula, Blythe Masters, break the buck, buy and hold, call centre, collateralized debt obligation, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Exxon Valdez, fear of failure, financial innovation, fixed income, high net worth, Home mortgage interest deduction, interest rate swap, laissez-faire capitalism, Long Term Capital Management, margin call, market bubble, market fundamentalism, Maui Hawaii, money market fund, moral hazard, mortgage debt, Northern Rock, Own Your Own Home, Ponzi scheme, quantitative trading / quantitative finance, race to the bottom, risk/return, Ronald Reagan, Rosa Parks, shareholder value, short selling, South Sea Bubble, statistical model, telemarketer, too big to fail, value at risk, zero-sum game

Government agency that conducts investigations at the request of members of Congress. GSEs: Government-sponsored enterprises. Washington-speak for Fannie Mae and Freddie Mac. HOEPA: The Homeownership and Equity Protection Act. A 1994 law giving the Federal Reserve the authority to prohibit abusive lending practices. HUD: Department of Housing and Urban Development. Sets “affordable housing goals” for Fannie Mae and Freddie Mac. LTCM: Long-Term Capital Management. Large hedge fund that collapsed in 1998. MBS: Mortgage-backed securities. NRSROs: Nationally Recognized Statistical Ratings Organizations. The three major credit rating agencies, Moody’s, Standard & Poor’s, and Fitch, were granted this status by the government. OCC: Office of the Comptroller of the Currency. The primary national bank regulator. OFHEO: Office of Federal Housing Enterprise Oversight.

The crisis was averted when the Treasury Department and the Fed, after weeks of around-the-clock effort, maneuvered to have the Exchange Stabilization Fund loan Mexico $20 billion, guaranteed by the United States. That was followed, in short order, by full-blown crises in Russia (which did default), Asia, and Latin America, as well as near crises in Egypt, South Africa, the Ukraine, and elsewhere. Each time, the three men helped contain the crisis while keeping it walled off from the U.S. economy. They did the same in the fall of 1998, when a giant hedge fund, Long-Term Capital Management, collapsed. An LTCM bankruptcy could have been devastating for Wall Street, since the big firms were all on the hook for tens of billions of dollars of LTCM’s losses, both as lenders and as counterparties. “In late-night phone calls, in marathon meetings and over bagels, orange juice, and quiche, these three men . . . are working to stop what has become a plague of economic panic,” Time wrote breathlessly.

To the extent the Committee to Save the World had answers, they were as smug as that cover photo. The developing world, they said, was new to this business of trusting in markets. They didn’t act enough like, well, us, with our supremely efficient market-driven economy. “A Thai banker who breaks the rules by passing $100,000 to his brother-in-law puts the whole system at risk,” is how the author of the article, Joshua Cooper Ramo, characterized their thinking. Even the Long-Term Capital Management disaster didn’t dent their enthusiasm for the way our own markets had evolved. LTCM was a firm that relied entirely on the tools of modern finance, chief among them derivatives, risk models, and debt. Its leverage ratio was a staggering 250 to 1, meaning that it had borrowed $250 for every $1 of equity on its balance sheet. The notional value of its derivatives book was more than $1.25 trillion, and the fact that LTCM traded almost exclusively in derivatives was the central reason it had been able to accumulate so much debt.


Manias, Panics and Crashes: A History of Financial Crises, Sixth Edition by Kindleberger, Charles P., Robert Z., Aliber

active measures, Asian financial crisis, asset-backed security, bank run, banking crisis, Basel III, Bernie Madoff, Black Swan, Bonfire of the Vanities, break the buck, Bretton Woods, British Empire, business cycle, buy and hold, Carmen Reinhart, central bank independence, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, Corn Laws, corporate governance, corporate raider, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, currency peg, death of newspapers, debt deflation, Deng Xiaoping, disintermediation, diversification, diversified portfolio, edge city, financial deregulation, financial innovation, Financial Instability Hypothesis, financial repression, fixed income, floating exchange rates, George Akerlof, German hyperinflation, Honoré de Balzac, Hyman Minsky, index fund, inflation targeting, information asymmetry, invisible hand, Isaac Newton, joint-stock company, large denomination, law of one price, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, new economy, Nick Leeson, Northern Rock, offshore financial centre, Ponzi scheme, price stability, railway mania, Richard Thaler, riskless arbitrage, Robert Shiller, Robert Shiller, short selling, Silicon Valley, South Sea Bubble, special drawing rights, telemarketer, The Chicago School, the market place, The Myth of the Rational Market, The Wealth of Nations by Adam Smith, too big to fail, transaction costs, tulip mania, very high income, Washington Consensus, Y2K, Yogi Berra, Yom Kippur War

The second aspect was that the Federal Reserve eased its monetary policy and reversed its tightening policy of 1994. An alternative starting date for the onset of the bubble is the summer of 1998, following the Asian Financial Crisis, the financial debacle in Moscow and the collapse of Long-Term Capital Management. The sharp depreciation of the Asian currencies led to an increase in the US trade deficit of more than $150 billion. Moreover, the Federal Reserve again eased policy, partly because of concern with the fragility of the monetary arrangements following the crisis in Long-Term Capital Management, until then the most professional and sophisticated of the many US hedge funds. In the twelve months after the end of June 1998 the market value of the stocks traded on the New York Stock Exchange increased by 40 percent, from $9005 billion to $12,671 billion.

Most of the banks in the area – except for those in Hong Kong and Singapore – would have been bankrupt in any reasonable ‘mark-to-market’ test. The crisis spread to Russia, there was a debacle in the ruble, and the country’s banking system collapsed in the summer of 1998. Investors then became more cautious and they sold risky securities and bought safer US government securities, and the changes in the relationship between the interest rates on these two groups of securities led to the collapse of Long-Term Capital Management, then the largest US hedge fund. The 1990s bubble in NASDAQ stocks Stocks in the United States are traded on either the over-the-counter market or on one of the organized stock exchanges, primarily the New York Stock Exchange. The typical pattern was that shares of young firms would initially be traded on the over-the-counter market and then most of these firms would incur the costs associated with obtaining a listing on the New York Stock Exchange because they believed that a listing would broaden the market and lead to higher prices for their stocks.

Sir Francis Baring knew of clerks worth less than £100 who were allowed discounts of £5000 to £10,000. The ‘phrenzy of speculation’ during this period strongly influenced the Currency School.32 In 1857 John Ball, a London accountant, reported knowing firms with capital under £10,000 and obligations of £900,000 and claimed it was a fair illustration.33 In Hamburg during the same boom, Schäffle reported a man with capital of £100 and £400,000 worth of acceptances outstanding.34 Long-Term Capital Management borrowed more than $125 billion; its capital was $5 billion. Its leverage ratio of 25 to 1 was much higher than the ratios of most other hedge funds, which generally were less than 10 to 1. In the eighteenth century, however, many firms, according to Wirth, speculated for ten to twenty times their capital during the boom of 1763.35 Lehman Brothers had capital of three percent in the several years prior to its collapse – and it tended to transfer some of its assets to affiliates at the end of each month to reduce its leverage ratios.


pages: 840 words: 202,245

Age of Greed: The Triumph of Finance and the Decline of America, 1970 to the Present by Jeff Madrick

accounting loophole / creative accounting, Asian financial crisis, bank run, Bretton Woods, business cycle, capital controls, collapse of Lehman Brothers, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, desegregation, disintermediation, diversified portfolio, Donald Trump, financial deregulation, fixed income, floating exchange rates, Frederick Winslow Taylor, full employment, George Akerlof, Hyman Minsky, income inequality, index fund, inflation targeting, inventory management, invisible hand, John Meriwether, Kitchen Debate, laissez-faire capitalism, locking in a profit, Long Term Capital Management, market bubble, minimum wage unemployment, MITM: man-in-the-middle, money market fund, Mont Pelerin Society, moral hazard, mortgage debt, Myron Scholes, new economy, North Sea oil, Northern Rock, oil shock, Paul Samuelson, Philip Mirowski, price stability, quantitative easing, Ralph Nader, rent control, road to serfdom, Robert Bork, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, Ronald Reagan: Tear down this wall, shareholder value, short selling, Silicon Valley, Simon Kuznets, technology bubble, Telecommunications Act of 1996, The Chicago School, The Great Moderation, too big to fail, union organizing, V2 rocket, value at risk, Vanguard fund, War on Poverty, Washington Consensus, Y2K, Yom Kippur War

Unlike Volcker, Greenspan, it is fair to say, was also a free market ideologue—that is, he took market efficiency and rationality as givens. He had more influence than any other figure over the direction the nation took over the next two decades, not merely in fighting inflation, but also in government’s role in the economy, effectively diminishing it. He repeated time and again that unfettered markets were best. A few weeks before the fall of the nation’s largest hedge fund, Long-Term Capital Management, in 1998, which collapsed from borrowing extreme amounts, Greenspan argued that such hedge funds were already effectively regulated—by their lenders. Lenders wouldn’t provide dangerous levels of debt to the clients because it was irrational to do so. But LTCM’s lenders were mostly caught unaware because the hedge funds were not required to make their loan positions known. In 1999, when arguing against the proposal of the head of the Commodities Futures Trading Commission to regulate financial derivatives, Greenspan claimed that unrestricted derivatives trading would stabilize finance, not disrupt it.

A large body of American opinion supported this development, and was mostly uncriticized by mainstream economists and the media. The acquiescence to ideology occurred even when markets lurched from financial crisis to crisis under Greenspan’s tenure—a stock market crash in 1987, a thrifts crisis in 1989, the collapse of junk bonds by 1990, a derivatives crisis in 1994, the Mexican peso collapse of 1994, the Asian financial crisis of 1997, the failure of Long-Term Capital Management and the Russian default on debt in 1998, and the severe stock market crash of 2000. Speculative binges enabled by both stimulative monetary policy and regulatory neglect preceded all these collapses. Levels of speculation rose to ever more dangerous heights each time. In the 1980s, the takeover movement built on soaring levels of debt, much of it ultimately bad, rose to unmanageable levels.

The following year Russia defaulted on its interest payments, and Brazil followed. The Greenspan Fed—formally, to repeat, decisions were made by the Open Market Committee, which Greenspan now effectively controlled—had again been ready to raise rates before this new crisis, but Greenspan now cut rates instead. Rubin again strongly urged the world’s central bankers to loosen policies. In October, the highly indebted hedge fund Long-Term Capital Management failed, in part due to the Russian default. Hedge funds, too, were mostly free of regulation or even disclosure requirements about their levels of debt. Only weeks before the LTCM collapse, as noted earlier, Greenspan said that the banks themselves “regulated those who lend money” and would provide the surveillance necessary. The funds also traded actively in unregulated derivatives markets, which enabled them to borrow still more against capital.


Global Governance and Financial Crises by Meghnad Desai, Yahia Said

Asian financial crisis, bank run, banking crisis, Bretton Woods, business cycle, capital controls, central bank independence, corporate governance, creative destruction, credit crunch, crony capitalism, currency peg, deglobalization, financial deregulation, financial innovation, Financial Instability Hypothesis, financial intermediation, financial repression, floating exchange rates, frictionless, frictionless market, German hyperinflation, information asymmetry, knowledge economy, liberal capitalism, liberal world order, Long Term Capital Management, market bubble, Mexican peso crisis / tequila crisis, moral hazard, Nick Leeson, oil shock, open economy, price mechanism, price stability, Real Time Gross Settlement, rent-seeking, short selling, special drawing rights, structural adjustment programs, Tobin tax, transaction costs, Washington Consensus

A ‘New Paradigm’ was hailed; the business cycle had been abolished we were told. It seemed that the knowledge economy did not obey the old laws of economics. There would be no longer boom and bust as a new generation of central bankers and prudent Finance Ministers had fashioned the perfect combination of monetary and fiscal policies for us. There was a warning in 1997 with the Asian crisis and the triple bypass for Long-Term Capital Management. The 1997 crisis was the first crisis of the new phase of globalisation. But while it sloshed about in Russia and Brazil, it failed to reach the shores of the New York or London financial markets. Smugness returned until in early 2001, the Dow Jones and Footsie began their journey southwards. We were soon hearing of a double-dip recession, retrenchment in the financial services sector and large budget deficits in the USA, Germany, France with no upturn in sight for Japan after ten years of stagnation.

By the end of that century, the TransAtlantic cable had been laid and as a result, Britain, France, Holland, Germany and the USA had interlinked financial markets, which moved in parallel, especially at times of crises. At the end of the twentieth century, the Asian crisis of the summer of 1997 brought us back to that world. That crisis originated in Thailand and after spreading across Indonesia, Malaysia, South Korea, leapt across to Russia, threatened to hit Brazil and caused the spectacular troubles1 at Long-Term Capital Management (LTCM) in the summer of 1998. That was the first crisis of the recent phase of globalisation. It led in its turn to demands for ‘new financial architecture’ and much activity by the IMF/World Bank and G7 leaders in the summer of 1998 was directed towards coping with the global crisis.2 As it happened (and this is my reading of the events of October 1998), a small number of interest rate cuts by the Federal Reserve (Fed) calmed the markets and resolved the crisis.

The need is to invest resources into building models based on the best available theory, calibrate them and then test which of the alternative provides a plausible explanation. It is not an easy task. It will require combining finance theory, econometrics and political economy. But it needs to be done. Notes 1 For the affairs at LTCM see Lowenstein, R. (2000) ‘When genius failed’, The Rise and Fall of Long Term Capital Management, Random House, New York. The Mexican peso crisis, which happened in December 1994, was regional and did not grow into a global crisis as the Asian one did. I am excluding it therefore. There were other national crises in Russia, Turkey, Argentina and Brazil. 2 For the 1998 debate on financial architecture see Eatwell and Taylor (1998). They propose a World Financial Authority as a regulator rather than a lender of last resort. 3 For excess volatility see Soros, George (2000) and for overvaluation and persistent bubble Shiller, R. (2001) Irrational Exuberance, Princeton University Press, Princeton, NJ. 4 Fama, E. (1970) Efficient capital markets: a review of theory and empirical work, Journal of Finance, 25: 383–417.


pages: 258 words: 71,880

Street Fighters: The Last 72 Hours of Bear Stearns, the Toughest Firm on Wall Street by Kate Kelly

bank run, buy and hold, collateralized debt obligation, corporate governance, corporate raider, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Donald Trump, fixed income, housing crisis, index arbitrage, Long Term Capital Management, margin call, moral hazard, quantitative hedge fund, Renaissance Technologies, risk-adjusted returns, shareholder value, technology bubble, too big to fail, traveling salesman

Norton & Co., 2009. Monica Langley. Tearing Down the Walls. New York: Simon & Schuster, 2003. Roger Lowenstein. When Genius Failed: The Rise and Fall of Long-Term Capital Management. New York: Random House, 2000. INDEX AAA ratings Ackermann, Josef acquisition, of Bear announcement of deal price and deal protection and J.C. Flowers and J. P. Morgan and, see J.P. Morgan, Bear acquisition and AIG (American International Group) Alix, Mike Alt-A mortgage loans American Express Angelo, John A.R. Baron & Co. Asia see also China; Japan asset management Atkins, Peter bailouts Bush and of Long-Term Capital Management see also Federal Reserve, Bear loan from Bainlardi, Peter “bake-offs” Bank America Corp. Bank of America Bank of New York (BONY) Bank One bankruptcy Bear’s consideration of Chapter Chapter debtor-in-possession financing and of Lehman opening for business and Barclays Bank Barron’s Bear Stearns Asset Management (BSAM) Bear Stearns Companies: annual media-industry conference of bankruptcy considered by bond-sales department of capital levels of corporate culture at crisis of confidence and debt load of downgrading of due diligence meetings at equities division of Bear Stearns Companies (cont.)

Even its charitable requirements for SMDs, which were codified in the late 1960s, were admired, but seldom emulated, by Bear’s competitors. Bear cared little for appearances. During the 1990s, it proudly hired castoffs from competing firms who had been fired after political battles or regulatory skirmishes. A trader’s outside reputation, Bear recruiters felt, had little bearing on his or her talent with a telephone, a computer terminal, and a pile of cash. In 1998, when the hedge fund Long-Term Capital Management nearly collapsed, Bear refused to participate in a bailout effort that included every other Wall Street firm. Ten years later, employees wondered if the lenders and competitors who pushed Bear to the brink were exacting revenge for the firm’s selfish behavior at that time. Bear’s executives could be curt. Schwartz had an investment banker’s polish, but he was a rare exception. Bear’s bond traders, long the rock stars of the firm, were brusque, arrogant, and uninterested in anyone who disagreed with their positions.

Marano, a Columbia University history major who had a large home in Madison, New Jersey, and a wine cellar full of great vintages, was one of the best-paid people at the company, and for good reason, he felt. Now, after a few bruising days in the stock market, his net worth had fallen by nearly half. “Yeah, I saw the same procession walk in,” Greenberger said, referring to the Cadwalader bankruptcy lawyers. “Yeah,” said Marano. “They looked like the undertakers.” 11:30 P.M. Matt Zames had been down this road before. He had started his career at Long-Term Capital Management in the winter of 1994, shortly after college. There he witnessed firsthand what could happen when a bunch of shortsighted executives didn’t manage their risk properly. In September 1998, when Long-Term’s massive losses had prompted an emergency meeting at the New York Fed, Wall Street’s top players had cobbled together an eleventh-hour bailout of the fund, hoping to stave off collateral damage to the financial system.


Capital Ideas Evolving by Peter L. Bernstein

Albert Einstein, algorithmic trading, Andrei Shleifer, asset allocation, business cycle, buy and hold, buy low sell high, capital asset pricing model, commodity trading advisor, computerized trading, creative destruction, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, diversification, diversified portfolio, endowment effect, equity premium, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, high net worth, hiring and firing, index fund, invisible hand, Isaac Newton, John Meriwether, John von Neumann, Joseph Schumpeter, Kenneth Arrow, London Interbank Offered Rate, Long Term Capital Management, loss aversion, Louis Bachelier, market bubble, mental accounting, money market fund, Myron Scholes, paper trading, passive investing, Paul Samuelson, price anchoring, price stability, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, statistical model, survivorship bias, systematic trading, technology bubble, The Wealth of Nations by Adam Smith, transaction costs, yield curve, Yogi Berra, zero-sum game

They can be caught in what is known as a “short squeeze,” in which they are unable to make delivery of the stock they have sold because they are unable to borrow it anywhere. Then they are forced to go into the market and buy it back at what is likely to be a higher price than the price at which they sold. Many hedge funds own illiquid assets or assets trading only in thin markets, where the probability of large losses is much greater than in conventional investing—as the disastrous experience of Long-Term Capital Management so dramatically demonstrated.* All these activities become even riskier when the fund uses borrowed money, which is frequently the case.9 By definition, most investors cannot outperform the market because they are the market. On the other hand, the available evidence suggests that fewer investors are able to win out over the others than would be the case if the markets were not so competitive.

His favorite approach is to tell people about the stocks that look especially attractive to him. If they agree right away that he is on to something, he figures the price of the stock already ref lects this idea, and he goes on to something else. But when his friends just don’t get it, he is inspired to study the matter further and, in all likelihood, invest in it.† * † For a more extended discussion of Long-Term Capital Management, see Chapter 6. See Mehrling (2005), pp. 253–254. bern_c02.qxd 3/23/07 8:53 AM Page 25 The Strange Paradox of Behavioral Finance 25 Treynor is a kind of lone wolf operator and prefers what he calls “slow ideas”—ideas that will take time to bear fruit and therefore have no attraction for most investors. In the more general case, where time horizons are much shorter, skilled investors often act so rapidly that they spoil the situation for one another as opportunities disappear almost instantly.

We shall return to this phenomenon from a different perspective in Chapter 6. These widely separated but memorable demonstrations of market inefficiency are seared into memory: the 50 percent rise in stock prices from the middle of 1928 to October 1929; the subsequent plummet of 85 percent to the low of June 1932; Black Monday of October 19, 1987, when stocks lost over 20 percent of their value in one day; the Long-Term Capital Management crisis of the summer of 1998 when the imminent failure of this hedge fund nearly pulled down the whole bern_c02.qxd 3/23/07 8:53 AM Page 29 The Strange Paradox of Behavioral Finance 29 financial system; the 140 percent boom from the end of 1995 to October 2000, and the subsequent 44 percent bust in February 2003. Irrational pricing in the market as a whole need not take the form of boom-and-bust.


pages: 526 words: 158,913

Crash of the Titans: Greed, Hubris, the Fall of Merrill Lynch, and the Near-Collapse of Bank of America by Greg Farrell

Airbus A320, Apple's 1984 Super Bowl advert, bank run, banking crisis, bonus culture, call centre, Captain Sullenberger Hudson, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, financial innovation, fixed income, glass ceiling, high net worth, Long Term Capital Management, mass affluent, Mexican peso crisis / tequila crisis, Nelson Mandela, plutocrats, Plutocrats, Ronald Reagan, six sigma, sovereign wealth fund, technology bubble, too big to fail, US Airways Flight 1549, yield curve

Then on August 9, 2007, a French bank, BNP Paribas, announced it would suspend the valuation of three subprime mortgage–based investment funds because liquidity in the market had disappeared. The fact that all trading in the market for these funds had stopped meant there was no longer a market. The BNP announcement caused the normal flow of overnight interbank funding to seize up on the Continent, spurring the European Central Bank to put 95 billion euros into the market as an emergency measure. For the first time in nine years, when Long Term Capital Management imploded in 1998 and threatened to take down several investment banks, including Merrill Lynch, O’Neal felt fear in the pit of his stomach. Back then, he was Merrill’s chief financial officer and the firm’s exposure to Long Term Capital, a hedge fund that bet the wrong way on interest rates, threatened Merrill’s access to overnight funding. O’Neal had to return from vacation in the summer of 1998, and for the next three months he spent every day and night worrying about how and whether Merrill Lynch would be funded.

The room, which had a southwesterly exposure, was bathed in the afternoon sunlight, but Tosi noticed that none of the electric lights were on. There was O’Neal slouched back in his chair, looking disheveled, unshaven, wearing a gray cardigan, his hands at his temples to prop up his slumping head. Tosi had never seen the CEO like this, and it was unnerving. “That fucking Semerci,” O’Neal muttered. “I should have known I could never trust him.” He then started talking about the Long Term Capital Management crisis almost a decade earlier, when he was CFO and Merrill Lynch nearly ran out of money. “Those fixed-income guys got me in 1998, and I swore I’d never let them do it to me again.” When Tosi left the office, he looked at Marian Brooks, O’Neal’s longtime secretary. There were tears in her eyes. A few hours later, after the sun had set, Greg Fleming came to O’Neal’s office, hoping to find the CEO.

“Okay, you guys have the general idea,” O’Neal said to the board, bringing his subordinates’ presentation to an abrupt end. Chris Hayward, Eric Heaton, Kelly, and Moriarty realized they had been given a cue to leave, and awkwardly departed. O’Neal now made his case to the directors. The problems on Merrill’s balance sheet could get far worse, and there was no way to quantify the potential losses at the moment, he said. He had lived through the Long Term Capital Management crisis in 1998, and once liquidity dries up, Merrill Lynch could get into deep trouble in almost no time. Given this situation, it was only prudent for the firm to look at potential partners, O’Neal explained. That’s why he had reached out to Wachovia. “Stan, this is a great franchise, an iconic brand,” said Cribiore. “It’s as famous as Coca-Cola. We don’t want to be sitting with a bank in Charlotte.”


pages: 471 words: 97,152

Animal Spirits: How Human Psychology Drives the Economy, and Why It Matters for Global Capitalism by George A. Akerlof, Robert J. Shiller

"Robert Solow", affirmative action, Andrei Shleifer, asset-backed security, bank run, banking crisis, business cycle, buy and hold, collateralized debt obligation, conceptual framework, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, Deng Xiaoping, Donald Trump, Edward Glaeser, en.wikipedia.org, experimental subject, financial innovation, full employment, George Akerlof, George Santayana, housing crisis, Hyman Minsky, income per capita, inflation targeting, invisible hand, Isaac Newton, Jane Jacobs, Jean Tirole, job satisfaction, Joseph Schumpeter, Long Term Capital Management, loss aversion, market bubble, market clearing, mental accounting, Mikhail Gorbachev, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, mortgage debt, Myron Scholes, new economy, New Urbanism, Paul Samuelson, plutocrats, Plutocrats, price stability, profit maximization, purchasing power parity, random walk, Richard Thaler, Robert Shiller, Robert Shiller, Ronald Reagan, South Sea Bubble, The Chicago School, The Death and Life of Great American Cities, The Wealth of Nations by Adam Smith, too big to fail, transaction costs, tulip mania, working-age population, Y2K, Yom Kippur War

This reduces the funds available to the non-bank banks. It also raises the rates that they must pay for the funds they are able to borrow. They may have been fully solvent before the flight to liquidity began, but in a liquidity crisis they may not be able to afford the higher rates required for continued borrowing.12 Bear Stearns and Long Term Capital Management The interactions between the Fed and Bear Stearns in 2008, and between the Fed and Long Term Capital Management in 1998, are illustrative of the Fed’s concern about the shadow banking system and the possibility that failures there would lead to a financial panic. On a Monday morning in March 2008 the public was stunned to discover that over the weekend Bear Stearns, a leading investment bank, had been merged with JPMorgan Chase at the bargain-basement price of $2 per share.

., 197n24 Liebow, Elliot, 161, 196n13 limited liability corporations, 27–29 Limits to Growth, The (study report), 141–42 Lincoln, Abraham, 175 Lindbeck, Assar, 189n17 linked verse, 139 liquidity problems, 80, 81, 82, 83, 85 Littlefield, Henry, 185n14 Liutuan, China, 126–27 Lo, Andrew W., 182n22, 198n9 loanable funds theory, 78–79 Lodge, Henry Cabot, 81 Lohr, Steve, 180n5 London School of Economics, 43 Long Term Capital Management (LTCM), 38, 82, 83–85 López Portillo, José, 53–54 Los Angeles, California, 36, 169, 198n8 Los Angeles Times, 142 Loury, Glenn, 162, 197n18 Love Is a Story (Sternberg), 52 Lowenstein, Roger, 186n16 LTCM. See Long Term Capital Management Ludvigson, Sydney C., 180n12 Lundborg, Per, 183n14 Lusardi, Annamaria, 122, 191n7,8 Luxembourg, 125, 192n17 Macaulay, Frederic, 184n6 McCabe, Kevin A., 189n15 McCloskey, Michael, 151, 195n5 McCloud, James F., 138 McCulloch, Robert, 185n20, 196n10 McDonald, Forrest, 185n22 McDonald, Ian, 188n2 McGrattan, Ellen R., 178n6 McKinley, William, 62 macroeconomics, 174; with and without animal spirits, 4–5; in classical economics, xxiv; confidence and, 13, 14; credit crunch and, 88–89, 90; full employment and, 3; inflation-unemployment trade-off and, 45, 46; Keynesian, xxii; minorities and, 158; money illusion and, 41, 42, 45, 46; new insight into, 171; response required by, 168 Madrian, Brigitte C., 191n6 Maharashtra, India, 34 Malaysia, 126 Mao Zedong, 26, 126 marginal propensity to consume (MPC), 14–15 Mark, Rebecca, 34 mark-to-market accounting, 33–34 marriage, stories in, 52 Marsh, Terry A., 193n6 Martin Luther King Day, 163 Mason, Joseph R., 181n18 Massachusetts Institute of Technology (MIT), 113, 141 Matsusaka, John G., 179n9 Meadows, Dennis L., 194n29 Meadows, Donella H., 194n29 Melino, Angelo, 191n9 mental accounts, 120–21, 192n25 Merrill Lynch, 133 Merton, Robert C., 84, 193n6 Meston, Lord, 71 Mexico, 53–54, 109 Miami, Florida, 36, 169, 198n8 Michigan Consumer Sentiment Index, 16–17, 179n2,9 Milken, Michael, 31–32 Mincer, Jacob, 19 minorities, 6, 157–66, 174, 196–97n1–24; anger in, 161–62; characteristics of those left behind, 161–63; education and, 165–66; importance of trying to assist, 166; real estate market and, 154–55; remedy for economic problems of, 163–66; why they are left behind, 158–60 Minsky, Hyman, xxiv, 177n2,7,8, 186n3 Mishkin, Frederic S., 180n9, 187n9, 191n9, 193n15 MIT.

The typical contract of a hedge fund gives its managers highly questionable incentives.22 A common compensation system for hedge funds gives managers a fixed percentage of the capital under management, typically 2%, and then 20% of the annual profits. On this basis hedge fund owners have a huge incentive to leverage their holdings as much as possible and to make investments that are extremely risky. Curiously it appears that the hedge funds did not, for the most part, invest heavily in sub-prime packages.23 Calomiris claims that, as sophisticated investors, they knew better.24 But the case of Long Term Capital Management (whose failure we shall discuss in considerably more detail in Chapter 7) tells us that hedge funds, leveraged as they are, can fail in unusual times that fall outside the scope of their hedging models. Right now we do not know whether failure of large hedge funds is the next shoe to drop in the current crisis, or whether they really are what they claim to be. They claim to take very little risk; they merely make bets on asset price spreads (or yield spreads) that are too high or too low.


pages: 162 words: 50,108

The Little Book of Hedge Funds by Anthony Scaramucci

Andrei Shleifer, asset allocation, Bernie Madoff, business process, carried interest, corporate raider, Credit Default Swap, diversification, diversified portfolio, Donald Trump, Eugene Fama: efficient market hypothesis, fear of failure, fixed income, follow your passion, Gordon Gekko, high net worth, index fund, John Meriwether, Long Term Capital Management, mail merge, margin call, mass immigration, merger arbitrage, money market fund, Myron Scholes, NetJets, Ponzi scheme, profit motive, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk-adjusted returns, risk/return, Ronald Reagan, Saturday Night Live, Sharpe ratio, short selling, Silicon Valley, Thales and the olive presses, Thales of Miletus, the new new thing, too big to fail, transaction costs, Vanguard fund, Y2K, Yogi Berra, zero-sum game

Short-Selling Investor: In an effort to hedge your portfolio, you borrow $100,000 so that you increase your kitty to $200,000. This leverage enables the manager to buy $140,000 worth of good stocks while shorting $60,000 worth of bad stocks, thus giving him more money to play with so he can better diversify his portfolio. As a result, the hedge fund manager incurs less stock-selection risk and less market risk. But, leverage can be a fickle bitch . . . just ask Long-Term Capital Management. As Warren Buffett says, “When you combine ignorance and leverage, you get some pretty interesting results.” Leverage can be tricky as it bears various levels of risk—counter party risk and market risk. I compare this alternative investment tool to a very sharp knife coming out of the steering wheel of your sports car; it can point at your heart as you are traveling downhill on an icy mountain road.

Consequently, a flood of money has poured into these funds, increasing the impact hedge funds have on the market and global economy, and affecting the everyman’s pocketbook. And Now for the Not-Quite-as-Successful By the mid-90s, it appeared that hedge funds had found the Shangri-La of investments. But just as they were about to meet the leprechaun and his pot of gold at the end of the rainbow, it happened—Long-Term Capital Management (LTCM) collapsed in 1998 and was later rescued by the federal government. Founded in 1994 by a proprietary trading legend, John Meriwether from Solomon Brothers; two Nobel Prize-winning economists, Robert C. Merton and Myron Scholes; and a slew of finance wizards, LTCM used an arbitrage strategy that exploited temporary changes in market behavior. By pair trading and betting on price convergence over a range of scenarios (we’ll discuss those strategies in Chapter 7), the LTCM band of brothers leveraged their $4 billion fund until it had a notional exposure of over $1 trillion dollars.

Fearful that LTCM’s collapse would signal a more widespread hedge fund fire, the Federal Reserve board intervened and orchestrated a $3.65-billion bailout—with the help of 14 other financial institutions. Each of the major broker dealers (with the exception of Bear Stearns) put up capital, took over the defunct fund, and worked patiently to unravel the trades once the market calmed down. According to the Fed’s William McDonough, “An abrupt and disorderly liquidation would have posed unacceptable risks to the American economy.” Sound familiar? Although Long Term Capital Management took the crown for the most-documented hedge fund failure, the runner-up is more than likely Amaranth Advisors. Founded in 2000, Amaranth Advisors successfully bet on the natural gas market and came up big, showering its clients with sparkling performance. And then came the summer of 2006. Thinking that there might be another Hurricane Katrina-like event that would result in the explosion of natural gas prices, Amaranth bet the farm and put all of its eggs in the natural gas basket.


pages: 505 words: 142,118

A Man for All Markets by Edward O. Thorp

3Com Palm IPO, Albert Einstein, asset allocation, beat the dealer, Bernie Madoff, Black Swan, Black-Scholes formula, Brownian motion, buy and hold, buy low sell high, carried interest, Chuck Templeton: OpenTable:, Claude Shannon: information theory, cognitive dissonance, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Edward Thorp, Erdős number, Eugene Fama: efficient market hypothesis, financial innovation, George Santayana, German hyperinflation, Henri Poincaré, high net worth, High speed trading, index arbitrage, index fund, interest rate swap, invisible hand, Jarndyce and Jarndyce, Jeff Bezos, John Meriwether, John Nash: game theory, Kenneth Arrow, Livingstone, I presume, Long Term Capital Management, Louis Bachelier, margin call, Mason jar, merger arbitrage, Murray Gell-Mann, Myron Scholes, NetJets, Norbert Wiener, passive investing, Paul Erdős, Paul Samuelson, Pluto: dwarf planet, Ponzi scheme, price anchoring, publish or perish, quantitative trading / quantitative finance, race to the bottom, random walk, Renaissance Technologies, RFID, Richard Feynman, risk-adjusted returns, Robert Shiller, Robert Shiller, rolodex, Sharpe ratio, short selling, Silicon Valley, Stanford marshmallow experiment, statistical arbitrage, stem cell, stocks for the long run, survivorship bias, The Myth of the Rational Market, The Predators' Ball, the rule of 72, The Wisdom of Crowds, too big to fail, Upton Sinclair, value at risk, Vanguard fund, Vilfredo Pareto, Works Progress Administration

Not a single one of the works of these economists will ultimately survive: Strategies that allow you to survive are not the same thing as the ability to impress colleagues. So the world today is divided into two groups using distinct methods. The first method is that of the economists who tend to blow up routinely or get rich collecting fees for managing money, not from direct speculation. Consider that Long-Term Capital Management, which had the crème de la crème of financial economists, blew up spectacularly in 1998, losing a multiple of what they thought their worst-case scenario was. The second method, that of the information theorists as pioneered by Ed, is practiced by traders and scientist-traders. Every surviving speculator uses explicitly or implicitly this second method (evidence: Ray Dalio, Paul Tudor Jones, Renaissance Technologies, even Goldman Sachs!).

The striking similarities between the two suggested to me that, just as some gambling games could be beaten, it might also be possible to do better than the market averages. Both can be analyzed using mathematics, statistics, and computers. Each requires money management, choosing the proper balance between risk and return. Betting too much, even though each individual bet is in your favor, can be ruinous. When the Nobel Prize winners running the giant hedge fund Long-Term Capital Management made this mistake, its collapse in 1998 almost destabilized the US financial system. On the other hand, playing safe and betting too little means you leave money on the table. The psychological makeup to succeed at investing also has similarities to that for gambling. Great investors are often good at both. Relishing the intellectual challenge and the fun of exploring the markets, I spent the summer of 1964 educating myself about them.

When the S&P 500 Index fell 23 percent on October 19, 1987, a leading academic finance professor said that if the market had traded every day for the thirteen-billion-year life of the universe, the chance of this happening even once was negligible. Another tool used today is to “stress-test” a portfolio by simulating the impact of major calamitous events of the past on the portfolio. In 2008, a multibillion-dollar hedge fund managed by a leading quant used ten-day windows from the crash of 1987, the First Gulf War, Hurricane Katrina, the 1998 Long-Term Capital Management crisis, the tech-induced market drop in 2000–02, the Iraq War, and so forth. All this data was applied to the fund’s 2008 portfolio and showed that these events would have led to losses of at most $500 million on a $13 billion portfolio, a risk of loss of no more than 4 percent. But they actually lost over 50 percent at their low in 2009, brought to the brink of ruin before finally recovering their losses in 2012.


pages: 256 words: 60,620

Think Twice: Harnessing the Power of Counterintuition by Michael J. Mauboussin

affirmative action, asset allocation, Atul Gawande, availability heuristic, Benoit Mandelbrot, Bernie Madoff, Black Swan, butter production in bangladesh, Cass Sunstein, choice architecture, Clayton Christensen, cognitive dissonance, collateralized debt obligation, Daniel Kahneman / Amos Tversky, deliberate practice, disruptive innovation, Edward Thorp, experimental economics, financial innovation, framing effect, fundamental attribution error, Geoffrey West, Santa Fe Institute, George Akerlof, hindsight bias, hiring and firing, information asymmetry, libertarian paternalism, Long Term Capital Management, loose coupling, loss aversion, mandelbrot fractal, Menlo Park, meta analysis, meta-analysis, money market fund, Murray Gell-Mann, Netflix Prize, pattern recognition, Philip Mirowski, placebo effect, Ponzi scheme, prediction markets, presumed consent, Richard Thaler, Robert Shiller, Robert Shiller, statistical model, Steven Pinker, The Wisdom of Crowds, ultimatum game

And Greenspan has been gracious in sharing his story and explaining why he was drawn to investment returns that looked, in retrospect, too good to be true. If you ask people to offer adjectives they associate with good decision makers, words like “intelligent” and “smart” are generally at the top of the list. But history contains plenty of examples of intelligent people who made poor decisions, with horrific consequences, as the result of cognitive mistakes. Consider the following: • In the summer of 1998, Long-Term Capital Management (LTCM), a U.S. hedge fund, lost over $4 billion and had to be bailed out by a consortium of banks. The senior professionals at LTCM, who included two recipients of the Nobel Prize in economics, were highly successful up to that point. As a group, the professionals were among the most intellectually impressive of any organization in the world and were large investors in their own fund.

While empirical research from as early as the 1920s showed that changes in the price of assets do not follow a normal, bell-shaped distribution, economic theory still rests on that assumption. If you have ever heard a financial expert refer to the stock market using terms like alpha, beta, or standard deviation, you have witnessed reductive bias in action. Most economists characterize markets using simpler, but wrong, price-change distributions. A number of high-profile financial blowups, including Long-Term Capital Management, show the danger of this bias.15 Benoit Mandelbrot, a French mathematician and the father of fractal geometry, was one of the earliest and most vocal critics of using normal distributions to explain how asset prices move.16 His chapter in The Random Character of Stock Market Prices, published in 1964, created a stir because it demonstrated that asset price changes were much more extreme than previous models had assumed.

For example, an investment bank could bundle corporate bonds into a pool, known as a collateralized debt obligation, and summarize the default correlation with Li’s equation rather than worry about the details of how each corporate bond within the pool would behave. While market participants described the formula as “beautiful, simple, and tractable,” it had a fatal flaw because correlations change. Consistent with reductive bias, the equation was based on an uncomplicated, stable world but was applied in a complex, dynamic world. As is often the case, default correlations rise when the economy turns south. The failure of Long-Term Capital Management illustrates how changing correlations can wreak havoc. LTCM observed that the correlation between its diverse investments was less than 10 percent over the prior five years. To stress test its portfolio, LTCM assumed that correlations could rise to 30 percent, well in excess of anything the historical data showed. But when the financial crisis hit in 1998, the correlations soared to 70 percent.


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More Than You Know: Finding Financial Wisdom in Unconventional Places (Updated and Expanded) by Michael J. Mauboussin

Albert Einstein, Andrei Shleifer, Atul Gawande, availability heuristic, beat the dealer, Benoit Mandelbrot, Black Swan, Brownian motion, butter production in bangladesh, buy and hold, capital asset pricing model, Clayton Christensen, clockwork universe, complexity theory, corporate governance, creative destruction, Daniel Kahneman / Amos Tversky, deliberate practice, demographic transition, discounted cash flows, disruptive innovation, diversification, diversified portfolio, dogs of the Dow, Drosophila, Edward Thorp, en.wikipedia.org, equity premium, Eugene Fama: efficient market hypothesis, fixed income, framing effect, functional fixedness, hindsight bias, hiring and firing, Howard Rheingold, index fund, information asymmetry, intangible asset, invisible hand, Isaac Newton, Jeff Bezos, Kenneth Arrow, Laplace demon, Long Term Capital Management, loss aversion, mandelbrot fractal, margin call, market bubble, Menlo Park, mental accounting, Milgram experiment, Murray Gell-Mann, Nash equilibrium, new economy, Paul Samuelson, Pierre-Simon Laplace, quantitative trading / quantitative finance, random walk, Richard Florida, Richard Thaler, Robert Shiller, Robert Shiller, shareholder value, statistical model, Steven Pinker, stocks for the long run, survivorship bias, The Wisdom of Crowds, transaction costs, traveling salesman, value at risk, wealth creators, women in the workforce, zero-sum game

A normal distribution is a powerful analytical tool, because you can specify the distribution with only two variables, the mean and standard deviation. The model, despite its elegance, has a problem: it doesn’t describe real world results very well. In particular, the model is remiss in capturing “fat tails”: infrequent but very large price changes. The failure of risk-management models to fully account for fat tails has led to some high-profile debacles, including the 1998 demise of the hedge fund Long Term Capital Management. Fat tails are closely associated with power laws, a mathematical link between two variables characterized by frequent small events and infrequent large events. Power laws are fascinating, and they empirically represent relationships as diverse as city sizes, earthquakes, and income distribution. While scientists still don’t have a firm grasp on the mechanisms behind power laws, their very existence provides investors with good insight.

Exposure, on the other hand, considers the likelihood—and potential risk—of an event that history (especially recent history) may not reveal. Buffett argues that in 2001 the insurance industry assumed huge terrorism risk without commensurate premiums because it was focused on experience, not exposure. Investors, too, must discern between experience and exposure. The high-profile failures of Long Term Capital Management and Victor Niederhoffer give witness to this point. Remarkably, however, standard finance theory does not easily accommodate extreme events. Financial economists generally assume that stock price changes are random, akin to the motion of pollen in water as molecules bombard it.1 In a triumph of modeling convenience over empirical results, finance theory treats price changes as independent, identically distributed variables and generally assumes that the distribution of returns is normal, or lognormal.

I also highly recommend Steven Crist, Betting on Myself: Adventures of a Horseplayer and Publisher (New York: Daily Racing Form Press, 2003). 5 From Robert Rubin’s commencement address, University of Pennsylvania, 1999, http://www.upenn.edu/almanac/v45/n33/speeches99.html. 6 See chapter 5. 7 Sarah Lichenstein, Baruch Fischhoff, and Lawrence D. Phillips, “Calibration of Probabilities,” in Judgment Under Uncertainty: Heuristics and Biases, ed. Daniel Kahneman, Paul Slovic, and Amos Tversky (Cambridge: Cambridge University Press, 1982), 306-34. 8 Peter Schwartz, Inevitable Surprises: Thinking Ahead in a Time of Turbulence (New York: Gotham Books, 2003). 9 Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (New York: Random House, 2000); Nassim Nicholas Taleb, The Black Swan: The Impact of the Highly Improbable (New York: Random House, 2007). 10 Daniel Kahneman and Amos Tversky, “Prospect Theory: An Analysis of Decision Under Risk,” Econometrica 47 (1979): 263-91. 11 Nassim Nicholas Taleb, Fooled By Randomness: The Hidden Role of Chance in Markets and in Life (New York: Texere, 2001), 89-90.


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What They Do With Your Money: How the Financial System Fails Us, and How to Fix It by Stephen Davis, Jon Lukomnik, David Pitt-Watson

activist fund / activist shareholder / activist investor, Admiral Zheng, banking crisis, Basel III, Bernie Madoff, Black Swan, buy and hold, centralized clearinghouse, clean water, computerized trading, corporate governance, correlation does not imply causation, credit crunch, Credit Default Swap, crowdsourcing, David Brooks, Dissolution of the Soviet Union, diversification, diversified portfolio, en.wikipedia.org, financial innovation, financial intermediation, fixed income, Flash crash, income inequality, index fund, information asymmetry, invisible hand, Kenneth Arrow, Kickstarter, light touch regulation, London Whale, Long Term Capital Management, moral hazard, Myron Scholes, Northern Rock, passive investing, performance metric, Ponzi scheme, post-work, principal–agent problem, rent-seeking, Ronald Coase, shareholder value, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical model, Steve Jobs, the market place, The Wealth of Nations by Adam Smith, transaction costs, Upton Sinclair, value at risk, WikiLeaks

Just as hurricanes do sometimes happen and insurance companies have to pay up, so, too, those otherwise stable relationships sometimes evaporate. When they do, they can take your life savings with them. It was just that sort of low-probability set of events that caused hedge fund Long-Term Capital Management to blow up in 1998, forcing the Federal Reserve to organize a $3.6 billion bailout of the fund, which at its height had controlled derivatives with a notional value of $1.25 trillion.24 Long-Term Capital Management used far more complex mathematical calculations than a manager who just writes put options. But fundamentally, it was exposed to the same risk.25 Weisman calls these strategies “informationless” because you don’t have to know much to create a great performance record—until disaster strikes.

The adjustments to the shape of the curve were many, but the fundamental assumption, that the variability of the outcomes was predictable, was largely unchallenged. 19. International Monetary Fund, “IMF Performance in the Run-up to the Financial and Economic Crisis: IMF Surveillance in 2004–07” (International Monetary Fund, Independent Evaluation Office, January 10, 2011), http://www.ieo-imf.org/ieo/pages/NewsLinks107.aspx. 20. Myron Scholes and Robert Merton were both directors of Long-Term Capital Management. Wikipedia.org/wiki/Long_Term_Capital_Management. 21. John Maynard Keynes, General Theory of Employment Interest and Money (Snowball Publishing, 2012), bk. 5, chap. 21. 22. Friedrich von Hayek, “The Pretense of Knowledge,” Nobel Prize acceptance speech, 1974, http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1974/hayek-lecture.html. 23. John Kenneth Galbraith, A History of Economics (Hamish Hamilton, 1987), 125.

The compass that bankers and regulators were using worked well according to its own logic, but it was pointing in the wrong direction, and they steered the ship onto the rocks. History does not record whether the Queen was satisfied with the academics’ response. She might, however, have noted that this economic-statistical model had been found wanting before—in 1998, when the collapse of the hedge fund Long-Term Capital Management nearly took the financial system down with it. Ironically, its directors included the two people who had shared the Nobel Prize in Economics the previous year.20 The Queen might also have noted the glittering lineup of senior economists who, over the last century, have warned against excessive confidence in predictions made using models. John Maynard Keynes, no mathematical slouch, warned eighty years ago that “too large a proportion of recent ‘mathematical’ economics are mere concoctions, as imprecise as the initial assumptions which they rest on, which allow the author to lose sight of the complexities and interdependencies of the real world in a maze of pretentious and unhelpful symbols.”21 Friedrich von Hayek, accepting his Nobel Prize in 1974, argued that “the failure of economists to guide policy more successfully is closely connected to their propensity to imitate as closely as possible the procedures of the … physical sciences.”


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The End of Wall Street by Roger Lowenstein

Asian financial crisis, asset-backed security, bank run, banking crisis, Berlin Wall, Bernie Madoff, Black Swan, break the buck, Brownian motion, Carmen Reinhart, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversified portfolio, eurozone crisis, Fall of the Berlin Wall, fear of failure, financial deregulation, fixed income, high net worth, Hyman Minsky, interest rate derivative, invisible hand, Kenneth Rogoff, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, Martin Wolf, money market fund, moral hazard, mortgage debt, negative equity, Northern Rock, Ponzi scheme, profit motive, race to the bottom, risk tolerance, Ronald Reagan, Rubik’s Cube, savings glut, short selling, sovereign wealth fund, statistical model, the payments system, too big to fail, tulip mania, Y2K

Table of Contents Title Page Copyright Page Dedication Introduction Chapter 1 - TO THE CROSSROADS Chapter 2 - SUBPRIME Chapter 3 - LENDERS Chapter 4 - NIAGARA Chapter 5 - LEHMAN Chapter 6 - DESPERATE SURGE Chapter 7 - ABSENCE OF FEAR Chapter 8 - CITI’S TURN Chapter 9 - RUBICON Chapter 10 - TOTTERING Chapter 11 - FANNIE’S TURN Chapter 12 - SLEEPLESS Chapter 13 - THE FORCES OF EVIL Chapter 14 - AFTERSHOCKS Chapter 15 - THE HEDGE FUND WAR Chapter 16 - THE TARP Chapter 17 - STEEL’S TURN Chapter 18 - RELUCTANT SOCIALIST Chapter 19 - GREAT RECESSION Chapter 20 - THE END OF WALL STREET Acknowledgements NOTES INDEX ABOUT THE AUTHOR ALSO BY ROGER LOWENSTEIN While America Aged: How Pension Debts Ruined General Motors, Stopped the NYC Subways, Bankrupted San Diego, and Loom as the Next Financial Crisis Origins of the Crash: The Great Bubble and Its Undoing When Genius Failed: The Rise and Fall of Long-Term Capital Management Buffett: The Making of an American Capitalist THE PENGUIN PRESS Published by the Penguin Group Penguin Group (USA) Inc., 375 Hudson Street, New York, New York 10014, U.S.A. • Penguin Group (Canada), 90 Eglinton Avenue East, Suite 700, Toronto, Ontario, Canada M4P 2Y3 (a division of Pearson Penguin Canada Inc.) • Penguin Books Ltd, 80 Strand, London WC2R 0RL, England • Penguin Ireland, 25 St.

Lean and sinewy, he resembled the actor Al Pacino, whose character in The Godfather (a movie Fuld watched repeatedly) he vaguely emulated, most famously in the brutal stares with which he responded to subordinates’ entreaties. His darting eyes seemed ever on the alert, as if for predators. Perhaps he had cause, for Lehman suffered a near-death experience almost every market cycle. In 1998, when the hedge fund Long-Term Capital Management imploded, seeming to imperil Wall Street, Fuld valiantly went on the road to keep Lehman’s creditors from withdrawing their lines of credit; his efforts saved the firm. He had the daring of a gambler who believes, deep down, that he will always be able to play the last card—that if down markets or a credit crunch ever swamped his firm, he would find a way to steer it home. Fuld had attended the University of Colorado, and his middling education left him deeply insecure among polished Ivy League investment bankers.

The biggest purveyor of CDO insurance by far was the financial giant American International Group. AIG was based in Manhattan, its Art Deco skyscraper sprouting defiantly from behind the squat fortress of the New York Federal Reserve Bank. However, it sold CDO protection out of its derivatives unit in London, AIG Financial Products, a corporate satellite that employed a squadron of highly trained quants. Not unlike Long-Term Capital Management, the ill-fated hedge fund, Financial Products was an obscure, little-known trading outfit whose tentacles wrapped around the world of high finance. It didn’t offer “insurance” in the traditional sense of writing policies; rather, it entered into derivative contracts known as credit default swaps, under which a counterparty—Goldman, say, or Merrill Lynch—paid an upfront fee for AIG to guarantee the value of a CDO, or some other security.


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Too big to fail: the inside story of how Wall Street and Washington fought to save the financial system from crisis--and themselves by Andrew Ross Sorkin

affirmative action, Andy Kessler, Asian financial crisis, Berlin Wall, break the buck, BRICs, business cycle, collapse of Lehman Brothers, collateralized debt obligation, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Emanuel Derman, Fall of the Berlin Wall, fear of failure, fixed income, Goldman Sachs: Vampire Squid, housing crisis, indoor plumbing, invisible hand, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, Mikhail Gorbachev, money market fund, moral hazard, naked short selling, NetJets, Northern Rock, oil shock, paper trading, risk tolerance, Robert Shiller, Robert Shiller, rolodex, Ronald Reagan, savings glut, shareholder value, short selling, sovereign wealth fund, supply-chain management, too big to fail, value at risk, éminence grise

He liked to tell the story about how he once sat at a blackjack table and watched a “whale” of a gambler in Vegas lose $4.5 million, doubling every lost bet in hopes his luck would change. Fuld took notes on a cocktail napkin, recording the lesson he learned: “I don’t care who you are. You don’t have enough capital.” You can never have enough. It was a lesson he had learned again in 1998 after the hedge fund Long-Term Capital Management blew up. In the immediate aftermath, Lehman was thought to be vulnerable because of its exposure to the mammoth fund. But it survived, barely, because the firm had a cushion of extra cash—and also because Fuld aggressively fought back. That was another takeaway from the Long-Term Capital fiasco: You had to kill rumors. Let them live, and they became self-fulfilling prophecies. As he fumed to the Washington Post at the time, “Each and every one of these rumors was proved to be incorrect.

But Corzine did not have a strong enough hold on the firm when, in 1996, he first made the case to its partners for why Goldman should go public. Resistance to the idea of an IPO was strong, as the bankers worried it would upend the firm’s partnership and culture. But with a big assist from Paulson, who became co-chief executive in June 1998, Corzine ultimately won the day: Goldman’s initial public offering was announced for September of that year. But that summer the Russian ruble crisis erupted and Long-Term Capital Management was teetering on the brink of collapse. Goldman suffered hundreds of millions of dollars in trading losses and had to contribute $300 million as part of a Wall Street bailout of Long-Term Capital that was orchestrated by the Federal Reserve Bank of New York. A rattled Goldman withdrew its offering at the last minute. What was known only to a small circle of Paulson’s closest friends was that he was actually considering quitting the firm, tired of Corzine, New York, and all the internal politics.

Peterson had been leading the search for a replacement for William McDonough, who was retiring after a decade at the helm of the New York Fed. McDonough, a prepossessing former banker with First National Bank of Chicago, had become best known for summoning the chief executives of fourteen investment and commercial banks in September 1998 to arrange a $3.65 billion private-sector bailout of the imploding hedge fund Long-Term Capital Management. Peterson had been having trouble with the search; none of his top choices was interested. Making his way down the candidates list, he came upon the unfamiliar name of Timothy Geithner and arranged to see him. At the interview, however, he was put off by Geithner’s soft-spokenness, which can border on mumbling, as well as by his slight, youthful appearance. Larry Summers, who had recommended Geithner, tried to assuage Peterson’s concerns.


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13 Bankers: The Wall Street Takeover and the Next Financial Meltdown by Simon Johnson, James Kwak

American ideology, Andrei Shleifer, Asian financial crisis, asset-backed security, bank run, banking crisis, Bernie Madoff, Bonfire of the Vanities, bonus culture, break the buck, business cycle, buy and hold, capital controls, Carmen Reinhart, central bank independence, Charles Lindbergh, collapse of Lehman Brothers, collateralized debt obligation, commoditize, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, Edward Glaeser, Eugene Fama: efficient market hypothesis, financial deregulation, financial innovation, financial intermediation, financial repression, fixed income, George Akerlof, Gordon Gekko, greed is good, Home mortgage interest deduction, Hyman Minsky, income per capita, information asymmetry, interest rate derivative, interest rate swap, Kenneth Rogoff, laissez-faire capitalism, late fees, light touch regulation, Long Term Capital Management, market bubble, market fundamentalism, Martin Wolf, money market fund, moral hazard, mortgage tax deduction, Myron Scholes, Paul Samuelson, Ponzi scheme, price stability, profit maximization, race to the bottom, regulatory arbitrage, rent-seeking, Robert Bork, Robert Shiller, Robert Shiller, Ronald Reagan, Saturday Night Live, Satyajit Das, sovereign wealth fund, The Myth of the Rational Market, too big to fail, transaction costs, value at risk, yield curve

—Korea Letter of Intent to the IMF, December 3, 19971 In the mid-1990s, financial crises in less developed parts of the world were only too common. Mexico had a major meltdown in 1994–1995 and former communist countries such as Russia, the Czech Republic, and Ukraine struggled with severe financial shocks. Then in 1997–1998, what seemed like the mother of all international financial crises swept from Thailand through Southeast Asia to Korea, Brazil, and Russia. The contagion even spread to the United States via Long-Term Capital Management (LTCM), an enormous and terribly named hedge fund, which came to the brink of collapse. In the United States, economists and policymakers took two main lessons from these crises. The first was that crises could be managed—by pushing other countries to become more like the United States. Through the experiences of 1997–1998, the U.S. Treasury Department and the International Monetary Fund (IMF) developed a game plan for handling financial crises: structural weaknesses such as a failing financial sector had to be dealt with immediately, without waiting for the economy to stabilize.

Our economic system is founded on the notion of fair competition in a market free from government influence. Our society cherishes few things more than the idea that all Americans have an equal opportunity to make money or participate in government. There is no construct more important in American political discourse than the “middle class.” The United States was not untouched by the emerging markets crisis of 1997–1998. In 1998, the most prestigious hedge fund in the world was arguably Long-Term Capital Management, founded only four years before in Greenwich, Connecticut, by a legendary trader, two Nobel Prize–winning economists, and a former vice chair of the Federal Reserve, among others.49 When the crisis broke out, LTCM had about $4 billion in capital (money contributed by investors), which it had leveraged up with over $130 billion in borrowed money.50 It bet that money not on ordinary stocks or bonds, but on complex arbitrage trades (betting that the difference between the prices of two similar assets would vanish) and directional trades (for example, betting that volatility in a given market would decrease).

In 1991, Citibank was facing severe losses on U.S. real estate and loans to Latin America and had to be bailed out by an investment from Saudi prince Al-Waleed bin Talal. In 1994, Orange County lost almost $2 billion on complicated interest rate derivatives sold by Merrill Lynch and other dealers; county treasurer Robert Citron pleaded guilty to securities fraud, although no one on the “sell side” of those transactions was convicted of anything. In 1998, Long-Term Capital Management collapsed in the wake of the Russian financial crisis and had to be rescued by a consortium of banks organized by the Federal Reserve. Scandals are a constant refrain throughout the history of the financial services industry. Particularly severe episodes of wrongdoing often lead to the implementation of new rules that at least close the particular barn door that had been left open in the past; the most important example was the new regulatory scheme created during the Great Depression.


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The Road to Ruin: The Global Elites' Secret Plan for the Next Financial Crisis by James Rickards

"Robert Solow", Affordable Care Act / Obamacare, Albert Einstein, asset allocation, asset-backed security, bank run, banking crisis, barriers to entry, Bayesian statistics, Ben Bernanke: helicopter money, Benoit Mandelbrot, Berlin Wall, Bernie Sanders, Big bang: deregulation of the City of London, bitcoin, Black Swan, blockchain, Bonfire of the Vanities, Bretton Woods, British Empire, business cycle, butterfly effect, buy and hold, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, cellular automata, cognitive bias, cognitive dissonance, complexity theory, Corn Laws, corporate governance, creative destruction, Credit Default Swap, cuban missile crisis, currency manipulation / currency intervention, currency peg, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, debt deflation, Deng Xiaoping, disintermediation, distributed ledger, diversification, diversified portfolio, Edward Lorenz: Chaos theory, Eugene Fama: efficient market hypothesis, failed state, Fall of the Berlin Wall, fiat currency, financial repression, fixed income, Flash crash, floating exchange rates, forward guidance, Fractional reserve banking, G4S, George Akerlof, global reserve currency, high net worth, Hyman Minsky, income inequality, information asymmetry, interest rate swap, Isaac Newton, jitney, John Meriwether, John von Neumann, Joseph Schumpeter, Kenneth Rogoff, labor-force participation, large denomination, liquidity trap, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, Mexican peso crisis / tequila crisis, money market fund, mutually assured destruction, Myron Scholes, Naomi Klein, nuclear winter, obamacare, offshore financial centre, Paul Samuelson, Peace of Westphalia, Pierre-Simon Laplace, plutocrats, Plutocrats, prediction markets, price anchoring, price stability, quantitative easing, RAND corporation, random walk, reserve currency, RFID, risk-adjusted returns, Ronald Reagan, Silicon Valley, sovereign wealth fund, special drawing rights, stocks for the long run, The Bell Curve by Richard Herrnstein and Charles Murray, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, theory of mind, Thomas Bayes, Thomas Kuhn: the structure of scientific revolutions, too big to fail, transfer pricing, value at risk, Washington Consensus, Westphalian system

Modern financial technology made the problem worse because derivatives allowed the asset-liability mismatch to be more highly leveraged, and spread among more counterparties in hard-to-find ways. When panic strikes, even central banks willing to act as lenders of last resort cannot easily untangle the web of transactions in time to avoid a domino-style crash of one bank after another. All of this was amply demonstrated in the Panic of 2008, and even earlier in the collapse of hedge fund Long-Term Capital Management in 1998. BlackRock had none of these problems. It was an asset manager, pure and simple. Clients entrusted it with assets to invest. There was no liability on the other side of the balance sheet. BlackRock did not need depositors or money market funds to finance its operations. BlackRock did not act as principal in exotic off-balance-sheet derivatives to leverage its client assets. A client hired BlackRock, gave it assets under an advisory agreement, and paid a fee for the advice.

The IMF gave emergency loans to Korea, Indonesia, and Thailand in the first phase of that global liquidity crunch. The crisis abated in the winter and spring of 1998, then burst into flames in late summer. Russia defaulted on its debt and devalued the ruble on August 17, 1998. The IMF prepared a financial firewall around Brazil, then seen as the next domino to fall. The world was shocked to learn the next domino was not a country, but a hedge fund—Long-Term Capital Management. The IMF had no authority to bail out a hedge fund. The task was left to the Federal Reserve Bank of New York, which supervised the banks that stood to fail if LTCM defaulted. In an intense six-day period, September 23–28, 1998, Wall Street, under the watchful eye of the Fed, cobbled together a $4 billion bailout to stabilize the fund. Once the bailout was closed, Fed chair Alan Greenspan assisted the banks with an interest rate cut at a scheduled Federal Open Market Committee (FOMC) meeting on September 29, 1998.

It was four times greater than the largest nuclear explosion ever, the fifty-megaton Tsar Bomba test by the USSR in 1961. After the 1883 Krakatoa explosion, there was nothing left of Krakatoa. The cause for investor concern is that certain systemic collapses are so large the system does not bounce back. The system ceases to exist. CHAPTER 4 Foreshock: 1998 I have reflected a long time on the Long-Term Capital Management crisis. The thing that struck me most was the story of LTCM … is a very modern crisis, but the way it was resolved was almost identical to the way that crises always used to be resolved. The central bank was brought in and banged a few heads together. There was an argument about whether they should have done it, but in the end, that was how it was resolved. Stanley Fischer, vice chairman of the Federal Reserve Board God gave Noah the rainbow sign, no more water but fire next time.


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Hubris: Why Economists Failed to Predict the Crisis and How to Avoid the Next One by Meghnad Desai

"Robert Solow", 3D printing, bank run, banking crisis, Berlin Wall, Big bang: deregulation of the City of London, Bretton Woods, BRICs, British Empire, business cycle, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, correlation coefficient, correlation does not imply causation, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, David Ricardo: comparative advantage, deindustrialization, demographic dividend, Eugene Fama: efficient market hypothesis, eurozone crisis, experimental economics, Fall of the Berlin Wall, financial innovation, Financial Instability Hypothesis, floating exchange rates, full employment, German hyperinflation, Gunnar Myrdal, Home mortgage interest deduction, imperial preference, income inequality, inflation targeting, invisible hand, Isaac Newton, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, laissez-faire capitalism, liquidity trap, Long Term Capital Management, market bubble, market clearing, means of production, Mexican peso crisis / tequila crisis, mortgage debt, Myron Scholes, negative equity, Northern Rock, oil shale / tar sands, oil shock, open economy, Paul Samuelson, price stability, purchasing power parity, pushing on a string, quantitative easing, reserve currency, rising living standards, risk/return, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, secular stagnation, seigniorage, Silicon Valley, Simon Kuznets, The Chicago School, The Great Moderation, The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, The Wealth of Nations by Adam Smith, Tobin tax, too big to fail, women in the workforce

But the US Federal Reserve acted quickly and decisively, much as the Bank of England used to, by cutting interest rates and injecting a lot of liquidity into the global banking system. There was a fascinating episode which should have been instructive for economists and active traders. During the brief interval when Russian bonds were falling in price, an American investment company – Long-Term Capital Management – whose directors included Nobel Prize winning economists, went bust.3 The basic strategy of the company was based on the assumption that if the interest rate differential widened between a US bond and a foreign bond, one should invest in the foreign bond as sooner or later the rates would converge. The foreign bond would appreciate in price as its yield declined to catch up with the US yield.

Activities on the financial front exploded as many new stock markets opened up and many new instruments were innovated: credit default swaps (CDS) and collateralized debt obligations (CDO) being lately the most notorious. Much of this was the consequence of the pioneering work of Black and Scholes on options. Hedge funds and many other institutions of what became known as the shadow banking structure also proliferated. Transactions on the forex markets reached a level of trillions of dollars. (The collapse of Long-Term Capital Management, which invested in foreign bonds, was one example of the collateral damage caused by the implosion in global financial markets.) The so-called emerging economies were able to benefit from the increased flow of foreign capital and used it to further their manufacturing industry. The WTO allowed greater exports from the EEs to the developed countries’ markets. But at the same time the free flow of capital and the flexible exchange rate systems proved too risky for some EEs.

Metzler, eds, Carnegie-Rochester Conference Series on Public Policy, 1.1 (1976): 19–46. 8.See, for instance, Frank Smets and Raf Wouters, An Estimated Stochastic Dynamic General Equilibrium Model of the Euro Area, ECB Working Paper 171 (European Central Bank, Frankfurt, 2002). 9.Fisher Black and Myron Scholes, “The Pricing of Options and Corporate Liabilities,” Journal of Political Economy, 81.3 (May–June 1973): 637–54. 6 The New Globalization 1.For some historical background, see Meghnad Desai, Marx’s Revenge: The Resurgence of Capitalism and the Death of Statist Socialism (Verso, London, 2002). 2.For background on the Asian crisis see Julia Leung, The Tides of Capital: How Asia Surmounted the Crisis and Is Now Guiding World Recovery (Official Monetary and Financial Institutions Forum, London, 2015). 3.See Roger Lowenstein, When Genius Failed: Rise and Fall of Long Term Capital Management (Fourth Estate, New York, 2002). 4.J. M. Keynes, The General Theory of Employment, Interest and Money (1936), in The Collected Writings of John Maynard Keynes, vol. 7 (Macmillan, London, 1978), pp. 158–9. 5.Many books describe and analyze the crisis in detail. See Andrew Ross Sorkin, Too Big to Fail (Viking, New York, 2009); Raghuram Rajan, Fault Lines: How Hidden Fractures Still Threaten the World Economy (Princeton University Press, Princeton, NJ, 2010). 6.Alan Greenspan’s testimony to the Senate Committee on Oversight and Government Reform, US House of Representatives, October 23, 2008.


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House of Cards: A Tale of Hubris and Wretched Excess on Wall Street by William D. Cohan

asset-backed security, call centre, collateralized debt obligation, corporate governance, corporate raider, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Deng Xiaoping, diversification, Financial Instability Hypothesis, fixed income, Hyman Minsky, Irwin Jacobs, John Meriwether, Long Term Capital Management, margin call, merger arbitrage, money market fund, moral hazard, mortgage debt, mutually assured destruction, Myron Scholes, New Journalism, Northern Rock, Renaissance Technologies, Rod Stewart played at Stephen Schwarzman birthday party, savings glut, shareholder value, sovereign wealth fund, too big to fail, traveling salesman, Y2K, yield curve

As the hour got later, the intensity of the situation ratcheted up exponentially. “That's why that night became such a crazy night— with JPMorgan there, the discussions with the Fed and the SEC—because we were going to have real problems in the morning,” said one senior executive. Finally, around midnight, Matt Zames, the co-head of global rates and currency trading at JPMorgan, arrived in the conference room. The brusque Zames had been a trader at Long-Term Capital Management when it blew up ten years earlier. The Bear Stearns executives started to run through the situation for Zames. “About ten minutes into it he goes, ‘Where's the Fed?’” Friedman said. “We said, ‘They're in one of the other conference rooms.' He goes, ‘Well, we can't talk about anything until we talk to the Fed. We've got Reg W issues'“—referring to a complicated regulation that limits the transactions between a bank and its affiliates.

I knew that we were highly dependent on overnight repo, except there was no flag. There was no ‘We're worried about Dreyfus. We're worrying about Fidelity. We're worrying about people rolling in the overnight repo.' Because this wasn't term repo, it was overnight. This was good collateral, and all of a sudden, poof! You're vulnerable to it being over at any time when you're leveraged. You didn't have a chance. So, that same lesson that we learned today, Long-Term Capital Management had back then [in 1998] and the tulip people had it back in the 1400s.” Although he had watched Schwartz on Wednesday morning on CNBC, until Thursday night Cayne, who had spent his last forty years at the company and built it into the fifth-largest securities firm on Wall Street, had no idea what had been transpiring. Nor, for that matter, did any of the board members. Salerno and Tese dialed into the call from their homes in Palm Beach after their aborted dinner.

The New York Times led with the story and highlighted both its rarity and its potentially devastating effects on the firm: “The Fed's intervention highlights the problems regulators face as they contemplate the prospect that investment banks, saddled with toxic securities tied to subprime mortgages, are losing the trust of their lenders and clients—the kiss of death on Wall Street, where confidence has always been the most precious asset of all.” The paper then quoted Samuel Hayes, a professor of investment banking at Harvard Business School. “The public has never fully understood how leveraged these institutions are,” he said. “But the market makers understand the inherent risk. This is a run on the bank, just like Long-Term Capital Management, Kidder and Drexel Burnham.” On Friday morning, Bear Stearns put out its own announcement that followed the JPMorgan script precisely, though Schwartz added his own clarifications. “Bear Stearns has been the subject of a multitude of market rumors regarding our liquidity,” Schwartz explained. “We have tried to confront and dispel these rumors and parse fact from fiction. Nevertheless, amidst this market chatter, our liquidity position in the last 24 hours had significantly deteriorated.


pages: 381 words: 101,559

Currency Wars: The Making of the Next Gobal Crisis by James Rickards

Asian financial crisis, bank run, Benoit Mandelbrot, Berlin Wall, Big bang: deregulation of the City of London, Black Swan, borderless world, Bretton Woods, BRICs, British Empire, business climate, buy and hold, capital controls, Carmen Reinhart, Cass Sunstein, collateralized debt obligation, complexity theory, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, currency peg, Daniel Kahneman / Amos Tversky, Deng Xiaoping, diversification, diversified portfolio, Fall of the Berlin Wall, family office, financial innovation, floating exchange rates, full employment, game design, German hyperinflation, Gini coefficient, global rebalancing, global reserve currency, high net worth, income inequality, interest rate derivative, John Meriwether, Kenneth Rogoff, laissez-faire capitalism, liquidity trap, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, Mexican peso crisis / tequila crisis, money market fund, money: store of value / unit of account / medium of exchange, Myron Scholes, Network effects, New Journalism, Nixon shock, offshore financial centre, oil shock, one-China policy, open economy, paradox of thrift, Paul Samuelson, price mechanism, price stability, private sector deleveraging, quantitative easing, race to the bottom, RAND corporation, rent-seeking, reserve currency, Ronald Reagan, sovereign wealth fund, special drawing rights, special economic zone, The Myth of the Rational Market, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Thomas Kuhn: the structure of scientific revolutions, time value of money, too big to fail, value at risk, War on Poverty, Washington Consensus, zero-sum game

They set an agenda, assign tasks, utilize staff and reassemble after a suitable interval, which could be a day or month, depending on the urgency of the situation. Progress is reported and new goals are set, all without the normal accoutrements of established bureaucracies or rigid governance. This process was something Geithner learned in the depths of the Asian financial crisis in 1997. He saw it again when it was deployed successfully in the bailout of Long-Term Capital Management in 1998. In that crisis, the heads of the “fourteen families,” the major banks at the time, came together with no template, except possibly the Panic of 1907, and in seventy-two hours put together a $3.6 billion all-cash bailout to save capital markets from collapse. In 2008, Geithner, then president of the New York Fed, revived the use of convening power as the U.S. government employed ad hoc remedies to resolve the failures of Bear Stearns, Fannie Mae and Freddie Mac from March to July of that year.

With few exceptions, the leading macroeconomists, policy makers and risk managers failed to foresee the collapse and were powerless to stop it except with the blunt object of unlimited free money. To explain why, it is illuminating to take 1947, the year of publication of Paul Samuelson’s Foundations of Economic Analysis, as an arbitrary dividing line between the age of economics as social science and the new age of economics as natural science. That dividing line reveals similarities in market behavior before and after. The collapse of Long-Term Capital Management in 1998 bears comparison to the collapse of the Knickerbocker Trust and the Panic of 1907 in its contagion dynamics and private resolution by bank counterparts with the most to lose. The stock market crash of October 19, 1987, when the Dow Jones Industrial Average dropped 22.61 percent in a single day, is reminiscent of the two-day drop of 23.05 percent on October 28–29, 1929. Unemployment in 2011 is comparable to the levels of the Great Depression, when consistent methodologies for the treatment of discouraged workers are used for both periods.

The debate between the efficient markets theorists and the social scientists would be just another arcane academic struggle but for one critical fact. The theory of efficient markets and its corollaries of random price movements and a bell curve distribution of risk had escaped from the lab and infected the entire trading apparatus of Wall Street and the modern banking system. The application of these flawed theories to actual capital markets activity contributed to the 1987 stock market crash, the 1998 implosion of Long-Term Capital Management and the greatest catastrophe of all—the Panic of 2008. One contagious virus that spread the financial economics disease was known as value at risk, or VaR. Value at risk is the method Wall Street used to manage risk in the decade leading up to the Panic of 2008 and it is still in widespread use today. It is a way to measure risk in an overall portfolio—certain risky positions are offset against other positions to reduce risk, and VaR claims to measure that offset.


pages: 313 words: 101,403

My Life as a Quant: Reflections on Physics and Finance by Emanuel Derman

Berlin Wall, bioinformatics, Black-Scholes formula, Brownian motion, buy and hold, capital asset pricing model, Claude Shannon: information theory, Donald Knuth, Emanuel Derman, fixed income, Gödel, Escher, Bach, haute couture, hiring and firing, implied volatility, interest rate derivative, Jeff Bezos, John Meriwether, John von Neumann, law of one price, linked data, Long Term Capital Management, moral hazard, Murray Gell-Mann, Myron Scholes, Paul Samuelson, pre–internet, publish or perish, quantitative trading / quantitative finance, Sharpe ratio, statistical arbitrage, statistical model, Stephen Hawking, Steve Jobs, stochastic volatility, technology bubble, the new new thing, transaction costs, volatility smile, Y2K, yield curve, zero-coupon bond, zero-sum game

The overheated tech-stock market of the late 1990s cast a warm, reflected glow on geeks of all types, as did the droves of hedge funds trying to use mathematical models to squeeze dollars out of subtleties. The guts to lose a lot of money carries its own aura. D.E. Shaw & Co., a NewYork trading house that was rumored to be making substantial profits doing "black box" computerized statistical arbitrage before their billion-dollar losses in 1998, and Long Term Capital Management, the quant-driven Connecticut hedge fund that ultimately needed a multibillion-dollar bailout, have both contributed to this more glamorous view of quantization. And indeed, many of the Long Term Capital protagonists are back in business again at new firms. The capacity to wreak destruction with your models provides the ultimate respectability. THE SACRED AND PROFANE There is an almost religious quality to the pursuit of physics that stems from its transcendent qualities.

But building a riskless money machine, especially on a large scale, is not that easy. There are not that many riskless profits to be harvested in the world. Eventually the struggle to make the same return on larger amounts of capital makes everriskier strategies tempting. In 1998 D. E. Shaw & Co., in partnership with the Bank ofAmerica, reportedly lost close to a billion dollars on the same sorts of strategies that decapitated Long Term Capital Management and took appreciable pounds of flesh out of many other hedge funds and investment banks. Meanwhile, in 1981, I attended the computer science courses offered by the Labs and learned the practical art of programming. I was especially entranced by language design and compiler writing, and spent most of my time creating specific little languages that allowed users to solve specialized problems.

Working away in my undistinguished cubicle-for the first year I had no seat in an office-I did occasionally feel incongruous. One day, as I mindlessly whistled a Beatles song to myself while I programmed my bond option model, I heard the 23-year old kid in the next cube turn around and exclaim astonishedly, "How do you know that?" In fact, though, age didn't matter that much if you had ability, and the turbulence in financial markets since then-the crashes of 1987 and 1989, the collapse of Long Term Capital Management and Russia's default in 1998-has made the appearance of maturity an advantage. Among the new people I met was Roscoe, the amiable, cheerily disillusioned leader of a group of good-humored programmer malcontents who occupied the cubicles on what he called Dissident Row Everyone on Dissident Row ate lunch early and then took a constitutional up to the Brooklyn Bridge and back again. Roscoe's real name was William Dumas and he was rumored to be related to Alexandre Dumas, pere.


pages: 478 words: 126,416

Other People's Money: Masters of the Universe or Servants of the People? by John Kay

Affordable Care Act / Obamacare, asset-backed security, bank run, banking crisis, Basel III, Bernie Madoff, Big bang: deregulation of the City of London, bitcoin, Black Swan, Bonfire of the Vanities, bonus culture, Bretton Woods, buy and hold, call centre, capital asset pricing model, Capital in the Twenty-First Century by Thomas Piketty, cognitive dissonance, corporate governance, Credit Default Swap, cross-subsidies, dematerialisation, disruptive innovation, diversification, diversified portfolio, Edward Lloyd's coffeehouse, Elon Musk, Eugene Fama: efficient market hypothesis, eurozone crisis, financial innovation, financial intermediation, financial thriller, fixed income, Flash crash, forward guidance, Fractional reserve banking, full employment, George Akerlof, German hyperinflation, Goldman Sachs: Vampire Squid, Growth in a Time of Debt, income inequality, index fund, inflation targeting, information asymmetry, intangible asset, interest rate derivative, interest rate swap, invention of the wheel, Irish property bubble, Isaac Newton, John Meriwether, light touch regulation, London Whale, Long Term Capital Management, loose coupling, low cost airline, low cost carrier, M-Pesa, market design, millennium bug, mittelstand, money market fund, moral hazard, mortgage debt, Myron Scholes, NetJets, new economy, Nick Leeson, Northern Rock, obamacare, Occupy movement, offshore financial centre, oil shock, passive investing, Paul Samuelson, peer-to-peer lending, performance metric, Peter Thiel, Piper Alpha, Ponzi scheme, price mechanism, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, railway mania, Ralph Waldo Emerson, random walk, regulatory arbitrage, Renaissance Technologies, rent control, risk tolerance, road to serfdom, Robert Shiller, Robert Shiller, Ronald Reagan, Schrödinger's Cat, shareholder value, Silicon Valley, Simon Kuznets, South Sea Bubble, sovereign wealth fund, Spread Networks laid a new fibre optics cable between New York and Chicago, Steve Jobs, Steve Wozniak, The Great Moderation, The Market for Lemons, the market place, The Myth of the Rational Market, the payments system, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Tobin tax, too big to fail, transaction costs, tulip mania, Upton Sinclair, Vanguard fund, Washington Consensus, We are the 99%, Yom Kippur War

They include the Markowitz model of portfolio allocation (to which Greenspan referred) and the Black–Scholes model (the derivative pricing model to which he alluded). The key components of academic financial theory, however, are the ‘efficient market hypothesis’ (EMH), for which Eugene Fama won the Nobel Prize in 2013, and the Capital Asset Pricing Model (CAPM), for which William Sharpe won the Nobel Prize in 1990. Sharpe shared that prize with Markowitz, and Myron Scholes received a Nobel Prize in 1997, just before the famous blow-up of Long-Term Capital Management, in which Scholes was a partner; Black had died in 1995. All of these financial economists have affiliations to the University of Chicago. EMH asserts that all available information about securities is ‘in the price’. Interest rates are expected to rise, Procter and Gamble owns many powerful brands, the Chinese economy is growing rapidly: these factors are fully reflected in the current level of long-term interest rates, the Procter & Gamble stock price and the exchange rate between the dollar and the renminbi.

The central bank might provide funds itself as ‘lender of last resort’ and/or help orchestrate a rescue operation by other financial institutions. But as the sector became more aggressive and competitive such co-operation diminished. Perhaps the last great co-ordinated rescue operation – which involved much official twisting of private-sector arms – was the support package for the racy and absurdly named hedge fund Long-Term Capital Management in 1998. (The foul-mouthed Jimmy Cayne, of Bear Stearns, who refused to participate, would receive his comeuppance a decade later when the Federal Reserve took pleasure in forcing a fire-sale of his failing business to J.P. Morgan.) But the concerns about banks that paralysed the USA in 1933, or which brought the global financial system close to collapse in 2008, were not like that.

And as investor interest in them grew, their prices became increasingly correlated with those of mainstream assets. From the 1990s private equity – which invested in a diversified collection of new businesses – and hedge funds – which adopted unconventional investment strategies – were favoured as diversifying ‘alternative assets’. The original hedge funds were run by legendary names such as George Soros and Julian Robertson: Long-Term Capital Management was the most famous of all. But after the new economy bubble burst in 2000, pension funds and large investors poured money into these so-called alternative investments. But as demand for ‘alternative assets’ increased, the resulting increased supply of ‘alternative assets’ came more and more to resemble repackaging of existing assets. Hedge funds built portfolios of derivatives, or packages of securitised loans, which tracked general economic developments, while private equity invested in larger, established businesses little different from those listed on public markets.


Firefighting by Ben S. Bernanke, Timothy F. Geithner, Henry M. Paulson, Jr.

Asian financial crisis, asset-backed security, bank run, Basel III, break the buck, Build a better mousetrap, business cycle, Carmen Reinhart, collapse of Lehman Brothers, collateralized debt obligation, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Doomsday Book, financial deregulation, financial innovation, housing crisis, Hyman Minsky, income inequality, invisible hand, Kenneth Rogoff, labor-force participation, light touch regulation, London Interbank Offered Rate, Long Term Capital Management, margin call, money market fund, moral hazard, mortgage debt, negative equity, Northern Rock, pets.com, price stability, quantitative easing, regulatory arbitrage, Robert Shiller, Robert Shiller, savings glut, short selling, sovereign wealth fund, special drawing rights, The Great Moderation, too big to fail

As a Princeton University economics professor, Ben had been a scholar of the Great Depression, the leading historical example of financial instability sinking the economy. As a career public servant at Treasury and later the International Monetary Fund, Tim had seen the challenges in dealing with financial crises in Mexico, Asia, and around the world. And as the CEO of Goldman Sachs, Hank had lived through episodes like the collapse of the hedge fund Long-Term Capital Management and the Russian default. We had all learned how quickly overheated markets could collapse, and while none of us was as worried as we should have been, none of us thought that financial innovations and the sophistication of modern finance had immunized us against crisis. The financial system is vital to the economy. But finance, at least as it’s organized in modern economies, is inherently fragile.

BEYOND BAGEHOT The Fed’s come-and-get-it approach did not end up luring many banks to the discount window early that fall—partly because the stigma of borrowing from the Fed persisted, partly because the turmoil eased. The stock market hit a record high, interbank lending rates stabilized, and Lehman completed its misguided acquisition of the real estate firm Archstone-Smith. So far, the crisis had played out like a rerun of 1998, when the giant hedge fund Long-Term Capital Management’s demise produced widespread anxiety, but, after a modest intervention by the Fed, no widespread damage. But this calm did not last. First Merrill Lynch announced the biggest write-down of troubled assets in Wall Street history and ousted its CEO. Then Citigroup broke Merrill’s record and ousted its CEO, the one who had said banks needed to keep dancing while the music was playing.

We decided to bring Wall Street’s top CEOs to the New York Fed on Friday night, September 12, to try to organize a private-sector solution—perhaps something like the Bear deal with Wall Street firms taking on risk instead of the Fed; or together with the Fed, to help another larger and stronger firm acquire Lehman; or perhaps even something like the 1998 deal where the New York Fed encouraged fourteen counterparties of Long-Term Capital Management to band together to buy the firm outright and liquidate its assets. This time, Wall Street had even greater reason to help avoid a collapse. Merrill Lynch looked like it would be the next domino to fall after Lehman, and then Morgan Stanley; not even Goldman Sachs, the investment bank with the strongest balance sheet and largest liquidity cushion, could survive an all-out run on its business model.


pages: 566 words: 155,428

After the Music Stopped: The Financial Crisis, the Response, and the Work Ahead by Alan S. Blinder

"Robert Solow", Affordable Care Act / Obamacare, asset-backed security, bank run, banking crisis, banks create money, break the buck, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, conceptual framework, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, Detroit bankruptcy, diversification, double entry bookkeeping, eurozone crisis, facts on the ground, financial innovation, fixed income, friendly fire, full employment, hiring and firing, housing crisis, Hyman Minsky, illegal immigration, inflation targeting, interest rate swap, Isaac Newton, Kenneth Rogoff, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, market bubble, market clearing, market fundamentalism, McMansion, money market fund, moral hazard, naked short selling, new economy, Nick Leeson, Northern Rock, Occupy movement, offshore financial centre, price mechanism, quantitative easing, Ralph Waldo Emerson, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, short selling, South Sea Bubble, statistical model, the payments system, time value of money, too big to fail, working-age population, yield curve, Yogi Berra

Never Again: Legacies of the Crisis Notes Sources Index LIST OF ACRONYMS AND ABBREVIATIONS ABCP: asset-backed commercial paper ABS: asset-backed securities AIG: American International Group AIG FP: AIG Financial Products AMLF: Asset-Backed Commercial Paper Money Market Mutual Fund Liquidity Facility ANPR: Advance Notice of Proposed Rulemaking ARM: adjustable-rate mortgage ARRA: American Reinvestment and Recovery Act (2009) BofA: Bank of America CBO: Congressional Budget Office CDO: collateralized debt obligation CDS: credit default swaps CEA: Council of Economic Advisers CEO: Chief Executive Officer CFMA: Commodity Futures Modernization Act (2000) CFPA: Consumer Financial Protection Agency CFPB: Consumer Financial Protection Bureau CFTC: Commodity Futures Trading Commission CME: Chicago Mercantile Exchange CP: commercial paper CPFF: Commercial Paper Funding Facility CPI: Consumer Price Index CPP: Capital Purchase Program DTI: debt (service)-to-income ratio ECB: European Central Bank EMH: efficient markets hypothesis ESF: Exchange Stabilization Fund FCIC: Financial Crisis Inquiry Commission FDIC: Federal Deposit Insurance Corporation FHA: Federal Housing Administration FHFA: Federal Housing Finance Agency FICO: Fair Isaac Company FOMC: Federal Open Market Committee FSA: Financial Services Authority (UK) FSLIC: Federal Savings and Loan Insurance Corporation FSOC: Financial Stability Oversight Council G7: Group of Seven (nations) GAAP: generally accepted accounting principles GAO: Government Accountability Office GDP: gross domestic product GLB: Gramm-Leach-Bliley Act (1999) GSE: government-sponsored enterprise H4H: Hope for Homeowners HAFA: Home Affordable Foreclosure Alternatives Program HAMP: Home Affordable Modification Program HARP: Home Affordable Refinancing Program HAUP: Home Affordable Unemployment Program HHF: Hardest Hit Fund HOLC: Home Owners’ Loan Corporation HUD: Department of Housing and Urban Development IMF: International Monetary Fund ISDA: International Swaps and Derivatives Association LIBOR: London Interbank Offer Rate LTCM: Long-Term Capital Management LTRO: Longer-Term Refinancing Operations LTV: loan-to-value (ratio) MBS: mortgage-backed securities MOM: my own money NBER: National Bureau of Economic Research NEC: National Economic Council NINJA (loans): no income, no jobs, and no assets NJTC: new jobs tax credit OCC: Office of the Comptroller of the Currency OFHEO: Office of Federal Housing Enterprise Oversight OMB: Office of Management and Budget OMT: Outright Monetary Transactions OPM: other people’s money OTC: over the counter OTS: Office of Thrift Supervision PDCF: Primary Dealer Credit Facility PIIGS: Portugal, Ireland, Italy, Greece, and Spain QE: quantitative easing Repo: repurchase agreement S&L: savings and loan association S&P: Standard and Poor’s SEC: Securities and Exchange Commission Section 13(3): of Federal Reserve Act SIFI: systemically important financial institution SIV: structured investment vehicle SPV: special purpose vehicle TAF: Term Auction Facility TALF: Term Asset-Backed Securities Loan Facility TARP: Troubled Assets Relief Program TBTF: too big to fail TED (spread): spread between LIBOR and Treasuries TIPS: Treasury Inflation-Protected Securities TLGP: Temporary Liquidity Guarantee Program TSLF: Term Securities Lending Facility UMP: unconventional monetary policy WaMu: Washington Mutual PREFACE When the music stops . . . things will be complicated.

Another involved a sale of derivatives by Bankers Trust to Proctor & Gamble, which led to a lawsuit by the latter and to the release of some crude and damning audiotapes. A third was the escapades of a single rogue trader, Nick Leeson, whose wild gambles in Singapore literally broke Barings, Britain’s oldest investment bank—and wound up as a movie. An inauspicious start, you might say. But that was nothing compared with what happened in the summer and fall of 1998, when losses at the now-infamous hedge fund Long-Term Capital Management (LTCM) helped set off a worldwide financial crisis—one that seemed monumental until it was dwarfed by the stunning events of 2007–2009. An overconfident LTCM got itself on the wrong side of a huge volume and variety of derivative bets, each of which entailed substantial amounts of synthetic leverage. On top of that, LTCM’s balance sheet was itself highly leveraged. The firm was on the fast track to oblivion, probably causing lots of collateral damage in its wake, when the Federal Reserve intervened by orchestrating a private-sector bailout by Wall Street firms.

The firm was also very profitable, especially for its top executives. The top five took home over $1.4 billion in cash and stock sales over the years 2000–2008. Bear was also contrarian in another sense. Ten years earlier, during the height of the 1998 financial crisis, it had earned the enmity of the other Wall Street banks when it alone refused to accept its pro rata share of the emergency buyout of what was left of the faltering hedge fund Long-Term Capital Management (LTCM). Bear’s refusal left a bitter aftertaste that Wall Streeters remembered in March 2008. One way in which Bear Stearns set its own course during the bubble was by becoming a huge player in the mortgage business, especially in the subprime mortgage business. Mortgage securitization became the largest component of Bear’s fixed-income division, which was in turn the company’s most profitable line of business, generating almost half the firm’s revenues.


Investment: A History by Norton Reamer, Jesse Downing

activist fund / activist shareholder / activist investor, Albert Einstein, algorithmic trading, asset allocation, backtesting, banking crisis, Berlin Wall, Bernie Madoff, break the buck, Brownian motion, business cycle, buttonwood tree, buy and hold, California gold rush, capital asset pricing model, Carmen Reinhart, carried interest, colonial rule, credit crunch, Credit Default Swap, Daniel Kahneman / Amos Tversky, debt deflation, discounted cash flows, diversified portfolio, dogs of the Dow, equity premium, estate planning, Eugene Fama: efficient market hypothesis, Fall of the Berlin Wall, family office, Fellow of the Royal Society, financial innovation, fixed income, Gordon Gekko, Henri Poincaré, high net worth, index fund, information asymmetry, interest rate swap, invention of the telegraph, James Hargreaves, James Watt: steam engine, joint-stock company, Kenneth Rogoff, labor-force participation, land tenure, London Interbank Offered Rate, Long Term Capital Management, loss aversion, Louis Bachelier, margin call, means of production, Menlo Park, merger arbitrage, money market fund, moral hazard, mortgage debt, Myron Scholes, negative equity, Network effects, new economy, Nick Leeson, Own Your Own Home, Paul Samuelson, pension reform, Ponzi scheme, price mechanism, principal–agent problem, profit maximization, quantitative easing, RAND corporation, random walk, Renaissance Technologies, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Sand Hill Road, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, spinning jenny, statistical arbitrage, survivorship bias, technology bubble, The Wealth of Nations by Adam Smith, time value of money, too big to fail, transaction costs, underbanked, Vanguard fund, working poor, yield curve

When it comes to failures, by contrast, leverage often takes the blame. This is precisely how most people understood the spectacular investment failure of Long-Term Capital Management, a large hedge fund management firm, in 1998. The firm, it was later discovered, had been magnifying its portfolio with leverage ratios as high as 100 to 1—that is, $100 of debt-equivalent employed for every dollar of equity committed. 6 Investment: A History Even though the firm was invested primarily in high-quality government bonds, its use of this extraordinary leverage created so much risk that even minor fluctuations in the value of its portfolio could cause extreme pressure on its available net worth. Had it not been for a government-organized bailout, Long-Term Capital Management would almost certainly have collapsed.5 On the other hand, there have been great investment successes over extended periods of time achieved by well-regarded investors (Warren Buffett again comes to mind) through the use of more moderate levels of financial leverage coupled with good asset selection and stable financing sources.

During the years leading up to the Great Recession of 2007–2009, there were widespread attitudes in various administrations and Congresses that led to relaxation of some of the more restrictive prohibitions that were the legacy of the Great Depression and subsequent financial crises such as the savings and loan crisis of the late 1980s, various international crises of the 1990s, and the collapse of Long-Term Capital Management in 1998. One notable example was the repeal of Glass-Steagall in the late 1990s. The Glass-Steagall Act passed by Congress in the 1930s prevented commercial banks from owning investment banks in a post-Depression attempt to prevent deposit-taking institutions from engaging in high-risk financial transactions.33 Throughout the period, competitive regulatory agencies were allowed to develop, gaps in regulatory coverage occurred and were not corrected, clarity in regulatory responsibilities was not established, and lapses in regulatory enforcement occurred.

Of course, this is precisely when the market is offering bargains—and some of the best value investors have come to realize this—but much of the market is too shaken to take advantage of the possibilities. The problem here is not so much one of theory but one of data; the truth is that there have not been an enormous number of these tail scenarios in major markets. In the last 25 years or so, we have seen the crash of 1987, the collapse of Long-Term Capital Management in 1998, the popping of the technology bubble in the late 1990s and into early 2000, and the Great Recession from 2007 to 2009. To build robust theories, or even effective working models, we require a broader set of data from which we can draw, synthesize, and eventually generalize. Of course, one does not want to overemphasize how problematic it is that there have been so few tail events in major markets—one certainly does not want to tempt fate and invite more.


pages: 278 words: 82,069

Meltdown: How Greed and Corruption Shattered Our Financial System and How We Can Recover by Katrina Vanden Heuvel, William Greider

Asian financial crisis, banking crisis, Bretton Woods, business cycle, buy and hold, capital controls, carried interest, central bank independence, centre right, collateralized debt obligation, conceptual framework, corporate governance, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, declining real wages, deindustrialization, Exxon Valdez, falling living standards, financial deregulation, financial innovation, Financial Instability Hypothesis, fixed income, floating exchange rates, full employment, housing crisis, Howard Zinn, Hyman Minsky, income inequality, information asymmetry, John Meriwether, kremlinology, Long Term Capital Management, margin call, market bubble, market fundamentalism, McMansion, money market fund, mortgage debt, Naomi Klein, new economy, offshore financial centre, payday loans, pets.com, plutocrats, Plutocrats, Ponzi scheme, price stability, pushing on a string, race to the bottom, Ralph Nader, rent control, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, sovereign wealth fund, structural adjustment programs, The Great Moderation, too big to fail, trade liberalization, transcontinental railway, trickle-down economics, union organizing, wage slave, Washington Consensus, women in the workforce, working poor, Y2K

Capital gained in value as a result. Labor took it in the neck. Economic ideologies are often elaborate rationales to justify taking care of some folks and neglecting others. Meanwhile, protecting the supply side of the economy, the chairman came to the rescue of the financial system and financial firms again and again, whenever they encountered serious peril or the stock market seriously wilted. The 1998 collapse of Long Term Capital Management was interpreted as threatening the safety of the financial system, so the Fed stepped in (what happened to the therapeutic effects of market discipline?). Likewise, the Fed reacted aggressively to the Russian debt crisis that year and the jitters over the “Y2K crisis” of 2000, and Greenspan provided quick liquidity or interest-rate cuts to calm other financial-market upsets. Greenspan did not formally try to deregulate the banking system, but simply declined to use the Fed’s regulatory powers to enforce regular order or discipline fraudulent behavior.

But the essence of their strategy would have been immediately recognizable to the provincial nail manufacturer in Stendhal’s The Red and the Black, Monsieur de Rênal, whose financial acumen consists of “getting himself paid exactly what he’s owed, while paying what he owes as late as possible.” Rarely has the concept of leverage been more clearly explained. Nobel prizes aside, that’s basically what many of the hedge funds are doing. It’s a strategy that works great right up to the point when it doesn’t, which is what happened to Long-Term Capital Management (LTCM) in September 1998, when the Russian government defaulted and the hedge fund suddenly had to pay what it owed before it got paid. That led to an almost $4 billion bailout orchestrated by the Federal Reserve amid concerns by U.S. financial officials that world credit markets would, as New York Fed president William McDonough quaintly put it at the time, “possibly cease to function for a period of one or more days and maybe longer.”

Foreclosures in Maryland were up more than 400 percent in the third quarter, compared with the first. Minority homeowners, like those in Cummings’s inner-city Baltimore district, are getting hit particularly hard. “I know that so often what happens is that when we’re making decisions in the suites, we forget about the people who actually have to go through this,” Cummings said. But “we’re becoming a bit alarmed.” In past financial implosions, of S&Ls in the eighties or Long Term Capital Management in the nineties, it was easy to name the villains but far trickier to find the victims. Not so here. They’re everywhere, not just in inner-city Baltimore. There are subdivisions in the exurbs that are beginning to resemble ghost towns. So what is to be done? The long-term challenge is to regulate an industry that, left to its own devices, seems to have eaten its young. Last week the Mortgage Reform and Anti Predatory Lending Act of 2007 passed out of Barney Frank’s House Financial Services Committee with the support of nine Republicans.


pages: 504 words: 139,137

Efficiently Inefficient: How Smart Money Invests and Market Prices Are Determined by Lasse Heje Pedersen

activist fund / activist shareholder / activist investor, algorithmic trading, Andrei Shleifer, asset allocation, backtesting, bank run, banking crisis, barriers to entry, Black-Scholes formula, Brownian motion, business cycle, buy and hold, buy low sell high, capital asset pricing model, commodity trading advisor, conceptual framework, corporate governance, credit crunch, Credit Default Swap, currency peg, David Ricardo: comparative advantage, declining real wages, discounted cash flows, diversification, diversified portfolio, Emanuel Derman, equity premium, Eugene Fama: efficient market hypothesis, fixed income, Flash crash, floating exchange rates, frictionless, frictionless market, Gordon Gekko, implied volatility, index arbitrage, index fund, interest rate swap, late capitalism, law of one price, Long Term Capital Management, margin call, market clearing, market design, market friction, merger arbitrage, money market fund, mortgage debt, Myron Scholes, New Journalism, paper trading, passive investing, price discovery process, price stability, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, random walk, Renaissance Technologies, Richard Thaler, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, selection bias, shareholder value, Sharpe ratio, short selling, sovereign wealth fund, statistical arbitrage, statistical model, stocks for the long run, stocks for the long term, survivorship bias, systematic trading, technology bubble, time value of money, total factor productivity, transaction costs, value at risk, Vanguard fund, yield curve, zero-coupon bond

Hedge fund indices have large correlations to equity markets, and the correlation has been growing over time. Also, hedge funds often have negative skewness and excess kurtosis, meaning that they sometimes have extreme returns, especially on the downside. Indeed, hedge funds, especially the small ones, have a high attrition rate, and the industry has been marked by some large blowups, including the failures of Long-Term Capital Management (LTCM), Bear Stearns’ credit funds, and Amaranth. Rather than looking at the performance of actual hedge funds, we can circumvent some of the issues discussed above by cutting to the chase and studying the actual trading strategies that hedge funds pursue as we do in this book. As we will see, the core strategies have worked more often than not over long time periods and worked for economic reasons of efficiently inefficient markets. 1.3.

The expected shortfall is the expected loss, given that you are losing more than the VaR: Another measure of risk is the stress loss. This measure is computed by performing various stress tests, that is, simulated portfolio returns during various scenarios, and then considering the worst-case loss in these scenarios. Such stress scenarios can include significant past events, such as the 1998 price shocks around the Long-Term Capital Management (LTCM) bailout, September 11, and the failure of Lehman Brothers, as well as imagined future events, such as the failure of a sovereign state (e.g., Greece), a large interest rate move, a large shock to equity prices, a spike in volatility, or a sharp increase in margin requirements. While estimates of volatility and, to some extent, VaR measure the risk during relatively “normal” markets over a fixed time horizon, stress tests tell you about risk during extreme events.

GS: Well, because I had developed this boom/bust theory. Call it a theory of bubbles. I’ve written books about it. I published a book in ’98 when I said I thought that markets were about to collapse, The Crisis of Global Capitalism. The prediction turned out to be false; the markets didn’t collapse. LHP: Well, it took a few more years. GS: The authorities managed to contain the problem in 1998. You had Long-Term Capital Management, and it was a pretty serious situation, which was saved by Bill McDonough, the head of the Federal Reserve in New York. He put the players in one room and said, “You’ve got to do something!” And then they saved the day. So, we survived ’98. But by allowing what I call this super bubble to develop, it grew larger and finally exploded in 2008. In 2006, I published a book, The Age of Fallibility, where I had a very short section that previewed what was coming.


Trading Risk: Enhanced Profitability Through Risk Control by Kenneth L. Grant

backtesting, business cycle, buy and hold, commodity trading advisor, correlation coefficient, correlation does not imply causation, delta neutral, diversification, diversified portfolio, fixed income, frictionless, frictionless market, George Santayana, implied volatility, interest rate swap, invisible hand, Isaac Newton, John Meriwether, Long Term Capital Management, market design, Myron Scholes, performance metric, price mechanism, price stability, risk tolerance, risk-adjusted returns, Sharpe ratio, short selling, South Sea Bubble, Stephen Hawking, the scientific method, The Wealth of Nations by Adam Smith, transaction costs, two-sided market, value at risk, volatility arbitrage, yield curve, zero-coupon bond

Now the place is a bit more civilized; but what is perhaps even more surprising is that the topic of hedge fund risk management has held my attention for the better part of a decade. Part of the reason for this is that I’ve had the honor to manage risk for some of the world’s finest traders, including Steve Cohen and Paul Tudor Jones, and have managed to survive such wide-ranging crises as the emerging markets meltdown of 1997, the collapse of Long-Term Capital Management (everyone’s favorite hedge fund till the winds blew ill there), the September 11 attacks, the fraud-related collapse of Enron and WorldCom, and a host of others too pedestrian to name in this space. Along the way, it is good that I’ve learned what I think are some valuable lessons. And what’s even better (at least from an expository perspective) is that these lessons are remarkably consistent with one another and draw from a surprisingly small set of themes — themes that will form the framework for the core arguments I will put forward in this book.

Most typically and perhaps most effectively, scenario analysis is applied to various arbitrage portfolios where the interplay between individual instruments is less easily captured by VaR’s more brute force mapping of positions in an account into easy-to-comprehend risk factors. The Risk Components of an Individual Portfolio 105 For purposes of illustration, I offer some examples of the application of scenario analysis to three specific types of arbitrage portfolios: This strategy, rendered somewhat infamous by the Long-Term Capital Management episode of a few years back, involves the simultaneous purchase and sale of fixedincome instruments with similar but nonidentical economic characteristics that exhibit pricing divergence, in the hopes that this divergence disappears over the life of the transaction. Often, this may feature the purchase and sale of bonds with similar credit qualities across differing maturities or of bonds with differing credit qualities across the same maturity.

The fact that they were starting to utilize less efficient substitutes was evident in the price action of these commodities. Many speculators who had ridden the upward trend to once (or perhaps twice) in a lifetime profit levels, were rumored to be getting out while they still could. The problems here had to do with size and scale. Against the backdrop of the Russian default, the collapse of Long-Term Capital Management, and a rapidly deteriorating state of capital markets on a global scale, even the most 120 TRADING RISK intrepid investors were busy engaging in wholesale portfolio liquidation in a frenzied effort to accumulate cash and consolidate losses. Then, one afternoon, there was a multi-billion dollar bid for a clearly overvalued commodity. Quickly, quickly, the market surmised that a large hedge fund was liquidating its largest holding—and rumors flew about the relative level of duress that precipitated such liquidation.


Griftopia: Bubble Machines, Vampire Squids, and the Long Con That Is Breaking America by Matt Taibbi

addicted to oil, affirmative action, Affordable Care Act / Obamacare, Bernie Sanders, Bretton Woods, buy and hold, carried interest, clean water, collateralized debt obligation, collective bargaining, computerized trading, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, David Brooks, desegregation, diversification, diversified portfolio, Donald Trump, financial innovation, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, illegal immigration, interest rate swap, laissez-faire capitalism, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, medical malpractice, money market fund, moral hazard, mortgage debt, obamacare, passive investing, Ponzi scheme, prediction markets, quantitative easing, reserve currency, Ronald Reagan, Sergey Aleynikov, short selling, sovereign wealth fund, too big to fail, trickle-down economics, Y2K, Yom Kippur War

The first was the stock market correction of October of that year, and the next was the recession of the early 1990s, brought about by the collapse of the S&L industry. Both disasters were caused by phenomena Greenspan had a long track record of misunderstanding. The 1987 crash was among other things caused by portfolio insurance derivatives (Greenspan was still fighting against regulation of these instruments five or six derivative-based disasters later, in 1998, after Long-Term Capital Management imploded and nearly dragged down the entire world economy), while Greenspan’s gaffes with regard to S&Ls like Charles Keating’s Lincoln Savings have already been described. His response to both disasters was characteristic: he slashed the federal funds rate and flooded the economy with money. Greenspan’s response to the 1990s recession was particularly dramatic. When he started cutting rates in May 1989, the federal funds rate was 9 percent.

To say that this was a radical reinterpretation of the entire science of economics is an understatement—economists had never dared measure “value” except in terms of actual concrete production. It was equivalent to a chemist saying that concrete becomes gold when you paint it yellow. It was lunacy. Greenspan’s endorsement of the “new era” paradigm encouraged all the economic craziness of the tech bubble. This was a pattern he fell into repeatedly. When a snooty hedge fund full of self-proclaimed geniuses called Long-Term Capital Management exploded in 1998, thanks to its managers’ wildly irresponsible decision to leverage themselves one hundred or two hundred times over or more to gamble on risky derivative bets, Greenspan responded by orchestrating a bailout, citing “systemic risk” if the fund was allowed to fail. The notion that the Fed would intervene to save a high-risk gambling scheme like LTCM was revolutionary. “Here, you’re basically bailing out a hedge fund,” says Dr.

The new law, which Greenspan pushed aggressively, not only prevented the federal government from regulating instruments like collateralized debt obligations and credit default swaps, it even prevented the states from regulating them using gaming laws—which otherwise might easily have applied, since so many of these new financial wagers were indistinguishable from racetrack bets. The amazing thing about the CFMA was that it was passed immediately after the Long-Term Capital Management disaster, a potent and obvious example of the destructive potential inherent in an unregulated derivatives market. LTCM was a secretive hedge fund that was making huge bets without collateral and keeping massive amounts of debt off its balance sheet, à la Enron—the financial equivalent of performing open heart surgery with unwashed hands, using a Super 8 motel bedspread as an operating surface.


pages: 369 words: 94,588

The Enigma of Capital: And the Crises of Capitalism by David Harvey

accounting loophole / creative accounting, anti-communist, Asian financial crisis, bank run, banking crisis, Bernie Madoff, Big bang: deregulation of the City of London, Bretton Woods, British Empire, business climate, call centre, capital controls, creative destruction, credit crunch, Credit Default Swap, David Ricardo: comparative advantage, deindustrialization, Deng Xiaoping, deskilling, equal pay for equal work, European colonialism, failed state, financial innovation, Frank Gehry, full employment, global reserve currency, Google Earth, Guggenheim Bilbao, Gunnar Myrdal, illegal immigration, indoor plumbing, interest rate swap, invention of the steam engine, Jane Jacobs, joint-stock company, Joseph Schumpeter, Just-in-time delivery, land reform, liquidity trap, Long Term Capital Management, market bubble, means of production, megacity, microcredit, moral hazard, mortgage debt, Myron Scholes, new economy, New Urbanism, Northern Rock, oil shale / tar sands, peak oil, Pearl River Delta, place-making, Ponzi scheme, precariat, reserve currency, Ronald Reagan, sharing economy, Silicon Valley, special drawing rights, special economic zone, statistical arbitrage, structural adjustment programs, the built environment, the market place, The Wealth of Nations by Adam Smith, Thomas L Friedman, Thomas Malthus, Thorstein Veblen, too big to fail, trickle-down economics, urban renewal, urban sprawl, white flight, women in the workforce

The financial crisis that rocked east and south-east Asia in 1997–8 was huge and spin-offs into Russia (which defaulted on its debt in 1998) and then Argentina in 2001 (precipitating a total collapse that led to political instability, factory occupations and take-overs, spontaneous highway blockades and the formation of neighbourhood collectives) were local catastrophes. In ,the United States the fall in 2001 of star companies like WorldCom and Enron, which were basically trading in financial instruments called derivatives, imitated the huge bankruptcy of the hedge fund Long Term Capital Management (whose management included two Nobel Prize winners in economics) in 1998. There were plenty of signs early on that all was not well in what became known as the ‘shadow banking system’ of over-the-counter financial trading and hence unregulated markets that had sprung up as if by magic after 1990. There have been hundreds of financial crises around the world since 1973, compared to very few between 1945 and 1973; and several of these have been property- or urban-development-led.

This was the way to avoid the regulator and free the market. The traders were by the mid-1990s often highly trained mathematicians and physicists (many arriving with doctorates in those fields straight from MIT) who delighted in the complex modelling of financial markets along lines pioneered back in 1972 when Fischer Black, Myron Scholes and Robert Merton (who later became infamous for their role in the Long-term Capital Management crash and bail-out in 1998) wrote out a mathematical formula for which they earned a Nobel Prize in Economics on how to value an option. The trading identified and exploited inefficiencies in markets and spread risks but, given its entirely new patterns, this permitted manipulations galore that were extremely difficult to regulate or even to spot because they were buried in the intricate ‘black box’ mathematics of computerised over-the-counter trading programs.

So much for Marx’s hope that the new technologies and organisational forms would render matters more readily understandable and transparent! Profits earned by many individual traders soared and bonuses went stratospheric. But so too did losses. By 2002, the writing should have clearly been on the wall. A young Singapore-based trader named Nicholas Leeson brought down the venerable bank of Baring, and companies like Enron, WorldCom, Global Crossing and Adelphia would bite the dust, as would Long-term Capital Management and the government of Orange County, California, all of them as a result of trading in these new unregulated markets (derivatives and options) and hiding their trades in all manner of shady accounting devices and mathematically sophisticated valuation systems. Technological and financial innovations of this sort have played a role in putting us all at risk under a rule of experts that has nothing to do with guarding the public interest but everything to do with using the monopoly power given by that expertise to earn huge bonuses for gung-ho traders who aspire to be billionaires in ten years’ time and thereby secure instant membership in the capitalist ruling class.


pages: 345 words: 87,745

The Power of Passive Investing: More Wealth With Less Work by Richard A. Ferri

asset allocation, backtesting, Bernie Madoff, buy and hold, capital asset pricing model, cognitive dissonance, correlation coefficient, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, endowment effect, estate planning, Eugene Fama: efficient market hypothesis, fixed income, implied volatility, index fund, intangible asset, Long Term Capital Management, money market fund, passive investing, Paul Samuelson, Ponzi scheme, prediction markets, random walk, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, survivorship bias, too big to fail, transaction costs, Vanguard fund, yield curve, zero-sum game

They decided to reduce their positions in subprime mortgages because they thought a lot of dumb money was buying. The firm is still in business today because they won that bet. However, this strategy doesn’t always work. There have been many occasions when betting against dumb money hasn’t worked out. Long Term Capital Management thought they were betting against dumb money by purchasing Russian bonds as others were dumping them in 1998. Russia ultimately defaulted on its foreign debt obligations. This led to insolvency for Long Term Capital Management and put the country on the verge of a financial market meltdown. In order to avoid the crisis, the president of the New York Federal Reserve had to orchestrate a bailout by several leading Wall Street firms. How the Dumb Money Gets Divided Tactical asset allocation is a zero-sum game.

The #1 fund in 2008 finished dead last in 2009. Buying recent past performance is a tough-love way to seek alpha. Investors’ love affair with last year’s top funds often turns into a messy divorce just a few years later. Former Federal Reserve chairman Alan Greenspan addressed manager persistence during testimony to Congress in 1998 in his Fed Speak way. Greenspan made this comment over the demise of Long-Term Capital Management, a failed hedge fund that threatened the entire financial system: This decade is strewn with examples of bright people who thought they had built a better mousetrap that could consistently extract an abnormal return from financial markets. Some succeed for a time. But while there may occasionally be misconfigurations among market prices that allow abnormal returns, they do not persist.9 Fund Termination Rates One interesting side study from persistence reports is fund termination rates.

French, “Luck versus Skill in the Cross Section of Mutual Fund Returns,” The Journal of Finance 65, no. 5 (October 2010): 1915–1947. 7. Jeroen Derwall and Joop Huij, “‘Hot Hands’ in Bond Funds,” ERIM Research Paper Series (April 16, 2007). 8. Marlena Lee, “Is There Skill among Bond Managers?” (working paper, Dimensional Fund Advisors, Austin, Texas, 2009). 9. Alan Greenspan, Private-Sector Refinancing of the Large Hedge Fund, Long-Term Capital Management, Testimony before the Committee on Banking and Financial Services, U.S. House of Representatives, October 1, 1998). 10. Mark M. Carhart, “On Persistence in Mutual Fund Performance,” The Journal of Finance 52, no. 1 (March 1997): 80. 11. Diane Del Guercio and Paula A. Tkac, “The Effect of Morningstar Ratings on Mutual Fund Flows” (working paper, University of Oregon Department of Finance, 2002). 12.


pages: 257 words: 13,443

Statistical Arbitrage: Algorithmic Trading Insights and Techniques by Andrew Pole

algorithmic trading, Benoit Mandelbrot, constrained optimization, Dava Sobel, George Santayana, Long Term Capital Management, Louis Pasteur, mandelbrot fractal, market clearing, market fundamentalism, merger arbitrage, pattern recognition, price discrimination, profit maximization, quantitative trading / quantitative finance, risk tolerance, Sharpe ratio, statistical arbitrage, statistical model, stochastic volatility, systematic trading, transaction costs

Analysis of a classic pair-trading strategy employing a first-order, dynamic linear model (see Chapter 3) and exhibiting a holding period of about two weeks applied to large capital equities shows a fascinating and revealing development. In March 2000 a trend to a lower frequency that began in 1996 was discovered. First hinted at in 1996, the scale of the change was within experienced local variation bounds, so the hint was only identifiable later. Movement in 1997 was marginal. In 1998, the problems with international credit defaults and the Long Term Capital Management debacle totally disrupted all patterns of performance making inference difficult and hazardous. Although the hint was detectable, the observation was considered unreliable. By early 2000, the hint, there for the fourth consecutive year and now cumulatively strong enough to outweigh expected noise variation, was considered a signal. Structural parameters of the ‘‘traded’’ model were recalibrated for the first time in five years, a move expected to improve return for the next few years by two or three points over what it would otherwise have been.

Such dramatic discriminatory action had not previously been described; certainly there was no prior episode in the history of statistical arbitrage. There are many hypotheses, fewer now entertained than was the case at the time, about the nature of the linkages between credit and equity markets in 1998, and why the price movements were so dramatic. Without doubt, the compounding factor of the demise of the hedge fund Long-Term Capital Management and the unprecedented salvage operation forced by the Federal Reserve upon unenthusiastic investment banks heightened prevalent fears of systemic failure of the U.S. financial system. At the naive end of the range of hypotheses is the true, but not by itself sufficient, notion that the Fed’s actions simply amplified normal panic reactions to a major economic failing. An important factor was the speed with which information, speculation, gossip, and twaddle was disseminated and the breadth of popular 146 STATISTICAL ARBITRAGE coverage from twenty-four hour ‘‘news’’ television channels to the Internet.

If it does not, then initial losses will be reversed before existing trades are unwound; damage is limited largely to (possibly stomach churning) P&L volatility. Destruction, when it occurs, is supercharged because both sides of spread bets are simultaneously adversely affected. In November 1994 Kidder Peabody, on being acquired, reportedly eliminated a pair trading portfolio of over $1 billion. Long Term Capital Management (LTCM), in addition to its advertized, highly leveraged, interest instrument bets, reportedly had a large pair trading portfolio that was liquidated (August 1998) as massive losses elsewhere threatened (and eventually undermined) solvency. 8.5 THE STORY OF REGULATION FAIR DISCLOSURE (FD) Regulation ‘‘Fair Disclosure’’ was proposed by the SEC on December 20, 1999 and had almost immediate practical impact.


pages: 733 words: 179,391

Adaptive Markets: Financial Evolution at the Speed of Thought by Andrew W. Lo

"Robert Solow", Albert Einstein, Alfred Russel Wallace, algorithmic trading, Andrei Shleifer, Arthur Eddington, Asian financial crisis, asset allocation, asset-backed security, backtesting, bank run, barriers to entry, Berlin Wall, Bernie Madoff, bitcoin, Bonfire of the Vanities, bonus culture, break the buck, Brownian motion, business cycle, business process, butterfly effect, buy and hold, capital asset pricing model, Captain Sullenberger Hudson, Carmen Reinhart, collapse of Lehman Brothers, collateralized debt obligation, commoditize, computerized trading, corporate governance, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, cryptocurrency, Daniel Kahneman / Amos Tversky, delayed gratification, Diane Coyle, diversification, diversified portfolio, double helix, easy for humans, difficult for computers, Ernest Rutherford, Eugene Fama: efficient market hypothesis, experimental economics, experimental subject, Fall of the Berlin Wall, financial deregulation, financial innovation, financial intermediation, fixed income, Flash crash, Fractional reserve banking, framing effect, Gordon Gekko, greed is good, Hans Rosling, Henri Poincaré, high net worth, housing crisis, incomplete markets, index fund, interest rate derivative, invention of the telegraph, Isaac Newton, James Watt: steam engine, job satisfaction, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Meriwether, Joseph Schumpeter, Kenneth Rogoff, London Interbank Offered Rate, Long Term Capital Management, longitudinal study, loss aversion, Louis Pasteur, mandelbrot fractal, margin call, Mark Zuckerberg, market fundamentalism, martingale, merger arbitrage, meta analysis, meta-analysis, Milgram experiment, money market fund, moral hazard, Myron Scholes, Nick Leeson, old-boy network, out of africa, p-value, paper trading, passive investing, Paul Lévy, Paul Samuelson, Ponzi scheme, predatory finance, prediction markets, price discovery process, profit maximization, profit motive, quantitative hedge fund, quantitative trading / quantitative finance, RAND corporation, random walk, randomized controlled trial, Renaissance Technologies, Richard Feynman, Richard Feynman: Challenger O-ring, risk tolerance, Robert Shiller, Robert Shiller, Sam Peltzman, Shai Danziger, short selling, sovereign wealth fund, Stanford marshmallow experiment, Stanford prison experiment, statistical arbitrage, Steven Pinker, stochastic process, stocks for the long run, survivorship bias, Thales and the olive presses, The Great Moderation, the scientific method, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, theory of mind, Thomas Malthus, Thorstein Veblen, Tobin tax, too big to fail, transaction costs, Triangle Shirtwaist Factory, ultimatum game, Upton Sinclair, US Airways Flight 1549, Walter Mischel, Watson beat the top human players on Jeopardy!, WikiLeaks, Yogi Berra, zero-sum game

Gilovich, Thomas, Robert Vallone, and Amos Tversky. 1985. “The Hot Hand in Basketball: On the Misperception of Random Sequences.” Cognitive Psychology 17: 295–314. Gimein, Mark. 2005. “Is a Hedge Fund Shakeout Coming Soon? This Insider Thinks So.” New York Times, September 4. Government Accountability Office (GAO). 1999. “Long-Term Capital Management: Regulators Need to Focus Greater Attention on Systemic Risk.” GAO/GGD- 00–3. –––. 2000. “Auditing and Financial Management: Responses to Questions Concerning Long-Term Capital Management and Related Events.” GAO/GGD- 00– 67R. –––. 2009. “Financial Markets Regulation: Financial Crisis Highlights Need to Improve Oversight of Leverage at Financial Institutions and across System.” GAO– 09–739. –––. 2013. “Securities and Exchange Commission: Improving Personnel Management Is Critical for Agency’s Effectiveness.”

In fact, the hedge fund industry is more like twenty to thirty cottage industries, each with its own particular specialty. The mix of this industry clearly is adaptive to market conditions: new funds are started to take advantage of emerging opportunities from one strategy, while other funds close down after experiencing losses from another strategy. But why should we care about hedge funds? One of my academic finance colleagues asked me just this question, right after the collapse of Long-Term Capital Management, a hedge fund that failed in 1998: “Isn’t this just a case of a bunch of rich guys losing their money—who cares?” The Adaptive Markets Hypothesis provides a compelling answer: hedge funds are an important indicator species in the financial ecosystem. During good times, hedge funds are the “tip of the spear”; they’ll take advantage of new investment opportunities as soon as they arise.

David Shaw’s success sparked an even larger wave of adaptive radiation, The Galapagos Islands of Finance • 241 as other hedge funds tried to reproduce his techniques, and as D. E. Shaw alumni left for new territories of their own. Evolutionary competition caused hedge funds to trawl the universities for high-caliber mathematical talent, not merely in finance, but in physics, mathematics, and computer science—the rise of the “quants.” One of the most audacious experiments in this new style of hedge fund was based in Greenwich, Connecticut. It called itself Long-Term Capital Management, or LTCM, as it soon became known. LTCM was the brainchild of John Meriwether, the former head of the domestic fi xed-income arbitrage group at Salomon Brothers, once one of Wall Street’s largest investment banks. Meriwether conceived LTCM to operate on a grand scale. If we think of hedge funds as analogous to biological species, then Meriwether’s vision of LTCM was to be one of the great filter-feeding whales of the oceanic depths, using very small fluctuations in the world’s bond markets for its financial sustenance.


pages: 364 words: 101,286

The Misbehavior of Markets: A Fractal View of Financial Turbulence by Benoit Mandelbrot, Richard L. Hudson

Albert Einstein, asset allocation, Augustin-Louis Cauchy, Benoit Mandelbrot, Big bang: deregulation of the City of London, Black-Scholes formula, British Empire, Brownian motion, business cycle, buy and hold, buy low sell high, capital asset pricing model, carbon-based life, discounted cash flows, diversification, double helix, Edward Lorenz: Chaos theory, Elliott wave, equity premium, Eugene Fama: efficient market hypothesis, Fellow of the Royal Society, full employment, Georg Cantor, Henri Poincaré, implied volatility, index fund, informal economy, invisible hand, John Meriwether, John von Neumann, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, market bubble, market microstructure, Myron Scholes, new economy, paper trading, passive investing, Paul Lévy, Paul Samuelson, plutocrats, Plutocrats, price mechanism, quantitative trading / quantitative finance, Ralph Nelson Elliott, RAND corporation, random walk, risk tolerance, Robert Shiller, Robert Shiller, short selling, statistical arbitrage, statistical model, Steve Ballmer, stochastic volatility, transfer pricing, value at risk, Vilfredo Pareto, volatility smile

Kurtosis bell curve with calculation of La Revue Britannique (Delacroix) Lagrange legacy of Lakebed sediments Langbein, Walter Laplace, Marquis Pierre-Simon de Bachelier and legacy of Least-squares method Gauss and Legendre and mathematics of Legendre, Adrien-Marie chance explored by Gauss v. least-squares method of Leibniz, Gottfried von Lenin Leontief, Wassily Lévy, Paul Bachelier and exceptional chance law from probability theory from Ligeti, Gyorgy Lintner, John Lo, Andrew W. Long-Term Capital Management LP (LTCM) Lorenz, Edward LTCM. See Long-Term Capital Management LP Lynch, Peter Machiavelli, Niccolo Madan, Dilip B. Magellan Fund Magnetism stochastic view of Mandelbrot, Benoit cotton mystery solved by eureka moment of Hurst heard of by IBM work of main work of persistence of Mandelbrot fractals Marcus, Alan J. Market behavior Bachelier on deceptiveness of efficiency in five rules of inherent uncertainty in investment bubbles in mathematical study of misleading in momentum effect in multifractal modeling of Oanda’s study of parable of personality in pictorial essay of research needed for risk in roughness in Russian crisis and tax deductions influencing time relativity in timing in trouble streaks in turbulence of value concept influencing Market cube diagram Market-to-book effect Markowitz, Harry influence of modern finance influenced by MPT from Nobel prize for portfolio theory of price changes understood by risk understood by Marshak, Jacob Marshall, Alfred Martingale condition Mathematics Bachelier on calculating fractal dimension with calculus in chaology computational nightmare of economists using expectation Gaussian geometry in Hilbert on invariance in Kolmogorov in least squares method in market studied with mean variance calculation with modeling with Nile river with nineteenth century Onsager in power law in price deviation in scaling in seismology in simplifying life through time in topology in wild randomness and Mehra, Rajnish Memory Efficient Market Hypothesis and financial market with long stock price movements with Meriwether, John Merrill Lynch CAPM used by Merton, Robert C.

Nobel prize for price changes understood by Santa Fe Institute Scaling patterns Bouchaud’s model with cotton prices with multifractal modeling of Nile river flooding with physics with probability curve with proportions controlled by railroad stock with theory of time-scale with turbulence with Scholes, Myron background of influence of Long-Term Capital Management with modern finance influenced by Nobel prize for options valued by stress test encouragement of Schoutens, Wim SEC. See Securities and Exchange Commission Securities and Exchange Commission (SEC) price continuity viewed by research need and turbulent trading viewed by Security Analysis (Graham and Dodd) Seismology Shakespeare, William Sharman, F.A. Sharpe, William F. asset valuation of CAPM discovered by economists’ view of expected return beta of influence of Long-Term Capital Management viewed by Markowitz and modern finance influenced by Nobel prize for risk understood by Sierpinski, Waclaw Sierpinski gasket fractals Skinner, B.F.

Anywhere the bell-curve assumption enters the financial calculations, an error can come out. History is replete with ironies. And it is one of the greatest that the truly wild nature of markets was re-discovered, at their cost, by two of the most ardent formulators of orthodox economics, Scholes and Merton. In 1993, the two Nobel laureates joined some heavyweight Wall Street bond traders in the creation of a new hedge fund, Long-Term Capital Management LP. The partners collectively contributed $100 million and raised a war-chest that eventually topped $7 billion. Their strategy was straightforward. They would scour the world for occasions when, by their orthodox valuation formulae, the prices of individual options appeared to be wrong. They would bet heavily—with a “leverage” or debt ratio as great as 50-to-1—on the market’s eventually correcting the mistake.


Systematic Trading: A Unique New Method for Designing Trading and Investing Systems by Robert Carver

asset allocation, automated trading system, backtesting, barriers to entry, Black Swan, buy and hold, cognitive bias, commodity trading advisor, Credit Default Swap, diversification, diversified portfolio, easy for humans, difficult for computers, Edward Thorp, Elliott wave, fixed income, implied volatility, index fund, interest rate swap, Long Term Capital Management, margin call, merger arbitrage, Nick Leeson, paper trading, performance metric, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, short selling, survivorship bias, systematic trading, technology bubble, transaction costs, Y Combinator, yield curve

Often requires leverage to achieve decent absolute returns in normal times; so gets killed in bad times. 40 Chapter Two. Systematic Trading Rules Positive skew Negative skew Examples: Examples: • Trend following strategies. • FX carry • Bets done by buying options, e.g. if you think the stock market will weaken then buying put options. • Fixed income relative value as practised by Long Term Capital Management (LTCM), a large hedge fund that blew up in 1998.** • John Paulson in 2006 buying cheap credit default swap insurance on securities backed by mortgages.* • Market making. • Tail protect hedge funds that try and provide cheap insurance against large market moves, as practised by Nassim Taleb amongst others. • Short option strategies, e.g. selling equity option ‘straddles’ (pairs of call and put options).

Often after a long stable period of rising markets these trades get swamped by people seeking extra returns. This results in the available profits being reduced, the apparent risk falling, and required leverage increasing further. Then the music stops and their negative skew becomes horribly apparent. 45 Systematic Trading Two classic examples are the meltdown of fixed income relative value hedge fund manager Long Term Capital Management in mid-199836 and the Quant Quake – sharp losses seen over just two days by equity relative value systematic funds in August 2007. Achievable Sharpe ratios This section is relevant to all readers It’s important to have a realistic sense of what level of Sharpe ratios (SR) are achievable. As I said in the previous chapter, inflated expectations can lead to over betting (which we’ll discuss more in chapter nine, ‘Volatility Targeting’) and overtrading (see chapter twelve, ‘Speed and Size’), both of which will seriously damage your chances of trading profitably.

Unfortunately in year 21 you make minus 100% and lose your entire investment. It turns out this system had seriously negative skew. Although this might seem like a bad result the Sharpe ratio after 21 years is still an excellent 1.7, even once the skew has revealed itself. Clearly this is not a genuine example, but less extreme instances of this have actually occurred. For example the SR of Long Term Capital Management, the hedge fund which blew up in 1998 and which I mentioned earlier in the chapter, was also around 4.6. The second path to the mirage of higher Sharpe is to trade more quickly. The law of active management implies that if you can realise a Sharpe ratio of 0.40 on a single instrument when trading with a holding period of a month, then betting once a day could boost that to an SR of 1.8.


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Fool's Gold: How the Bold Dream of a Small Tribe at J.P. Morgan Was Corrupted by Wall Street Greed and Unleashed a Catastrophe by Gillian Tett

accounting loophole / creative accounting, asset-backed security, bank run, banking crisis, Black-Scholes formula, Blythe Masters, break the buck, Bretton Woods, business climate, business cycle, buy and hold, collateralized debt obligation, commoditize, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, easy for humans, difficult for computers, financial innovation, fixed income, housing crisis, interest rate derivative, interest rate swap, Kickstarter, locking in a profit, Long Term Capital Management, McMansion, money market fund, mortgage debt, North Sea oil, Northern Rock, Renaissance Technologies, risk tolerance, Robert Shiller, Robert Shiller, Satyajit Das, short selling, sovereign wealth fund, statistical model, The Great Moderation, too big to fail, value at risk, yield curve

Aggressive and high-risk hedge funds exploded onto the scene, some growing so large that they were competing in earnest with the new banking behemoths. The financial world was becoming “flat,” morphing into one seething, interlinked arena for increasingly free and fierce competition. Those playing in this twenty-first-century domain of unfettered cyberfinance knew these changes carried risks. The fate of hedge fund maverick Long-Term Capital Management was a deeply troubling cautionary tale. LTCM, which had been created in 1994, epitomized the new era of finance. It was run by a group of academics and traders who ardently believed in libertarian economics and who were dedicated to the cause of using computing power and mathematical skills to hunt for trading opportunities all over the world. Robert Merton, a Nobel laureate and one of the partners in LTCM, was a friend of Peter Hancock, and he—like the J.P.

To Geithner, it was a classic case of a “collective action problem.” In late 2004, he acted, encouraging Corrigan to head a study of a group of leading Wall Street financiers to examine the state of the complex financial world. By then Corrigan was working as a managing director at Goldman Sachs and had already conducted one such exercise, back in 1999, which set out the lessons to be learned after the Long-Term Capital Management hedge fund collapsed. This second study would have a much wider agenda, analyzing the state of complex finance more generally. When the three-hundred-page report was finally released in the summer of 2005, it duly demanded that banks overhaul their back office procedures for credit derivatives. “Dear Hank,” Corrigan wrote in a letter to Henry Paulson, then CEO at Goldman Sachs, that accompanied the report.

The drama was also spurring wide debate about what had gone wrong. Only a few days after Bear Stearns collapsed, Timothy Geithner had urged Jerry Corrigan, his predecessor at the New York Fed, to organize a “voluntary” Wall Street report on how complex finance could be made less risky. Corrigan was only too happy to oblige. Corrigan had already overseen two earlier studies, one on the lessons from the implosion of Long-Term Capital Management, and the second, in 2005, just as the credit bubble was getting under way, on the state of complex finance. Corrigan was convinced that his third report, though, would be the most important. “We need to ask some important rhetorical questions—like, Why did everyone miss the boat?” Corrigan observed. “I am still mystified by that—that is the big issue. Yes, we knew that risk was mispriced, but we did not see what was coming!


The Rise of Carry: The Dangerous Consequences of Volatility Suppression and the New Financial Order of Decaying Growth and Recurring Crisis by Tim Lee, Jamie Lee, Kevin Coldiron

active measures, Asian financial crisis, asset-backed security, backtesting, bank run, Bernie Madoff, Bretton Woods, business cycle, capital asset pricing model, Capital in the Twenty-First Century by Thomas Piketty, collapse of Lehman Brothers, collateralized debt obligation, Credit Default Swap, credit default swaps / collateralized debt obligations, cryptocurrency, debt deflation, distributed ledger, diversification, financial intermediation, Flash crash, global reserve currency, implied volatility, income inequality, inflation targeting, labor-force participation, Long Term Capital Management, Lyft, margin call, market bubble, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, negative equity, Network effects, Ponzi scheme, purchasing power parity, quantitative easing, random walk, rent-seeking, reserve currency, rising living standards, risk/return, sharing economy, short selling, sovereign wealth fund, Uber and Lyft, uber lyft, yield curve

But for currency carry trades, there are two sides to a currency exchange rate, and if a carry crash means a crash of carry recipient currencies, it is also likely to mean a “melt-up” in the value of the funding currency. The first true example of this was the melt-up of the yen that occurred in early October 1998, at the end of the Asia and Russia crisis and following the collapse of giant hedge fund Long-Term Capital Management (LTCM). Over October 7–8 of that THE RISE OF CARRY 24 year, the dollar collapsed against the yen by almost 15 percent, much of that melt-up of the yen exchange rate occurring during lunchtime hours in London (beginning of the day’s trading in the United States), when the yen moved a number of “big figures” in just a few minutes. At the time this was unprecedented. That carry crash was the culmination of a currency carry trade, directed principally at East Asian economies, which had built up from the early 1990s and had exploded in size during the mid-1990s.

It defies the logic of economics, based on rationality, that the market would price the yen to generate an even bigger trade surplus in the future when the prospective path of net foreign assets is already unsustainable based on the current surplus. . . . The reason . . . is the growth of “carry trades.” . . . Since March 2004 banks’ gross foreign assets have now increased roughly Yen 30 trillion, the same magnitude as the huge rise from August 1996 to December 1997, the heyday of Long-Term Capital Management. It is worth mentioning that over the period since early 2004 the Korean Won has now appreciated by about 33% against the yen, and at this point is still rising sharply against the yen despite looking increasingly overvalued even against the dollar. This was written in January 2006, but over the subsequent year the yenfunded carry trade became far larger in size. In a widely quoted paper in THE RISE OF CARRY 28 January 2007, pi Economics estimated the size of the yen-funded carry trade to be “well in excess of US$1 trillion,” an estimate that subsequently received support from others in the financial community.

HFR now estimates that by the end of 2018 hedge fund assets under management (AUM) were US$3.1 trillion, a 25-fold increase from 1996. By comparison global stock market capitalization has roughly tripled over that same period. Moreover, the influence of hedge funds is magnified by two additional factors: leverage and trading frequency. The use of leverage means that hedge funds control far more securities than represented by their AUM. This was most dramatically illustrated in 1998 when Long Term Capital Management (LTCM), the gold standard for hedge funds at the time, collapsed spectacularly. Entering that year, LTCM managed just under US$5 billion, but with an estimated leverage of 25 to 1, it controlled securities worth US$125 billion. Leverage not only multiplies the assets under a hedge fund’s control; it also directly reduces its margin for error, in turn making the portfolio much less stable.


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Makers and Takers: The Rise of Finance and the Fall of American Business by Rana Foroohar

accounting loophole / creative accounting, activist fund / activist shareholder / activist investor, additive manufacturing, Airbnb, algorithmic trading, Alvin Roth, Asian financial crisis, asset allocation, bank run, Basel III, bonus culture, Bretton Woods, British Empire, business cycle, buy and hold, call centre, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, carried interest, centralized clearinghouse, clean water, collateralized debt obligation, commoditize, computerized trading, corporate governance, corporate raider, corporate social responsibility, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, crowdsourcing, David Graeber, deskilling, Detroit bankruptcy, diversification, Double Irish / Dutch Sandwich, Emanuel Derman, Eugene Fama: efficient market hypothesis, financial deregulation, financial intermediation, Frederick Winslow Taylor, George Akerlof, gig economy, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, High speed trading, Home mortgage interest deduction, housing crisis, Howard Rheingold, Hyman Minsky, income inequality, index fund, information asymmetry, interest rate derivative, interest rate swap, Internet of things, invisible hand, John Markoff, joint-stock company, joint-stock limited liability company, Kenneth Rogoff, Kickstarter, knowledge economy, labor-force participation, London Whale, Long Term Capital Management, manufacturing employment, market design, Martin Wolf, money market fund, moral hazard, mortgage debt, mortgage tax deduction, new economy, non-tariff barriers, offshore financial centre, oil shock, passive investing, Paul Samuelson, pensions crisis, Ponzi scheme, principal–agent problem, quantitative easing, quantitative trading / quantitative finance, race to the bottom, Ralph Nader, Rana Plaza, RAND corporation, random walk, rent control, Robert Shiller, Robert Shiller, Ronald Reagan, Satyajit Das, Second Machine Age, shareholder value, sharing economy, Silicon Valley, Silicon Valley startup, Snapchat, Social Responsibility of Business Is to Increase Its Profits, sovereign wealth fund, Steve Jobs, technology bubble, The Chicago School, the new new thing, The Spirit Level, The Wealth of Nations by Adam Smith, Tim Cook: Apple, Tobin tax, too big to fail, trickle-down economics, Tyler Cowen: Great Stagnation, Vanguard fund, zero-sum game

By the late 1990s, the world was in the midst of yet another emerging-market crisis, this time brought on by the further deregulation of global capital flows orchestrated by the Clinton administration. (Treasury secretary Rubin and his deputy and then successor, Lawrence Summers, were principal architects of these measures, and finance lobbied vigorously for them.) Too much money had flowed into the markets too quickly, ending up in speculative projects that were now going bust. Dominos were falling in Asia, Brazil, Russia, and the West, eventually toppling an infamous hedge fund, Long-Term Capital Management (LTCM), which nearly tanked the US financial system. Citigroup alone lost half its quarterly profit, year over year, as a result. The Fed was once again left to pick up the pieces—though in that case, unlike with the bailouts of 2008, the banks themselves had to take responsibility for their losses. All of this underscored just how complex the system and its most powerful institutions had become.

According to former CFTC head Gary Gensler, also a former Goldman Sachs derivatives expert (and now CFO of Hillary Clinton’s presidential campaign), prior to the 2008 crisis around 90 percent of the entire derivatives market was in an unregulated space, not subject to oversight or central clearing on public exchanges.23 Gensler, who made it his business while at the CFTC to try to change that, has special insight into just how damaging that opacity can be. In 1998, while working in the Clinton administration for then–Treasury secretary Robert Rubin, he was assigned the task of trying to sort out the potential financial implications of the implosion of the hedge fund Long-Term Capital Management (LTCM). The culprit: a $1.25 trillion swaps portfolio gone bad. Gensler remembers going out to LTCM’s headquarters in Greenwich, Connecticut, on a Sunday to investigate. “It quickly became clear to me that we had no idea what the ramifications would be in our financial system, and where, because these trades were booked in the Cayman Islands,” he says. “It was a terrible feeling.”24 Derivatives—be they interest rate swaps, foreign exchange bets, or energy futures—have real-world impacts, as we’ve already seen.

The task is particularly difficult since in the thirty years leading up to the passage of the Dodd-Frank financial reform act in 2010, nobody in Washington paid much attention to such firms. As part of the shadow banking sector, they were presumed to operate in a sphere that wouldn’t touch the average consumer’s finances too much, which turned out to be untrue. Just think of the demise of the hedge fund Long-Term Capital Management and the global market ripples it created; the government’s intervention to offset the impact of the fund’s failure belies the notion that shadow banking entities don’t enjoy federal backstopping of the Too Big to Fail kind, albeit implicitly rather than explicitly. Since the financial crisis of 2008, it’s the shadow banking sector rather than the federally guaranteed banks that has grown like kudzu, as risk migrates to the darkest parts of the system.


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Stocks for the Long Run 5/E: the Definitive Guide to Financial Market Returns & Long-Term Investment Strategies by Jeremy Siegel

Asian financial crisis, asset allocation, backtesting, banking crisis, Black-Scholes formula, break the buck, Bretton Woods, business cycle, buy and hold, buy low sell high, California gold rush, capital asset pricing model, carried interest, central bank independence, cognitive dissonance, compound rate of return, computer age, computerized trading, corporate governance, correlation coefficient, Credit Default Swap, Daniel Kahneman / Amos Tversky, Deng Xiaoping, discounted cash flows, diversification, diversified portfolio, dividend-yielding stocks, dogs of the Dow, equity premium, Eugene Fama: efficient market hypothesis, eurozone crisis, Everybody Ought to Be Rich, Financial Instability Hypothesis, fixed income, Flash crash, forward guidance, fundamental attribution error, housing crisis, Hyman Minsky, implied volatility, income inequality, index arbitrage, index fund, indoor plumbing, inflation targeting, invention of the printing press, Isaac Newton, joint-stock company, London Interbank Offered Rate, Long Term Capital Management, loss aversion, market bubble, mental accounting, money market fund, mortgage debt, Myron Scholes, new economy, Northern Rock, oil shock, passive investing, Paul Samuelson, Peter Thiel, Ponzi scheme, prediction markets, price anchoring, price stability, purchasing power parity, quantitative easing, random walk, Richard Thaler, risk tolerance, risk/return, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, stocks for the long run, survivorship bias, technology bubble, The Great Moderation, the payments system, The Wisdom of Crowds, transaction costs, tulip mania, Tyler Cowen: Great Stagnation, Vanguard fund

CNBC became so popular that major investment houses made sure that all their brokers watched the station on television or their desktop computers so that they could be one step ahead of clients calling in with breaking business news. The bull market psychology appeared impervious to financial and economic shocks. The first wave of the Asian crisis sent the market down a record 554 points on October 27, 1997, and closed trading temporarily. But this did little to dent investors’ enthusiasm for stocks. The following year, the Russian government defaulted on its bonds, and Long-Term Capital Management, considered the world’s premier hedge fund, found itself entangled in speculative positions measured in the trillions of dollars that it could not trade. These events sent the Dow Industrials down almost 2,000 points, or 20%, but three quick Fed rate cuts sent the market soaring again. On March 29, 1999, the Dow closed above 10,000, and it then went on to a record close of 11,722.98 on January 14, 2000.

But what caught my attention was the yield on U.S. Treasury bills. A Treasury auction of three-month bills conducted that afternoon was so heavily oversubscribed that buyers sent the interest rate down to 6 hundredths of 1 percent. I had monitored markets closely for almost 50 years, through the savings and loan crises of the 1970s, the 1987 stock market crash, the Asian crisis, the Long-Term Capital Management crisis, the Russian default, the 9/11 terrorist attack, and many other crises. But I had never seen investors rush to Treasuries like this. The last time Treasury bill yields had fallen toward zero was during the Great Depression, 75 years earlier.4 My eyes returned to the screen in front of me, and a chill went down my spine. Was this a replay of a period that we economists thought was dead and gone?

By the time the Fed finally lowered rates on July 6, 1995, in response to the weakening economy, the S&P 500 stood at 554, about 15 percent higher than on the day the Fed began to raise rates. FIGURE 14-2 S&P 500 and Fed Funds Rate, 1990–2013 As the economy recovered and inflation threatened once again, the Fed tightened 25 basis points on March 25, 1997; yet stocks continued to rise. In response to the Asian crisis and chaos in the Treasury market caused by the failure of Long-Term Capital Management in August 1998, the Fed lowered the funds rate on September 29, 1998. But the stock market was 33.0 percent higher than it was 18 months earlier when the Fed first raised rates. As the U.S. economy sloughed off the Asian crisis, the Fed began tightening again on June 30, 1999, when the S&P Index rose to 1,373. But stocks continued upward, with the S&P 500 hitting its high on March 24, 2000, at 1,527, which was 12 percent higher than the previous June.


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Fortune's Formula: The Untold Story of the Scientific Betting System That Beat the Casinos and Wall Street by William Poundstone

Albert Einstein, anti-communist, asset allocation, beat the dealer, Benoit Mandelbrot, Black-Scholes formula, Brownian motion, buy and hold, buy low sell high, capital asset pricing model, Claude Shannon: information theory, computer age, correlation coefficient, diversified portfolio, Edward Thorp, en.wikipedia.org, Eugene Fama: efficient market hypothesis, high net worth, index fund, interest rate swap, Isaac Newton, Johann Wolfgang von Goethe, John Meriwether, John von Neumann, Kenneth Arrow, Long Term Capital Management, Louis Bachelier, margin call, market bubble, market fundamentalism, Marshall McLuhan, Myron Scholes, New Journalism, Norbert Wiener, offshore financial centre, Paul Samuelson, publish or perish, quantitative trading / quantitative finance, random walk, risk tolerance, risk-adjusted returns, Robert Shiller, Robert Shiller, Ronald Reagan, Rubik’s Cube, short selling, speech recognition, statistical arbitrage, The Predators' Ball, The Wealth of Nations by Adam Smith, transaction costs, traveling salesman, value at risk, zero-coupon bond, zero-sum game

Meriwether left Salomon Brothers during a scandal-driven shake-up in which Meriwether was, it appears, innocent of wrong-doing. He decided to start a hedge fund. It was a good time to do that. Princeton-Newport’s long run had convinced many wealthy investors of the possibility of beating the market while containing risk scientifically. Scores of new hedge funds were started in the early 1990s. Of all these new funds, Meriwether’s Long-Term Capital Management was to become the best known. Ed Thorp first heard of Meriwether’s fund through a mutual friend. The friend knew some of the people who were writing software for the new fund. “It’s gonna be a great investment,” Thorp was told, “and for ten million dollars you can get into it.” Like most of the new group of fund managers, Meriwether promised better-than-market returns through science and software.

It didn’t help that Merton was second only to Samuelson as a critic of the Kelly criterion. Thorp also had heard that Meriwether was a “martingale man.” “The general chatter was that he was a high roller, and it wasn’t clear that the size of his bets were justified,” Thorp recalled. “The story was that if he got in the hole, if things went against him, he’d bet more. If things still went against him, he’d bet more.” Kicking and Screaming LONG-TERM CAPITAL MANAGEMENT (LTCM) was the first fund to raise a billion dollars. It did this by projecting a 30 percent annual return net of fees—better than even Princeton-Newport had done. LTCM’s partners charged 25 percent of profits (rather than the usual 20) plus 1 percent of invested assets per year. The 25 percent fee was a deal-breaker for the trustees of the Rockefeller Foundation, who decided they did not have that kind of money to burn.

He persuaded many of them to roll their money over into a new fund that Koonmen was starting, Eifuku Master Trust. One of the first things Koonmen had to explain to his investors was how to pronounce “Eifuku.” It was ay-foo-koo. Eifuku means “eternal luck.” Soros invested in Eifuku. So did several high-net-worth Kuwaitis and UBS, a Swiss bank still smarting from the distinction of having been Long-Term Capital Management’s largest investor. Like Meriwether, Koonmen believed that his management was worth a 25 percent cut of the profits. He also intended to rake in 2 percent of the fund’s assets each year, profitable or not. Koonmen installed his LTCM pool table in Eifuku’s offices on the eleventh floor of the Kamiyacho MT Building. These lavish offices were the most extreme ostentation in Tokyo’s real estate market.


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The Man Who Solved the Market: How Jim Simons Launched the Quant Revolution by Gregory Zuckerman

affirmative action, Affordable Care Act / Obamacare, Albert Einstein, Andrew Wiles, automated trading system, backtesting, Bayesian statistics, beat the dealer, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, blockchain, Brownian motion, butter production in bangladesh, buy and hold, buy low sell high, Claude Shannon: information theory, computer age, computerized trading, Credit Default Swap, Daniel Kahneman / Amos Tversky, diversified portfolio, Donald Trump, Edward Thorp, Elon Musk, Emanuel Derman, endowment effect, Flash crash, George Gilder, Gordon Gekko, illegal immigration, index card, index fund, Isaac Newton, John Meriwether, John Nash: game theory, John von Neumann, Loma Prieta earthquake, Long Term Capital Management, loss aversion, Louis Bachelier, mandelbrot fractal, margin call, Mark Zuckerberg, More Guns, Less Crime, Myron Scholes, Naomi Klein, natural language processing, obamacare, p-value, pattern recognition, Peter Thiel, Ponzi scheme, prediction markets, quantitative hedge fund, quantitative trading / quantitative finance, random walk, Renaissance Technologies, Richard Thaler, Robert Mercer, Ronald Reagan, self-driving car, Sharpe ratio, Silicon Valley, sovereign wealth fund, speech recognition, statistical arbitrage, statistical model, Steve Jobs, stochastic process, the scientific method, Thomas Bayes, transaction costs, Turing machine

Almost convulsing, Brown pulled his colleague out of the room. “I don’t want anyone recording us!” he screamed, appearing a bit frightened. The embarrassed representative had to ask the visitor to kindly turn off his machine. They were going a bit overboard. At that point, no one really cared what Simons and his team were up to. His two largest rivals, Long-Term Capital Management and D. E. Shaw, were commanding the full attention of investors. Founded by John Meriwether—himself a former mathematics instructor—Long-Term Capital Management also filled its ranks with professors, including Eric Rosenfeld, an MIT-trained finance PhD and computer devotee, and Harvard’s Robert C. Merton and Myron Scholes, who would become Nobel laureates. The team—mostly introverts, all intellectuals—downloaded historic bond prices, distilled overlooked relationships, and built computer models predicting future behavior.

One staffer was so shocked by the terms of the financing that he shifted most of his life savings into Medallion, realizing the most he could lose was about 20 percent of his money. The banks embraced the serious risk despite having ample reason to be wary. For one thing, they had no clue why Medallion’s strategies worked. And the fund only had a decade of impressive returns. In addition, Long-Term Capital Management had imploded just a few years earlier, providing a stark lesson regarding the dangers of relying on murky models. Brown realized there was another huge benefit to the basket options: They enabled Medallion’s trades to become eligible for the more favorable long-term capital gains tax, even though many of them lasted for just days or even hours. That’s because the options were exercised after a year, allowing Renaissance to argue they were long-term in nature.

Jason Zweig, “Data Mining Isn’t a Good Bet for Stock-Market Predictions,” Wall Street Journal, August 8, 2009, https://www.wsj.com/articles/SB124967937642715417. 5. Lux, “The Secret World of Jim Simons.” 6. Robert Lipsyte, “Five Years Later, A Female Kicker’s Memorable Victory,” New York Times, October 19, 2000, https://www.nytimes.com/2000/10/19/sports/colleges-five-years-later-a-female-kicker-s-memorable-victory.html. 7. Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (New York: Random House, 2000). 8. Suzanne Woolley, “Failed Wizards of Wall Street,” BusinessWeek, September 21, 1998, https://www.bloomberg.com/news/articles/1998-09-20/failed-wizards-of-wall-street. 9. Timothy L. O’Brien, “Shaw, Self-Styled Cautious Operator, Reveals It Has a Big Appetite for Risk,” New York Times, October 15, 1998, https://www.nytimes.com/1998/10/15/business/shaw-self-styled-cautious-operator-reveals-it-has-a-big-appetite-for-risk.html. 10.


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What's Your Future Worth?: Using Present Value to Make Better Decisions by Peter Neuwirth

backtesting, big-box store, Black Swan, collective bargaining, discounted cash flows, en.wikipedia.org, Long Term Capital Management, Rubik’s Cube, Skype, the scientific method

This is fundamentally the same problem I have with the econometric models discussed earlier (Taleb’s “regime change”).33 The fact that so many of the sophisticated investment strategies that have purported to eliminate or dramatically reduce risk have time and time again blown up, creating bigger and bigger messes (most recently during the financial crisis of 2008–9) should be viewed as prima facie evidence that there is something deeply flawed in the proposition that we can truly understand the underlying nature of the randomness that governs the future. Unfortunately, our memories are short. The fact that hedge funds based on these mathematical models crash and burn far more often than the theory that they are based on says is possible has not seemed to slow the growth of this paradigm. Each time there is a spectacular blow up (e.g., Long Term Capital Management’s collapse in 1998), it is written off as a “failure to execute,” an “impossible to predict event,” or some technical flaw in the model, which can simply be tweaked so that it doesn’t happen again.34 Present Value to the Rescue—What Step 3 is Really About At this point, you may be asking yourself why I have spent so much time telling stories about the impossibility of making predictions.

See FCC Record, Volume 07, No. 09, p. 2724, April 20–May 1, 1992. 31. Nassim N. Taleb, The Black Swan (Random House [Trade Paperback edition], 2010). 32. From 1/1/1982 to 1/1/2000 the S&P 500 rose from 122.55 to 1469.25, a return of almost 15%/year 33. Taleb, Fooled by Randomness, 113–115. 34. There were countless postmortems after the LTCM collapse. See for example: Philippe Jorion, “Risk Management Lessons from Long-Term Capital Management,” European Financial Management 6 (September 2000): 277–300. Chapter 8 35. Peter Neuwirth, “The Time Value of Time.” Contingencies, Vol. 9 No.1 January/February 1997: 47–50. 36. Frederick, Shane, George Lowenstein, and Ted O’Donoghue, “Time Discounting and Time Preference: A Critical Review.” Journal of Economic Literature 40: 351–401. 37. Their website is at disability-insurance-specialists.com 38.

See also “Black Swan”; Taleb, Nassim Nicholas and Big Data, 66 considering all possible, 5 doesn’t really exist, 2–3 imagining the, 65–76 impossibility of predicting the, 95–96, 118 nature of the, 66–70 non-attachment to any particular, 69 and objectivity evaluating likelihood of scenarios, 69 predicting the, 3 thinking about the, 68–70 uncertainty about the, 39, 67 unlikely scenarios, 125–126 G General Equilibrium Model, 91 H hedge funds, 94 Heinlein, Robert, 65 hot steaks, 78 I induction, principle of, 90. See also “Black Swan”; fooled by randomness; Taleb, Nassim Nicholas information age, 1 Internet, 92 Ippolitto, Dean, 99 K Kahneman, Daniel, 10, 77 L Leiber, Fritz, 65–66 licensed actuary, 3. See also actuarial exams liquidity premium, 54 Live Long and Prosper (Vernon), 158–159 Long Term Capital Management, 94 M McLeish, David, 80–83. See also expanding funnel of doubt medical tests and Present Value, 135–138 modeling, 83. See also Big Data Money for Life (Vernon), 157 N Newtonian physics, 90 non-financial decision, 40 now and the later, weigh the, 97–108 O OPERS, 121, 122, 124, 128 Oregon Public Employees Retirement System. See OPERS organizations and communities, present value for, 117–128 P pension plan, 156–157.


When Free Markets Fail: Saving the Market When It Can't Save Itself (Wiley Corporate F&A) by Scott McCleskey

Asian financial crisis, asset-backed security, bank run, barriers to entry, Bernie Madoff, break the buck, call centre, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, financial innovation, fixed income, information asymmetry, invisible hand, Isaac Newton, iterative process, Long Term Capital Management, margin call, money market fund, moral hazard, mortgage debt, place-making, Ponzi scheme, prediction markets, risk tolerance, shareholder value, statistical model, The Wealth of Nations by Adam Smith, time value of money, too big to fail, web of trust

Clearly, a big firm has the capacity to take down a number of other firms because it has positions or other exposures to a large number of firms. But a medium-size firm that is highly leveraged (borrows a great deal of money and then invests it) can easily punch above its weight in the market, and its failure can thus also be magnified. It is doubtful, for instance, that regulators would have identified Long Term Capital Management (LTCM) as too big to fail until it failed, its size having increased dramatically but away from the eyes of the regulators as it bet, ultimately the wrong way, on arbitrage between the prices of bonds. It was only after the Asian and Russian financial crises led to huge losses at LTCM that it became apparent how exposed the large investment banks were to LTCM, and how its failure could have systemic consequences.

So it was not long before the question arose as to what to do if a failing firm is so big and so central to the rest of the system that its collapse could take the rest of the system with it. This was a question of two parts: first, whether it is possible for a firm to become so big that its failure would cause irreversible destruction to the system, and second, what to do when such a firm teeters on the brink of collapse. This has not always been an entirely academic parlor game, since large firms have felt the icy hand of death on their shoulders before—Barings and Long Term Capital Management, among others. But the crisis thrust the question into the real world, and questions of ideology and principle gave way to expediency and practicality. That is not necessarily a bad thing; it simply reflected the fact that big decisions needed to be made immediately if not sooner. As discussed in greater detail in Chapter 2, the notion of a firm being too big to fail is really shorthand for a firm being too interconnected to fail.

See also Troubled Asset Relief Program (TARP) accountability of senior management and boards, 22 Anti-Trust Division of Justice and phone market, 17–18 anti-trust powers/legislation, 18 assets weighted by level of risk, 16 banks, keep them small, 17–18 bonds, arbitrage between prices of, 16 capital cushion requirements, 17 capital requirements, increase, 19–20 commercial vs. investment banking activities, 18 conclusion, 22–23 do nothing, 22 financial disclosures, mandatory, 19 Glass-Steagall Act, bring back, 18–19 government intervention vs. free market principles, 17, 21 government support is swiftest, 23 hedge funds, 16, 19, 102, 105, 157–58 highly leveraged firm, 16 Long Term Capital Management, 16 market capitalization, 16 moral hazard encourages inordinate risks, 22 pay limits for officers, 20 n 191 Plan B, 10, 20, 22, 30, 81, 144 policy options, 17–22 proprietary trading by commercial banks, 19 Resolution Authority, 20–22 risk of unknown loss, 21 Sherman Anti-Trust Act, 18 systemic risk, identify, 22 too-big-to-fail concept, 15–17 Volcker, Fed Chairman Paul, 18–19 Volcker Rule, 19 Insurance Core Principles, 140 International Association of Insurance Supervisors (IAIS), 140–41 International Organization of Securities Commissioners (IOSCO), 140 international regulations Asia, regulatory initiatives in, 136 Basel Committee for Banking Supervision (BCBS), 140 Code of Conduct Fundamentals for Credit Rating Agencies, 140 conclusion, 141 EU privacy laws, 137, 141 Europe, stock exchanges in, 135 The European Union, 136–38 Financial Stability Board (FSB), 54, 139– 40, 184–85 FSA’s Handbook of regulations, 138 global markets, interconnectedness of, 134 herd mentality (short-term market movements), 134 Insurance Core Principles, 140 International Association of Insurance Supervisors (IAIS), 140–41 International Organization of Securities Commissioners (IOSCO), 140 international organizations, 139–41 Markets in Financial Instruments Directive (MiFID), 136 overseas regulators, 135–39 privacy laws, 134–35, 137, 141 Prospectus Directive governs filing requirements, 137 regulation, principles based vs. rulesbased, 138–39 SEC and shift toward principles-based regulation, 138 Sunday is the new Monday, 133–35 U.S.


pages: 394 words: 85,734

The Global Minotaur by Yanis Varoufakis, Paul Mason

active measures, banking crisis, Berlin Wall, Big bang: deregulation of the City of London, Bretton Woods, business climate, business cycle, capital controls, Carmen Reinhart, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, colonial rule, corporate governance, correlation coefficient, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, debt deflation, declining real wages, deindustrialization, endogenous growth, eurozone crisis, financial innovation, first-past-the-post, full employment, Hyman Minsky, industrial robot, Joseph Schumpeter, Kenneth Rogoff, Kickstarter, labour market flexibility, light touch regulation, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, market fundamentalism, Mexican peso crisis / tequila crisis, money market fund, mortgage debt, Myron Scholes, negative equity, new economy, Northern Rock, paper trading, Paul Samuelson, planetary scale, post-oil, price stability, quantitative easing, reserve currency, rising living standards, Ronald Reagan, special economic zone, Steve Jobs, structural adjustment programs, systematic trading, too big to fail, trickle-down economics, urban renewal, War on Poverty, WikiLeaks, Yom Kippur War

., New Frontier social programmes, 83, 84 Keynes, John Maynard: Bretton Woods conference, 59, 60, 62, 109; General Theory, 37; ICU proposal, 60, 66, 90, 109, 254, 255; influence on New Dealers, 81; on investment decisions, 48; on liquidity, 160–1; trade imbalances, 62–6 Keynsianism, 157 Kim Il Sung, 77 Kissinger, Henry, 94, 98, 106 Kohl, Helmut, 201 Korea, 91, 191, 192 Korean War, 77, 86 labour: as a commodity, 28; costs, 104–5, 104, 105, 106, 137; hired, 31, 45, 46, 53, 64; scarcity of, 34–5; value of, 50–2 labour markets, 12, 202 Labour Party (British), 69 labourers, 32 land: as a commodity, 28; enclosure, 64 Landesbanken, 203 Latin America: effect of China on, 215, 218; European banks’ exposure to, 203; financial crisis, 190 see also specific countries lead, prices, 96 Lebensraum, 67 Left-Right divide, 167 Lehman Brothers, 150, 152–3 leverage, 121–2 leveraging, 37 Liberal Democratic Party (Japan), 187 liberation movements, 79, 107 LIBOR (London Interbank Offered Rate), 148 liquidity traps, 157, 190 Lloyds TSB, 153, 156 loans: and CDOs, 7–8, 129–31; defaults on, 37 London School of Economics, 4, 66 Long-Term Capital Management (LTCM) hedge fund collapse, 13 LTCM (Long-Term Capital Management) hedge fund collapse, 2, 13 Luxembourg, support for Dexia, 154 Maastricht Treaty, 199–200, 202 MacArthur, Douglas, 70–1, 76, 77 machines, and humans, 50–2 Malaysia, 91, 191 Mao, Chairman, 76, 86, 91 Maresca, John, 106–7 Marjolin, Robert, 73 Marshall, George, 72 Marshall Plan, 71–4 Marx, Karl: and capitalism, 17–18, 19, 34; Das Kapital, 49; on history, 178 Marxism, 181, 182 Matrix, The (film), 50–2 MBIA, 149, 150 McCarthy, Senator Joseph, 73 mercantilism, in Germany, 251 merchant class, 27–8 Merkel, Angela, 158, 206 Merrill Lynch, 149, 153, 157 Merton, Robert, 13 Mexico: effect of China on, 214; peso crisis, 190 Middle East, oil, 69 MIE (military-industrial establishment), 82–3 migration, Crash of 2008, 3 military-industrial complex mechanism, 65, 81, 182 Ministry for International Trade and Industry (Japan), 78 Ministry of Finance (Japan), 187 Minotaur legend, 24–5, 25 Minsky, Hyman, 37 money markets, 45–6, 53, 153 moneylenders, 31, 32 mortgage backed securities (MBS) 232, 233, 234 NAFTA (North American Free Trade Agreement), 214 National Bureau of Economic Research (US), 157 National Economic Council (US), 3 national income see GDP National Security Council (US), 94 National Security Study Memorandum 200 (US), 106 nationalization: Anglo Irish Bank, 158; Bradford and Bingley, 154; Fortis, 153; Geithner–Summers Plan, 179; General Motors, 160; Icelandic banks, 154, 155; Northern Rock, 151 NATO (North Atlantic Treaty Organization), 76, 253 negative engineering, 110 negative equity 234 neoliberalism, 139, 142; and greed, 10 New Century Financial, 147 New Deal: beginnings, 45; Bretton Woods conference, 57–9; China, 76; Global Plan, 67–71, 68; Japan, 77; President Kennedy, 84; support for the Deutschmark, 74; transfer union, 65 New Dealers: corporate power, 81; criticism of European colonizers, 79 ‘new economy’, 5–6 New York stock exchange, 40, 158 Nietzsche, Friedrich, 19 Nixon, Richard, 94, 95–6 Nobel Prize for Economics, 13 North American Free Trade Agreement (NAFTA), 214 North Atlantic Treaty Organization (NATO), 76 North Korea see Korea Northern Rock, 148, 151 Obama administration, 164, 178 Obama, Barack, 158, 159, 169, 180, 230, 231 OECD (Organisation for Economic Co-operation and Development), 73 OEEC (Organisation for European Economic Co-operation), 73, 74 oil: global consumption, 160; imports, 102–3; prices, 96, 97–9 OPEC (Organization of the Petroleum Exporting Countries), 96, 97 paradox of success, 249 parallax challenge, 20–1 Paulson, Henry, 152, 154, 170 Paulson Plan, 154, 173 Penn Bank, 40 Pentagon, the, 73 Plaza Accord (1985), 188, 192, 213 Pompidou, Georges, 94, 95–6 pound sterling, devaluing, 93 poverty: capitalism as a supposed cure for, 41–2; in China, 162; reduction in the US, 84; reports on global, 125 predatory governance, 181 prey–predator dynamic, 33–5 prices, flexible, 40–1 private money, 147, 177; Geithner–Summers Plan, 178; toxic, 132–3, 136, 179 privatization, of surpluses, 29 probability, estimating, 13–14 production: cars, 70, 103, 116, 157–8; coal, 73, 75; costs, 96, 104; cuts in, 41; in Japan, 185–6; processes, 30, 31, 64; steel, 70, 75 production–distribution cycle, 54 property see real estate prophecy paradox, 46, 47, 53 psychology, mass, 14 public debt crisis, 205 quantitative easing, 164, 231–6 railway bubbles, 40 Rational Expectations Hypothesis (REH), 15–16 RBS (Royal Bank of Scotland), 6, 151, 156; takeover of ABN-Amro, 119–20 Reagan, Ronald, 10, 99, 133–5, 182–3 Real Business Cycle Theory (RBCT), 15, 16–17 real estate, bubbles, 8–9, 188, 190, 192–3 reason, deferring to expectation, 47 recession predictions, 152 recessions, US, 40, 157 recycling mechanisms, 200 regulation, of banking system, 10, 122 relabelling, 14 religion, organized, 27 renminbi (RMB), 213, 214, 217, 218, 253 rentiers, 165, 187, 188 representative agents, 140 Reserve Bank of Australia, 148 reserve currency status, 101–2 risk: capitalists and, 31; riskless, 5, 6–9, 14 Roach, Stephen, 145 Robbins, Lionel, 66 Roosevelt, Franklin D., 165; attitude towards Britain, 69; and bank regulation, 10; New Deal, 45, 58–9 Roosevelt, Theodore (‘Teddy’), 180 Royal Bank of Scotland (RBS), 6, 151, 156; takeover of ABN-Amro, 119–20 Rudd, Kevin, 212 Russia, financial crisis, 190 Saudi Arabia, oil prices, 98 Scandinavia, Gold Standard, 44 Scholes, Myron, 13 Schopenhauer, Arthur, 19 Schuman, Robert, 75 Schumpter, Joseph, 34 Second World War, 45, 55–6; aftermath, 87–8; effect on the US, 57–8 seeds, commodification of, 163 shares, in privatized companies, 137, 138 silver, prices, 96 simulated markets, 170 simulated prices, 170 Singapore, 91 single currencies, ICU, 60–1 slave trade, 28 SMEs (small and medium-sized enterprises), 186 social welfare, 12 solidarity (asabiyyah), 33–4 South East Asia, 91; financial crisis, 190, 191–5, 213; industrialization, 86, 87 South Korea see Korea sovereign debt crisis, 205 Soviet Union: Africa, 79; disintegration, 201; Marshall Plan, 72–3; Marxism, 181, 182; relations with the US, 71 SPV (Special Purpose Vehicle), 174 see also EFSF stagflation, 97 stagnation, 37 Stalin, Joseph, 72–3 steel production, in Germany, 70 Strauss-Kahn, Dominique, 60, 254, 255 Summers, Larry, 230 strikes, 40 sub-prime mortgages, 2, 5, 6, 130–1, 147, 149, 151, 166 success, paradox of, 33–5, 53 Suez Canal trauma, 69 Suharto, President of Indonesia, 97 Summers, Larry, 3, 132, 170, 173, 180 see also Geithner–Summers Plan supply and demand, 11 surpluses: under capitalism, 31–2; currency unions, 61; under feudalism, 30; generation in the EU, 196; manufacturing, 30; origin of, 26–7; privatization of, 29; recycling mechanisms, 64–5, 109–10 Sweden, Crash of 2008, 155 Sweezy, Paul, 73 Switzerland: Crash of 2008, 155; UBS, 148–9, 151 systemic failure, Crash of 2008, 17–19 Taiwan, 191, 192 Tea Party (US), 162, 230, 231, 281 technology, and globalization, 28 Thailand, 91 Thatcher, Margaret, 117–18, 136–7 Third World: Crash of 2008, 162; debt crisis, 108, 219; interest rate rises, 108; mineral wealth, 106; production of goods for Walmart, 125 tiger economies, 87 see also South East Asia Tillman Act (1907), 180 time, and economic models, 139–40 Time Warner, 117 tin, prices, 96 toxic theory, 13–17, 115, 133–9, 139–42 trade: balance of, 61, 62, 64–5; deficits (US), 111, 243; global, 27, 90; surpluses, 158 trades unions, 124, 137, 202 transfer unions, New Deal, 65 Treasury Bills (US), 7 Treaty of Rome, 237 Treaty of Versailles, 237 Treaty of Westphalia, 237 trickle-down, 115, 135 trickle-up, 135 Truman Doctrine, 71, 71–2, 77 Truman, Harry, 73 tsunami, effects of, 194 UBS, 148–9, 151 Ukraine, and the Crash of 2008, 156 UN Security Council, 253 unemployment: Britain, 160; Global Plan, 96–7; rate of, 14; US, 152, 158, 164 United States see US Unocal, 106 US economy, twin deficits, 22–3, 25 US government, and South East Asia, 192 US Mortgage Bankers Association, 161 US Supreme Court, 180 US Treasury, 153–4, 156, 157, 159; aftermath of the Crash of 2008, 160; Geithner–Summers Plan, 171–2, 173; bonds, 227 US Treasury Bills, 109 US (United States): aftermath of the Crash of 2008, 161–2; assets owned by foreign state institutions, 216; attitude towards oil price rises, 97–8; China, 213–14; corporate bond purchases, 228; as a creditor nation, 57; domestic policies during the Global Plan, 82–5; economy at present, 184; economy praised, 113–14; effects of the Crash of 2008, 2, 183; foreign-owned assets, 225; Greek Civil War, 71; labour costs, 105; Plaza Accord, 188; profit rates, 106; proposed invasion of Afghanistan, 106–7; role in the ECSC, 75; South East Asia, 192 value, costing, 50–1 VAT, reduced, 156 Venezuela, oil prices, 97 Vietnamese War, 86, 91–2 vital spaces, 192, 195, 196 Volcker, Paul: 2009 address to Wall Street, 122; demand for dollars, 102; and gold convertibility, 94; interest rate rises, 99; replaced by Greenspan, 10; warning of the Crash of 2008, 144–5; on the world economy, 22, 100–1, 139 Volcker Rule, 180–1 Wachowski, Larry and Andy, 50 wage share, 34–5 wages: British workers, 137; Japanese workers, 185; productivity, 104; prophecy paradox, 48; US workers, 124, 161 Wal-Mart: The High Cost of Low Price (documentary, Greenwald), 125–6 Wall Street: Anglo-Celtic model, 12; Crash of 2008, 11–12, 152; current importance, 251; Geithner–Summers Plan, 178; global profits, 23; misplaced confidence in, 41; private money, 136; profiting from sub-prime mortgages, 131; takeovers and mergers, 115–17, 115, 118–19; toxic theory, 15 Wallace, Harry, 72–3 Walmart, 115, 123–7, 126; current importance, 251 War of the Currents, 39 Washington Mutual, 153 weapons of mass destruction, 27 West Germany: labour costs, 105; Plaza Accord, 188 Westinghouse, George, 39 White, Harry Dexter, 59, 70, 109 Wikileaks, 212 wool, as a global commodity, 28 working class: in Britain, 136; development of, 28 working conditions, at Walmart, 124–5 World Bank, 253; origins, 59; recession prediction, 149; and South East Asia, 192 World Trade Organization, 78, 215 written word, 27 yen, value against dollar, 96, 188, 193–4 Yom Kippur War, 96 zombie banks, 190–1

POSTCRIPT TO THE NEW EDITION NOTES RECOMMENDED READING SELECT BIBLIOGRAPHY INDEX Abbreviations AC alternating current ACE aeronautic–computer–electronics complex AIG American Insurance Group ATM automated telling machine CDO collateralized debt obligation CDS credit default swap CEO chief executive officer DC direct current ECB European Central Bank ECSC European Coal and Steel Community EFSF European Financial Stability Facility EIB European Investment Bank EMH Efficient Market Hypothesis ERAB Economic Recovery Advisory Board EU European Union FDIC Federal Deposit Insurance Corporation GDP gross domestic product GM General Motors GSRM global surplus recycling mechanism IBRD International Bank for Reconstruction and Development ICU International Currency Union IMF International Monetary Fund LTCM Long-Term Capital Management (hedge fund) MIE military–industrial establishment NAFTA North American Free Trade Agreement NATO North Atlantic Treaty Organization OECD Organisation for Economic Co-operation and Development OEEC Organisation for European Economic Co-operation OMT outright monetary operations OPEC Organization of the Petroleum Exporting Countries RBCT Real Business Cycle Theory RBS Royal Bank of Scotland REH Rational Expectations Hypothesis RMB renminbi – Chinese currency SME small and medium-sized enterprise SPV Special Purpose Vehicle TARP Troubled Asset Relief Program For Danae Stratou, my global partner Preface to the new edition This book originally aimed at pressing a useful metaphor into the service of elucidating a troubled world; a world that could no longer be understood properly by means of the paradigms that dominated our thinking before the Crash of 2008.

Unlike previous crises, such as the dotcom crash of 2001, the 1991 recession, Black Monday,1 the 1980s Latin American debacle, the slide of the Third World into a vicious debt trap, or even the devastating early 1980s depression in Britain and parts of the US, this crisis was not limited to a specific geography, a certain social class or particular sectors. All the pre-2008 crises were, in a sense, localized. Their long-term victims were hardly ever of importance to the powers-that-be, and when (as in the case of Black Monday, the Long-Term Capital Management (LTCM) hedge fund fiasco of 1998 or the dotcom bubble of two years later) it was the powerful who felt the shock, the authorities had managed to come to the rescue quickly and efficiently. In contrast, the Crash of 2008 had devastating effects both globally and across the neoliberal heartland. Moreover, its effects will be with us for a long, long time. In Britain, it was probably the first crisis in living memory really to have hit the richer regions of the south.


pages: 479 words: 113,510

Fed Up: An Insider's Take on Why the Federal Reserve Is Bad for America by Danielle Dimartino Booth

Affordable Care Act / Obamacare, asset-backed security, bank run, barriers to entry, Basel III, Bernie Sanders, break the buck, Bretton Woods, business cycle, central bank independence, collateralized debt obligation, corporate raider, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, Donald Trump, financial deregulation, financial innovation, fixed income, Flash crash, forward guidance, full employment, George Akerlof, greed is good, high net worth, housing crisis, income inequality, index fund, inflation targeting, interest rate swap, invisible hand, John Meriwether, Joseph Schumpeter, liquidity trap, London Whale, Long Term Capital Management, margin call, market bubble, Mexican peso crisis / tequila crisis, money market fund, moral hazard, Myron Scholes, natural language processing, negative equity, new economy, Northern Rock, obamacare, price stability, pushing on a string, quantitative easing, regulatory arbitrage, Robert Shiller, Robert Shiller, Ronald Reagan, selection bias, short selling, side project, Silicon Valley, The Great Moderation, The Wealth of Nations by Adam Smith, too big to fail, trickle-down economics, yield curve

The brainchild of John Meriwether: Stephanie Yang, “The Epic Story of How a ‘Genius’ Hedge Fund Almost Caused a Global Financial Meltdown,” BusinessInsider Singapore, July 11, 2014. As markets sank, the hedge fund lost $2 billion: Ibid. At least $1 trillion was at risk: Ibid. The heads of more than a dozen: Michael Fleming and Weiling Lui, “Near Failure of Long-Term Capital Management,” Federal Reserve Bank of New York, Federal Reserve History, September 1998, www.federalreservehistory.org/Events/DetailView/52. “Had the failure of LTCM”: FRB: Testimony of Chairman Alan Greenspan, “Private-Sector Refinancing of the Large Hedge Fund, Long-Term Capital Management,” Committee on Banking and Financial Services, U.S. House of Representatives, October 1, 1998, www.federalreserve.gov/boarddocs/testimony/1998/19981001.htm. On February 15, 1999: Joshua Cooper Ramo, “The Three Marketeers,” Time, February 15, 1999, content.time.com/time/world/article/0,8599,2054093,00.html.

The few post-meeting notices about coming changes in monetary policy that the Fed issued were short, under two hundred words, and full of Fedspeak, code words that people on Wall Street parsed like witch doctors examining sheep entrails for clues to the future. Words like “slightly” and “moderately” in Fedspeak did not mean the same thing. Every nuance mattered. Two years after I arrived in New York, tremors shook the markets when the hedge fund Long-Term Capital Management (LTCM) shocked the Street by declaring it was on the verge of insolvency. The brainchild of John Meriwether, former head of bond trading at Salomon Brothers, LTCM was launched in February 1994 with $1.25 billion in capital and a cadre of hotshots who built financial models that would take bond arbitrage to never-before-seen heights of profitability. Meriwether hired PhD economists David Mullins, former vice chairman of the Federal Reserve, and Robert C.

., 36 Gorton, Gary, 125–27, 128 government shutdown, 234 Grant, James, 198 Great Depression, 177 Great Moderation, 65, 87 Greece, bailout of, 188–89 Greenburg, Alan, 105 Greenspan, Alan, 6, 13, 16–17, 19, 26, 47, 60, 77, 78, 91, 153, 220 Black Friday and, 64–65 education of, 48–49 financial crisis and, 167 housing bubble and, 8, 20–21, 23, 27, 50 inflation targeting and, 195–96 irrational exuberance comment of, 11, 12 Long-Term Capital Management crisis and, 14, 15 on too-big-to-fail banks, 187 Greenspan Put, 64–65 Gregory, Joe, 131 groupthink, 9, 50, 166, 197 Gunther, Jeffrey, 207, 208 Hackett, Jim, 71 Haines, Mark, 216 Harker, Patrick, 259 Hartnett, Michael, 1 Hatzius, Jan, 29 Hayes, Samuel L., 144 Hayman Capital Management, 115 high-frequency trading, 190 Hilsenrath, Jon, 80, 195, 223, 228, 233, 237, 245, 260, 262 Hoenig, Thomas, 181, 197, 210, 213 household formation, 211 housing bubble, 6, 20–29 adjustable rate mortgages (ARMs) and, 22 author’s warnings regarding, 23–26 Bernanke and, 23, 74 Fisher on, 89 FOMC conclusions regarding lack of, 78–79 Geithner’s failure to anticipate, 55 Greenspan and, 8, 20–21, 23, 27, 50 lowered mortgage standards and, 21–22 reinflating of, in 2012, 232 subprime mortgages and, 21, 22, 27, 28, 74–75 systemic risk and, 26, 28 Yellen’s failure to see, 86–87, 88–89 housing market, 4–5, 215.


pages: 524 words: 120,182

Complexity: A Guided Tour by Melanie Mitchell

Alan Turing: On Computable Numbers, with an Application to the Entscheidungsproblem, Albert Einstein, Albert Michelson, Alfred Russel Wallace, anti-communist, Arthur Eddington, Benoit Mandelbrot, bioinformatics, cellular automata, Claude Shannon: information theory, clockwork universe, complexity theory, computer age, conceptual framework, Conway's Game of Life, dark matter, discrete time, double helix, Douglas Hofstadter, en.wikipedia.org, epigenetics, From Mathematics to the Technologies of Life and Death, Geoffrey West, Santa Fe Institute, Gödel, Escher, Bach, Henri Poincaré, invisible hand, Isaac Newton, John Conway, John von Neumann, Long Term Capital Management, mandelbrot fractal, market bubble, Menlo Park, Murray Gell-Mann, Network effects, Norbert Wiener, Norman Macrae, Paul Erdős, peer-to-peer, phenotype, Pierre-Simon Laplace, Ray Kurzweil, reversible computing, scientific worldview, stem cell, The Wealth of Nations by Adam Smith, Thomas Malthus, Turing machine

-Canada Power System Outage Task Force’s Final Report on the August 14, 2003 Blackout in the United States and Canada: Causes and Recommendations [https://reports.energy.gov/]. “The computer system of the US Customs and Border protection agency”: see Schlossberg, D. “LAX Computer Crash Strands International Passengers.” ConsumerAffairs.com, August 13, 2007, [http://www.consumeraffairs.com/news04/ 2007/08/lax_computers.html]; and Schwartz, J., “Who Needs Hackers?” New York Times, September 12, 2007. “Long-Term Capital Management”: see, e.g., Government Accounting Office, Long-Term Capital Management: Regulators Need to Focus Greater Attention on Systemic Risk. Report to Congressional Request, 1999, [http://www.gao.gov/cgi-bin/getrpt?GGD-00-3]; and Coy, P., Woolley, S., Spiro, L. N., and Glasgall, W., Failed wizards of Wall Street. Business Week, September 21, 1998. “The threat is complexity itself”: Andreas Antonopoulos, quoted in Schwartz, J., “Who Needs Hackers?”

Its failure quickly caused a cascading failure of other network cards, and within about an hour of the original failure, the entire system shut down. The Customs agency could not process arriving international passengers, some of whom had to wait on airplanes for more than five hours. A third example shows that cascading failures can also happen when network nodes are not electronic devices but rather corporations. August–September 1998: Long-Term Capital Management (LTCM), a private financial hedge fund with credit from several large financial firms, lost nearly all of its equity value due to risky investments. The U.S. Federal Reserve feared that this loss would trigger a cascading failure in worldwide financial markets because, in order to cover its debts, LTCM would have to sell off much of its investments, causing prices of stocks and other securities to drop, which would force other companies to sell off their investments, causing a further drop in prices, et cetera.

Control without hierarchy. Nature, 446(7132), 2007, p. 143. Gould, S. J. Is a new and general theory of evolution emerging? Paleobiology, 6, 1980, pp. 119–130. Gould, S. J. Sociobiology and the theory of natural selection. In G.W. Barlow and J. Silverberg (editors), Sociobiology: Beyond Nature/Nurture?, pp. 257–269. Boulder, CO: Westview Press Inc., 1980. Government Accounting Office. Long-Term Capital Management: Regulators Need to Focus Greater Attention on Systemic Risk. Report to Congressional Request, 1999 [http://www.gao.gov/cgi-bin/getrpt?GGD-00-3]. Grant, B. The powers that be. The Scientist, 21(3), 2007. Grene, M. and Depew, D., The Philosophy of Biology: An Episodic History. Cambridge, U.K.: Cambridge University Press, 2004. Grinnell, G. J. The rise and fall of Darwin’s second theory.


pages: 387 words: 119,244

Making It Happen: Fred Goodwin, RBS and the Men Who Blew Up the British Economy by Iain Martin

asset-backed security, bank run, Basel III, beat the dealer, Big bang: deregulation of the City of London, call centre, central bank independence, computer age, corporate governance, corporate social responsibility, credit crunch, Credit Default Swap, deindustrialization, deskilling, Edward Thorp, Etonian, Eugene Fama: efficient market hypothesis, eurozone crisis, falling living standards, financial deregulation, financial innovation, G4S, high net worth, interest rate swap, invisible hand, joint-stock company, Kickstarter, light touch regulation, London Whale, Long Term Capital Management, moral hazard, negative equity, Neil Kinnock, Nick Leeson, North Sea oil, Northern Rock, old-boy network, pets.com, Red Clydeside, shareholder value, The Wealth of Nations by Adam Smith, too big to fail, upwardly mobile, value at risk

The pioneers were mathematicians and scientists who realised that with the application of serious brainpower, and computing, it was possible to beat the market far more effectively than testosterone-fuelled traders dealing on the basis of instinct or feel for the market ever could.2 Hedge funds gradually expanded into so-called ‘alternative investment’ firms, making all sorts of trades and buying and selling anything that offered the prospect of a large return. The client pays a fat fee to be involved. There are obviously considerable risks. Hedge funds do blow up if there are just a few misjudgements, and they are lightly regulated. In 1998 the implosion in the United States of the splendidly misnamed Long-Term Capital Management necessitated a $3.6bn rescue by Wall Street firms, at the instigation of the authorities, because the fear was that its failure would spread panic in the markets.3 Long-Term Capital Management was a Greenwich-based firm. For a while its failure shook the prevailing confidence that complex computerised models and innovative new financial products offered stability and ever-bigger profits. The moment of reflection was fleeting. The hedge funds – in Greenwich, in New York, in London and elsewhere – rapidly continued their lucrative work into the booming first decade of the new century.

Bob McGinnis, who ran the mortgage securitisation business, was stripped of his responsibilities. McGinnis and Levine were old colleagues. They had worked together at Salomon Brothers in the late 1980s, collaborating on what may even have been Wall Street’s first ever securitisation of sub-prime mortgages. McGinnis had joined Greenwich in 1997 and experienced the Royal Bank takeover when it bought NatWest.8 Greenwich had weathered the crisis in the markets when Long-Term Capital Management fell over in 1998. After the shock of 9/11 Greenwich had prospered, as most of its competition was based in lower Manhattan near the ruins of the World Trade Center and faced months of disruption. Now, after everything, Levine was effectively dumping him over lunch. ‘Why do you carry on working, Bob? You should stop,’ Levine told his colleague. ‘What’s it all for? Who are you going to leave all your money to?’

Chapter 10 1 ‘Greenwich’s outrageous fortune’, Vanity Fair, July 2006. 2 Edward O. Thorp was one such pioneer in America, a Maths professor who perfected a gambling system and wrote the best-selling books Beat the Dealer and then Beat the Stock Market. In the early 1970s he applied his talents to creating a hedge fund, Princeton Newport Partners. 3 When Genius Failed: The Rise and Fall of Long-term Capital Management, Roger Lowenstein, 2000. 4 ‘$363m is average pay for top hedge fund managers’, USA Today, 26 May 2005. 5 Kruger founded Five Mile Capital. 6 Angelo Mozilo built Countrywide, plunged deep into sub-prime and after the crisis was targeted by the US authorities. See ‘Mozilo settles Countrywide fraud case for $65m’, Reuters, 15 October 2010. 7 See Fool’s Gold: How Unrestrained Greed Corrupted a Dream, Shattered Global Markets and Unleashed a Catastrophe, Gillian Tett, 2009. 8 The senior team at Greenwich were initially contemptuous of their new owners, just a small Scottish bank, say several of those there at the time. 9 ‘RBS revealed as key part of consortium behind Ferrovial’s BAA bid’, Scotsman, 6 March 2006. 10 A complaint of some senior RBS investment bankers was that it paid too little, because Goodwin was reluctant to sanction salaries of a similar size to those paid to Diamond and his colleagues at Barclays.


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On the Brink: Inside the Race to Stop the Collapse of the Global Financial System by Henry M. Paulson

asset-backed security, bank run, banking crisis, break the buck, Bretton Woods, buy and hold, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, Doha Development Round, fear of failure, financial innovation, fixed income, housing crisis, income inequality, London Interbank Offered Rate, Long Term Capital Management, margin call, money market fund, moral hazard, Northern Rock, price discovery process, price mechanism, regulatory arbitrage, Ronald Reagan, Saturday Night Live, short selling, sovereign wealth fund, technology bubble, too big to fail, trade liberalization, young professional

They couldn’t sell their Russian holdings, which had become worthless, so they started selling other investments, like mortgage securities, which drove down their value. Even if you had a conservatively managed mortgage business, as Goldman did, you lost heavily. The markets began to seize up, and securities that had been very liquid suddenly became illiquid. The biggest victim of this was the hedge fund Long-Term Capital Management, whose failure, it was feared, might lead to a broad collapse of the markets. The investment banking industry, prodded by the Federal Reserve, banded together to bail out LTCM, but the pain was broader. I remember watching some of our competitors struggling for survival because they had relied on short-term funding that they couldn’t roll over. Goldman made money—I think we ended up earning 12 percent on capital for the year—but we were hemorrhaging for a month or two, and it was frightening.

And while Bear hadn’t posted the massive losses of some of its rivals, its huge exposure to bonds and mortgages made it vulnerable. Bear had found itself in increasingly difficult straits since the previous summer, when, in one of the first signs of the impending crisis, it had been forced to shut down two hedge funds heavily invested in collateralized debt obligations. For all that, I also knew Bear as a scrappy firm that liked to do things its own way: alone on Wall Street it had refused to help rescue Long-Term Capital Management in 1998. Bear’s people were survivors. They had always seemed to find a way out of trouble. For months, Steel and I had been pushing Bear, and many other investment banks and commercial banks, to raise capital and to improve their liquidity positions. Some, including Merrill Lynch and Morgan Stanley, had raised billions from big investors such as foreign governments’ sovereign wealth funds.

We learned a lot doing Bear Stearns, and what we learned scared us. CHAPTER 6 Late March 2008 For the first few days after the Bear Stearns rescue, the markets calmed. Share prices firmed up, while credit default swap spreads on the investment banks eased. Some at Treasury, and in the market, thought that after seven long months, we had finally reached a turning point, just as the industry intervention in Long-Term Capital Management had marked the beginning of the end of 1998’s troubles. But I remained wary. Bear Stearns’s failure had called into question not only the business models but also the very viability of the other investment banks. This uncertainty was unfair for those firms that, after adjusting for accounting differences, had stronger capital positions and better balance sheets than many commercial banks.


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Extreme Money: Masters of the Universe and the Cult of Risk by Satyajit Das

affirmative action, Albert Einstein, algorithmic trading, Andy Kessler, Asian financial crisis, asset allocation, asset-backed security, bank run, banking crisis, banks create money, Basel III, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, Bonfire of the Vanities, bonus culture, Bretton Woods, BRICs, British Empire, business cycle, capital asset pricing model, Carmen Reinhart, carried interest, Celtic Tiger, clean water, cognitive dissonance, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, corporate raider, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, debt deflation, Deng Xiaoping, deskilling, discrete time, diversification, diversified portfolio, Doomsday Clock, Edward Thorp, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, eurozone crisis, Everybody Ought to Be Rich, Fall of the Berlin Wall, financial independence, financial innovation, financial thriller, fixed income, full employment, global reserve currency, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, happiness index / gross national happiness, haute cuisine, high net worth, Hyman Minsky, index fund, information asymmetry, interest rate swap, invention of the wheel, invisible hand, Isaac Newton, job automation, Johann Wolfgang von Goethe, John Meriwether, joint-stock company, Jones Act, Joseph Schumpeter, Kenneth Arrow, Kenneth Rogoff, Kevin Kelly, laissez-faire capitalism, load shedding, locking in a profit, Long Term Capital Management, Louis Bachelier, margin call, market bubble, market fundamentalism, Marshall McLuhan, Martin Wolf, mega-rich, merger arbitrage, Mikhail Gorbachev, Milgram experiment, money market fund, Mont Pelerin Society, moral hazard, mortgage debt, mortgage tax deduction, mutually assured destruction, Myron Scholes, Naomi Klein, negative equity, NetJets, Network effects, new economy, Nick Leeson, Nixon shock, Northern Rock, nuclear winter, oil shock, Own Your Own Home, Paul Samuelson, pets.com, Philip Mirowski, plutocrats, Plutocrats, Ponzi scheme, price anchoring, price stability, profit maximization, quantitative easing, quantitative trading / quantitative finance, Ralph Nader, RAND corporation, random walk, Ray Kurzweil, regulatory arbitrage, rent control, rent-seeking, reserve currency, Richard Feynman, Richard Thaler, Right to Buy, risk-adjusted returns, risk/return, road to serfdom, Robert Shiller, Robert Shiller, Rod Stewart played at Stephen Schwarzman birthday party, rolodex, Ronald Reagan, Ronald Reagan: Tear down this wall, Satyajit Das, savings glut, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, Slavoj Žižek, South Sea Bubble, special economic zone, statistical model, Stephen Hawking, Steve Jobs, survivorship bias, The Chicago School, The Great Moderation, the market place, the medium is the message, The Myth of the Rational Market, The Nature of the Firm, the new new thing, The Predators' Ball, The Wealth of Nations by Adam Smith, Thorstein Veblen, too big to fail, trickle-down economics, Turing test, Upton Sinclair, value at risk, Yogi Berra, zero-coupon bond, zero-sum game

In April 1973, shortly after publication of the Black Scholes paper, the Chicago Board of Option Exchange (CBOE), coincidentally, began trading stock options in its converted smoking lounge. The advent of handheld calculators, made by Texas Instruments and Hewlett-Packard, which could be programmed to calculate option prices using the model, appeared. Texas Instruments advertised in The Wall Street Journal: “you can find the Black-Scholes value using our...calculator.”12 Black went on to a long career at Goldman Sachs. Scholes moved to Salomon Brothers and Long Term Capital Management (LTCM), where Merton joined him. As the Nobel prize in Economics is not awarded posthumously, Fischer Black’s death in 1995 robbed him of a share of the award that went to Scholes and Merton for the development of option pricing models. During his life, when Black appeared infrequently on the floor of the CBOE, trading would halt momentarily and a loud cheer and clapping would break out.

A 24 percent fall in the value of the underlying bonds translated into a $1.8 billion loss for the lending banks. Bear Stearns agreed, under pressure, to provide a $1.6 billion loan (over 10 percent of the firm’s equity) to the less leveraged High Grade Structured Credit Fund, letting its more leveraged sibling fail. Jimmy Cayne, cigar-smoking, bridge-playing, and (allegedly) pot-smoking Bear Stearns’ CEO, sought a one-year moratorium on margin calls. In 1998, when Wall Street bailed out Long Term Capital Management (LTCM), Bear famously rejected a similar proposal. Merrill, a big lender, now seized and tried to auction off $800 million of collateral. There were few buyers in sight and the prices were in free fall. Shortly after the Bear funds collapsed, the UK hedge fund Peleton Partners (the name refers to the leading group in a bicycle road race) failed. Following a similar strategy to the Bear Stearns funds, Peleton had recently won an industry award for best new fixed-income hedge fund.

In recent years, many macro funds, like the fabled Quantum and Tiger Funds, restructured or disappeared. Some hedge fund managers are exceptionally skilful. Soros, Tudor Jones, and James Simons, an ex-mathematics professor and former code breaker, have outstanding records. For others, investment Viagra boosted performance. Some, like the Bear Stearns hedge funds, used leverage to increase returns. In 2009, in a Freudian slip, George Soros referred to Long Term Capital Management (LTCM) as “leveraged capital.”14 Others increased returns by investing in illiquid or complex securities. Some managers seek an information edge. The credo of SAC, a hedge fund operated by billionaire art collector Steve Cohen, is: “Get information before anyone else.”15 Hedge funds test the boundary of insider trading and market abuse. In 2010, U.S. Federal Investigators began investigating a spider-web of insider trading, involving billionaire investor Raj Rajaratnam, founder of the Galleon hedge fund.


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The End of Theory: Financial Crises, the Failure of Economics, and the Sweep of Human Interaction by Richard Bookstaber

"Robert Solow", asset allocation, bank run, bitcoin, business cycle, butterfly effect, buy and hold, capital asset pricing model, cellular automata, collateralized debt obligation, conceptual framework, constrained optimization, Craig Reynolds: boids flock, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, dark matter, disintermediation, Edward Lorenz: Chaos theory, epigenetics, feminist movement, financial innovation, fixed income, Flash crash, Henri Poincaré, information asymmetry, invisible hand, Isaac Newton, John Conway, John Meriwether, John von Neumann, Joseph Schumpeter, Long Term Capital Management, margin call, market clearing, market microstructure, money market fund, Paul Samuelson, Pierre-Simon Laplace, Piper Alpha, Ponzi scheme, quantitative trading / quantitative finance, railway mania, Ralph Waldo Emerson, Richard Feynman, risk/return, Saturday Night Live, self-driving car, sovereign wealth fund, the map is not the territory, The Predators' Ball, the scientific method, Thomas Kuhn: the structure of scientific revolutions, too big to fail, transaction costs, tulip mania, Turing machine, Turing test, yield curve

There are systems that are complex, but we do not see them as such because we have more than enough time to navigate through them. Reflexivity Now we get to the critical source of complexity we must address when we are operating in the human sphere, the one that comes from the nature of human interaction and experience: reflexivity. In September 1998, when the vaunted but ill-fated hedge fund Long-Term Capital Management (LTCM) was facing strains on its capital, the firm issued its famous “Dear Investor” letter asking clients for more funding. LTCM explained, rationally, that there were large opportunities ahead, but recent losses had left it a bit short of cash. Would you send us some? With that letter its failure was all but guaranteed, because the letter contributed to the perception that LTCM was in trouble, and investors reacted in a way that led those perceptions to be realized.

Vayanos (2004) argues for a similar dynamic through the path of anticipated mutual fund redemptions: investors redeem from mutual funds when asset prices—and hence fund performance—drop to a low enough level, so when the mutual fund thinks it is close to a point where redemptions will start to occur, it will take actions to increase fund liquidity. Kyle and Xiong (2001) show how a decline in prices can lead to liquidations because of decreasing absolute risk aversion. 6. Bookstaber (2007). Market breakdowns after the collapse of Long-Term Capital Management in 1998 (Lowenstein 2000) and during the 2008 financial crisis have similar story lines. Large declines in asset prices were exacerbated by sales from leveraged investors (and borrowers), overwhelming the balance sheets and capacity of traditional market makers. The result was accelerating price declines, more deleveraging, and, in the worst cases, a breakdown of market functioning. These breakdowns can occur based on common factors as well as the assets themselves, as demonstrated by the rapid drying up of liquidity and price declines due to rapid forced selling by a group of leveraged equity funds that were following similar factor-based strategies in 2007 (Khandani and Lo 2011). 7.

Lo, Andrew W. 2012. “Reading about the Financial Crisis: A Twenty-one-Book Review.” Journal of Economic Literature 50, no. 1: 151–78. doi: 10.1257/jel.50.1.151. Lorenz, Edward N. 1963. “Deterministic Nonperiodic Flow.” Journal of the Atmospheric Sciences 20, no. 2: 130–41. doi: 10.1175/1520-0469(1963)020<0130:DNF>2.0.CO;2. Lowenstein, Roger. 2000. When Genius Failed: The Rise and Fall of Long-Term Capital Management. New York: Random House. Lucas, Robert, Jr. 1977. “Understanding Business Cycles.” Carnegie-Rochester Conference Series on Public Policy 5: 7–29. doi: 10.1016/0167-2231(77)90002-1. ———. 1981. Studies in Business-Cycle Theory. Cambridge, MA: MIT Press. ———. 2009. “In Defense of the Dismal Science.” The Economist, August 6. http://www.economist.com/node/14165405. ———. 2011. “What Economists Do.”


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The Man Who Knew: The Life and Times of Alan Greenspan by Sebastian Mallaby

"Robert Solow", airline deregulation, airport security, Andrei Shleifer, anti-communist, Asian financial crisis, balance sheet recession, bank run, barriers to entry, Benoit Mandelbrot, Bretton Woods, business cycle, central bank independence, centralized clearinghouse, collateralized debt obligation, conceptual framework, corporate governance, correlation does not imply causation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency peg, energy security, equity premium, fiat currency, financial deregulation, financial innovation, fixed income, Flash crash, forward guidance, full employment, Hyman Minsky, inflation targeting, information asymmetry, interest rate swap, inventory management, invisible hand, Kenneth Rogoff, Kickstarter, Kitchen Debate, laissez-faire capitalism, Long Term Capital Management, low skilled workers, market bubble, market clearing, Martin Wolf, money market fund, moral hazard, mortgage debt, Myron Scholes, new economy, Nixon shock, Northern Rock, paper trading, paradox of thrift, Paul Samuelson, plutocrats, Plutocrats, popular capitalism, price stability, RAND corporation, rent-seeking, Robert Shiller, Robert Shiller, rolodex, Ronald Reagan, Saturday Night Live, savings glut, secular stagnation, short selling, The Great Moderation, the payments system, The Wealth of Nations by Adam Smith, too big to fail, trade liberalization, unorthodox policies, upwardly mobile, WikiLeaks, women in the workforce, Y2K, yield curve, zero-sum game

“Where we are most vulnerable is with regard to the adequacy of our examinations,” Greenspan had observed after the Fed’s failure to restrain the banks that had lent heedlessly to Long-Term Capital Management. “If we had to meet the standards that people think exist, we would have five times as many examiners.” Having arrived at this conclusion, Greenspan had embraced a pair of assumptions that he knew to be precarious. First, however reckless financiers might sometimes be, their risk managers would generally restrain them, perhaps prodded by regulators who might help at the margin. Second, when risk management did fail, the Fed would clean up afterward—disciplining miscreants like Bankers Trust, bailing out banks like Continental Illinois, cutting interest rates aggressively in the face of shocks such as the failure of Long-Term Capital Management. Like the pre-1914 gold standard, these assumptions had held up over a long period.12 There had been crises, certainly.

But in the real world—as opposed to the world of thought experiments—short rates drove long ones. Prell’s staff had tested the correlations going back four decades, and the results were quite clear. Even during the 1980s, when inflation and inflation expectations had been on everybody’s minds, their influence on long-term interest rates had been marginal. Vice Chairman David Mullins, who would soon leave the Fed for the efficient-market-minded hedge fund Long-Term Capital Management, could scarcely contain himself. Prell’s model was “transparently nonsensical and violates enormous evidence which has been accumulated on the way markets work, including market efficiency,” he insisted. A core assumption of academic finance was that investors were forward-looking—what mattered was not their experience of short rates in the past, but rather their expectation of short rates in the future.

The quants delighted in slicing ordinary bonds into strange “strips”; the flows of money they generated were separated into interest-only payments and principal-only repayments, creating new securities known as IOs and POs; there were inverse IOs, inverse POs, and even a mind-boggling creature called the forward inverse IO. Firms such as Morgan Stanley assembled teams of scientists to apply ideas like chaos theory to markets, and hedge funds such as Long-Term Capital Management began to bet not on the direction of a market’s move but rather on how far it would move in either direction. The sheer speed with which derivatives proliferated was remarkable. As of the end of 1987, the face value of privately negotiated derivatives—mostly interest-rate swaps—amounted to under $1 trillion. Seven years later, the number had soared more than tenfold, reaching $11 trillion.1 In the wake of the disasters at Orange County, Procter & Gamble, and Gibson Greeting Cards, Fortune’s Carol Loomis did her best to understand what was happening.


Quantitative Trading: How to Build Your Own Algorithmic Trading Business by Ernie Chan

algorithmic trading, asset allocation, automated trading system, backtesting, Black Swan, Brownian motion, business continuity plan, buy and hold, compound rate of return, Edward Thorp, Elliott wave, endowment effect, fixed income, general-purpose programming language, index fund, John Markoff, Long Term Capital Management, loss aversion, p-value, paper trading, price discovery process, quantitative hedge fund, quantitative trading / quantitative finance, random walk, Ray Kurzweil, Renaissance Technologies, risk-adjusted returns, Sharpe ratio, short selling, statistical arbitrage, statistical model, survivorship bias, systematic trading, transaction costs

., trading an overly large portfolio): In despair, one tries to recoup the losses by adding fresh capital; in greed, one adds capital too quickly after initial successes with a strategy. Therefore, the one golden rule in risk management is to keep the size of your portfolio under control at all times. This is, however, easier said than done. Large, well-known funds have succumbed to the temptation to overleverage and failed: Long-Term Capital Management in 2000 (Lowenstein, 2000) and Amaranth Advisors in 2006 (epchan. blogspot.com/2006/10/highly-improbable-event.html). In the Amaranth Advisors case, the leverage employed on one single strategy (natural gas calendar spread trade) due to one single trader (Brian Hunter) is so large that a $6 billion dollar loss was incurred, comfortably wiping out the fund’s equity—a textbook case of risk mismanagement.

P1: JYS c08 JWBK321-Chan August 27, 2008 15:20 Printer: Yet to come CHAPTER 8 Conclusion Can Independent Traders Succeed? uantitative trading gained notoriety in the summer of 2007 when some enormous hedge funds run by some of the most reputable money managers rung up losses measured in billions in just a few days (though some had recovered by the end of the month). They brought back bad memories of other notorious hedge fund debacles such as that of Long-Term Capital Management and Amaranth Advisors (both referenced in Chapter 6), except that this time it was not just one trader or one firm, but losses at multiple funds over a short period of time. And yet, ever since I began my career in the institutional quantitative trading business, I have spoken to many small, independent traders, working in shabby offices or their spare bedrooms, who gain small but steady and growing profits year-in and year-out, quite unlike the stereotypical reckless day traders of the popular imagination.

See Sharpe ratio Information, slow diffusion of, 117–118 Interactive Brokers, 15, 73, 82, 83 Investors, herdlike behavior of, 118–119 J January effect, 143–146 backtesting, 144–146 Java, 80, 85 P1: JYS ind JWBK321-Chan October 2, 2008 14:7 178 K Kalman filter, 116 Kavanaugh, Paul, 149 Kelly formula, 95, 97, 100–103, 105, 107, 153, 161 calculating the optimal allocation based on, 100–102 calculating the optimal leverage based on, 99 simple derivation of, when return distribution is Gaussian, 112–113 Kerviel, Jérôme, 160 Khandani, Amir, 104 Kirk Report, 10 L LeSage, James, 168 Leverage, 5, 95–103 Liquidnet, 73 Lo, Andrew, 104 Logical Information Machines, 35, 36 Long-only versus market-neutral strategies, calculating Sharpe ratio for, 45–47 Long-Term Capital Management, 110, 157 Long-term wealth, maximizing, 96 Look-ahead bias, 51–52 Loss aversion, 108–109 M Market impact, 22 MarketQA (Quantitative Analytics), 35 Markov models, hidden, 116, 121 Printer: Yet to come INDEX R , 21, 32–34, MATLAB 137–139 calculating optimal allocation using Kelly formula, 100–102 a quick survey of, 163–168 using in automated trading systems, 80, 81, 83, 85 using to avoid look-ahead bias, 51–52 using to backtest January effect, 144–146 mean-reverting strategy with and without transaction costs, 61–65 year-on-year seasonal trending strategy, 146–148 using to calculate maximum drawdown and its duration, 48–50 using to calculate Sharpe ratio for long-only strategies, 46–47 using for pair trading, 56–58, 59–60 using to scrape web pages for financial data, 34 MCSI Barra, 35, 136 Mean-reverting versus momentum strategies, 116–119 Mean-reverting time series, calculation of the half-life of, 141–142 Millennium Partners, 12 Model risk, 107 ModelStation (Clarifi), 35 Momentum strategies, mean-reverting versus, 116–119 P1: JYS ind JWBK321-Chan October 2, 2008 14:7 Index Money and risk management, 95–113 optimal capital allocation and leverage, 95–103 psychological preparedness, 108–111 risk management, 103–108 Murphy, Kevin, 168 N National Association of Securities Dealers (NASD) Series 7 examination, 70 National Bureau of Economic Research, 10 Neural networks, 116 New York Mercantile Exchange (NYMEX), 16, 149 Northfield Information Services, 136 O Oanda, 37, 73 Octave, 33 O-Matrix, 33 Ornstein-Uhlenbeck formula, 140–141, 142 Out-of-sample testing, 53–55 P Pair trading of GLD and GDX, 55 Paper trading, 55 testing your system by, 89–90 Parameterless trading models, 54–55 PFG Futures, 73 Plus-tick rule, elimination of, 92, 120 Posit (ITG), 73 Position risk, 107 Printer: Yet to come 179 Post earnings announcement drift (PEAD), 118 Principal component analysis (PCA), 136–139 Profit and loss (P&L), 6, 89 curve, 20 Programming consultant, hiring a, 86–87 Psychological preparedness, 108–111 Q Qian, Edward, 154 Quantitative Analytics, 35 Quantitative Services Group, 136 Quantitative trading, 1–8 business case for, 4–8 demand on time, 5–7 marketing, nonnecessity of, 7–8 scalability, 5 the way forward, 8 special topics in, 115–156 exit strategy, 140–143 factor models, 133–139 high-frequency trading strategies, 151–153 high-leverage versus high-beta portfolio, 153–154 mean-reverting versus momentum strategies, 116–119 regime switching, 119–126 seasonal trading strategies, 143–151 stationarity and cointegration, 126–133 who can become a quantitative trader, 2–4 Quotes-plus.com, 37 P1: JYS ind JWBK321-Chan October 2, 2008 14:7 180 R Random walking, 116 REDIPlus trading platform (Goldman Sachs), 73, 82, 83, 84 Regime shifts, 25, 91–92 Regime switching, 119–126 academic attempts to model, 120–121 Markov, 121 using a machine learning tool to profit from, 122–126 Regulation T (SEC), 5, 14, 69–70 Renaissance Technologies Corporation, 104 Representativeness bias, 109 Reverse split, 38 Risk management, 103–108.


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No One Would Listen: A True Financial Thriller by Harry Markopolos

backtesting, barriers to entry, Bernie Madoff, buy and hold, call centre, centralized clearinghouse, correlation coefficient, diversified portfolio, Edward Thorp, Emanuel Derman, Eugene Fama: efficient market hypothesis, family office, financial thriller, fixed income, forensic accounting, high net worth, index card, Long Term Capital Management, Louis Bachelier, offshore financial centre, Ponzi scheme, price mechanism, quantitative trading / quantitative finance, regulatory arbitrage, Renaissance Technologies, risk-adjusted returns, risk/return, rolodex, Sharpe ratio, statistical arbitrage, too big to fail, transaction costs, your tax dollars at work

Fourth, his reported returns couldn’t come from the market performance or options hedging, but there was no indication of where they did come from. Fifth, Rampart’s returns from products similar to Madoff’s had been substantially less than those claimed by Madoff. As I wrote, “In down months, our ... program experienced losses ... whereas Madoff reports only 3 losing months out of 87, a claim I believe impossible to obtain using option income strategies. In August 1998, in the midst of the Russian default and the Long Term Capital Management twin crises, the S&P dropped 14.58 percent, yet Madoff earned 0.30 percent. In January 2000, the S&P 500 dropped 5.09 percent, yet Madoff earned 2.72 percent. Our current test portfolios do not support this....” And the sixth red flag specifically noted that while the market had 26 down months in the 87-month period presented, Madoff had only 3, and “the methods given for the return generation are not possible or even plausible.

So not only did he urge me to go public, but he also introduced me to John Wilke, an investigative reporter at the Wall Street Journal whom he greatly respected. “This is the guy,” he told me. “This is the guy.” Pat Burns made the initial contact with Wilke. In preparation for that I sent him a one-page memo suggesting a three-part package for the Journal, which that paper could promote as “the largest hedge fund blowup since that of Long-Term Capital Management in August-October 1998. And, in reality, since it will likely involve hundreds of billions in selling pressure, the losses to investors will be akin to the largest company in the S&P 500, General Electric (with a market capitalization of $373 billion) suddenly collapsing.” I sat in my office late into the night, and as I wrote this I could almost feel the hope igniting inside me again.

If the average hedge fund is assumed to be levered 4:1, it doesn’t take a rocket scientist to realize that there might be anywhere from a few hundred billion on up in selling pressure in the wake of a $20 - $50 billion hedge fund fraud. With the hedge fund market estimated to be $1 trillion, having one hedge fund with 2% - 5% of the industry’s assets under management suddenly blow up, it is hard to predict the severity of the resulting shock wave. You just know it’ll be unpleasant for anywhere from a few days to a few weeks but the fall out shouldn’t be anywhere near as great as that from the Long Term Capital Management Crises. Using the hurricane scale with which we’ve all become quite familiar with this year, I’d rate BM turning out to be a Ponzi Scheme as a Category 2 or 3 hurricane where the 1998 LTCM Crises was a Category 5. 2. Hedge fund, fund of funds with greater than a 10% exposure to Bernie Madoff will likely be faced with forced redemptions. This will lead to a cascade of panic selling in all of the various hedge fund sectors whether equity related or not.


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The Death of Money: The Coming Collapse of the International Monetary System by James Rickards

Affordable Care Act / Obamacare, Asian financial crisis, asset allocation, Ayatollah Khomeini, bank run, banking crisis, Ben Bernanke: helicopter money, bitcoin, Black Swan, Bretton Woods, BRICs, business climate, business cycle, buy and hold, capital controls, Carmen Reinhart, central bank independence, centre right, collateralized debt obligation, collective bargaining, complexity theory, computer age, credit crunch, currency peg, David Graeber, debt deflation, Deng Xiaoping, diversification, Edward Snowden, eurozone crisis, fiat currency, financial innovation, financial intermediation, financial repression, fixed income, Flash crash, floating exchange rates, forward guidance, G4S, George Akerlof, global reserve currency, global supply chain, Growth in a Time of Debt, income inequality, inflation targeting, information asymmetry, invisible hand, jitney, John Meriwether, Kenneth Rogoff, labor-force participation, Lao Tzu, liquidationism / Banker’s doctrine / the Treasury view, liquidity trap, Long Term Capital Management, mandelbrot fractal, margin call, market bubble, market clearing, market design, money market fund, money: store of value / unit of account / medium of exchange, mutually assured destruction, obamacare, offshore financial centre, oil shale / tar sands, open economy, plutocrats, Plutocrats, Ponzi scheme, price stability, quantitative easing, RAND corporation, reserve currency, risk-adjusted returns, Rod Stewart played at Stephen Schwarzman birthday party, Ronald Reagan, Satoshi Nakamoto, Silicon Valley, Silicon Valley startup, Skype, sovereign wealth fund, special drawing rights, Stuxnet, The Market for Lemons, Thomas Kuhn: the structure of scientific revolutions, Thomas L Friedman, too big to fail, trade route, undersea cable, uranium enrichment, Washington Consensus, working-age population, yield curve

Washington Post, April 23, 2013, http://www.washingtonpost.com/blogs/worldviews/wp/2013/04/23/syrian-hackers-claim-ap-hack-that-tipped-stock-market-by-136-billion-is-it-terrorism. Knight Capital fiasco . . . : Scott Patterson, Jenny Strasburg, and Jacob Bunge, “Knight Upgrade Triggered Old Trading System, Big Losses,” Wall Street Journal, August 14, 2012, http://online.wsj.com/news/articles/SB10000872396390444318104577589694289838100. bailout of the hedge fund Long-Term Capital Management . . . : The author was general counsel of Long-Term Capital Management and the principal negotiator of the 1998 bailout arranged by the Federal Reserve Bank of New York. While LTCM was a well-known trader in fixed-income and derivatives markets, the extent of its trading in equity markets was not well known. LTCM was the largest risk arbitrageur in the world, with over $15 billion in equity positions on pending deals. Upon reviewing the books and records of LTCM with the author and CEO John Meriwether on September 20, 1998, Peter R.

Such behavior exists only in relatively calm, unperturbed markets, but in actual panic situations, selling pressure feeds on itself, and buyers are nowhere to be found. A major panic will spread exponentially and lead to total collapse absent an act of force majeure by government. This panic dynamic has actually commenced twice in the past sixteen years. In September 1998 global capital markets were hours away from total collapse before the completion of a $4 billion, all-cash bailout of the hedge fund Long-Term Capital Management, orchestrated by the Federal Reserve Bank of New York. In October 2008 global capital markets were days away from the sequential collapse of most major banks when Congress enacted the TARP bailout, while the Fed and Treasury intervened to guarantee money-market funds, prop up AIG, and provide trillions of dollars in market liquidity. In neither panic did the Fed’s imaginary bargain hunters show up to save the day.

Paper Money or the True Gold Standard: A Monetary Reform Plan Without Official Reserve Currencies. Lehrman Institute, 2012. Lind, Michael. Land of Promise: An Economic History of the United States. New York: Harper, 2012. Litan, Robert E., and Benn Steill. Financial Statecraft: The Role of Financial Markets in American Foreign Policy. New Haven, Conn.: Yale University Press, 2006. Lowenstein, Roger. When Genius Failed: The Rise and Fall of Long-Term Capital Management. New York: Random House, 2000. Luman, Ronald R., ed. Unrestricted Warfare Symposium. 3 vols. Laurel, Md.: Johns Hopkins University Applied Physics Laboratory, 2007–9. McGregor, James. No Ancient Wisdom, No Followers. Westport, Conn.: Prospecta Press, 2012. Mackay, Charles. Extraordinary Popular Delusions and the Madness of Crowds. New York: Farrar, Straus and Giroux, 1932.


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The Spider Network: The Wild Story of a Math Genius, a Gang of Backstabbing Bankers, and One of the Greatest Scams in Financial History by David Enrich

Bernie Sanders, call centre, centralized clearinghouse, computerized trading, Credit Default Swap, Downton Abbey, Flash crash, Goldman Sachs: Vampire Squid, information asymmetry, interest rate derivative, interest rate swap, London Interbank Offered Rate, London Whale, Long Term Capital Management, Nick Leeson, Northern Rock, Occupy movement, performance metric, profit maximization, tulip mania, zero-sum game

After the 1987 market crash, a White House report blamed derivatives for worsening the crisis by intensifying the snowball-like nature of panicked selling. In April 1994, derivatives landed on the cover of Time under the headline “Risky Business on Wall Street.” (The magazine’s cover illustration was of an evil-looking nerd staring at a computer screen.) And in 1998, the chaotic collapse of the giant, derivatives-investing hedge fund Long-Term Capital Management, run by mathematicians and Nobel Prize–winning economists, further underscored the instruments’ risks. “Every time there’s been a fire, these guys [derivative traders] have been around it,” the former U.S. Treasury secretary Nicholas Brady noted in response. But derivatives were not going anywhere. * * * IBM had a problem. The company, with operations all over the world, had issued debt to finance its European businesses in Swiss francs and German marks.

The explanation didn’t make sense—why had they printed the materials in the first place? Before long, Hayes’s trading positions became common knowledge across Tokyo. Rival banks started to attack. This was hardly an unprecedented phenomenon—and it made Hayes’s willingness to talk openly to rivals and brokers about his trading positions especially tough to comprehend. Back in the late 1990s, Long-Term Capital Management, at the time the world’s largest hedge fund, unraveled in the space of six late-summer weeks partly because Wall Street banks like Goldman Sachs had gleaned valuable information about what assets it was holding. (Hayes was familiar with this tale, having read When Genius Failed, the definitive account of the fund’s collapse.) Banks had a number of potential reasons to try to undermine a rival trader’s wagers.

I gleaned further information from the months of testimony and evidence presented at the trials of Hayes and the former brokers, as well as from the reports and settlement documents of various government panels and enforcement agencies. I read a number of books—fiction and nonfiction—in preparation for writing The Spider Network. I reread some of the classics of the business genre, especially those that Hayes had mentioned to me were influential to him. Those included Barbarians at the Gate: The Fall of RJR Nabisco by Bryan Burrough and John Helyar, and When Genius Failed: The Rise and Fall of Long-Term Capital Management by Roger Lowenstein, as well as a smattering of Michael Lewis books. I also read a number of fascinating books related to Asperger’s syndrome. They included the sublime The Curious Incident of the Dog in the Night-Time by Mark Haddon; Look Me in the Eye: My Life with Asperger’s by John Elder Robison; and The Rosie Project by Graeme Simsion. In many cases, the dialogue and quotes in this book come directly from phone recordings that I have listened to or transcripts I have read—or conversations, text messages, and scenes that I witnessed or participated in.


pages: 831 words: 98,409

SUPERHUBS: How the Financial Elite and Their Networks Rule Our World by Sandra Navidi

activist fund / activist shareholder / activist investor, assortative mating, bank run, barriers to entry, Bernie Sanders, Black Swan, Blythe Masters, Bretton Woods, butterfly effect, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, central bank independence, cognitive bias, collapse of Lehman Brothers, collateralized debt obligation, commoditize, conceptual framework, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, diversification, East Village, Elon Musk, eurozone crisis, family office, financial repression, Gini coefficient, glass ceiling, Goldman Sachs: Vampire Squid, Google bus, Gordon Gekko, haute cuisine, high net worth, hindsight bias, income inequality, index fund, intangible asset, Jaron Lanier, John Meriwether, Kenneth Arrow, Kenneth Rogoff, knowledge economy, London Whale, Long Term Capital Management, longitudinal study, Mark Zuckerberg, mass immigration, McMansion, mittelstand, money market fund, Myron Scholes, NetJets, Network effects, offshore financial centre, old-boy network, Parag Khanna, Paul Samuelson, peer-to-peer, performance metric, Peter Thiel, plutocrats, Plutocrats, Ponzi scheme, quantitative easing, Renaissance Technologies, rent-seeking, reserve currency, risk tolerance, Robert Gordon, Robert Shiller, Robert Shiller, rolodex, Satyajit Das, shareholder value, Silicon Valley, social intelligence, sovereign wealth fund, Stephen Hawking, Steve Jobs, The Future of Employment, The Predators' Ball, The Rise and Fall of American Growth, too big to fail, women in the workforce, young professional

See Financial leaders thought, 47–51 LeFrak, Richard, 129, 192 Legal norms, 222 “Legalized corruption,” 175–176 Lehman Brothers, 8, 20, 41, 56, 61, 157, 172, 177, 181–183, 205 Lending Club, 189 Lennon, John, 199 Levitt, Steven, 140 Leyne, Strauss-Kahn & Advisors, 195 Leyne, Thierry, 195 Liar’s Poker, 221 Liberia, 27, 171 Limits to Growth, The, 220 Links definition of, xxvi to hubs, 19 in human relationships, 19 system stability through, 215 Lipton, David, 165 Liversis, Andrew, 205 Lloyds, 137 Lobbying, 122 Lobbyists, 175 Loeb, Daniel, 91, 109 London, 43 London Business School, 48, 166, 175 London School of Economics, 16, 63, 142 “London Whale,” 57 Long Term Capital Management, 207–209 Loungani, Prakash, 50 Louvre, 132 Lowenstein, Roger, 208 Loyalty, 23 LTCM. See Long Term Capital Management “Lucky Sperm Club,” 137 Lutnick, Howard, 76 M Ma, Jack, 103 Macroeconomic trends, 70 Magic Mountain, The, 2 “Magic roundabout,” 134 Malloch-Brown, Lord Mark, 27 Manchurian Candidate, The, 67 Mankiw, Greg, 84 Mann, Thomas, 2 Mannesmann AG, 142–143 “Mansplaining,” 152–153 Marks, Howard, 90 Marrakech, 194 Marron, Donald, 209 Marx, Karl, 219 Massachusetts Institute of Technology, 36, 81, 84, 149, 185 Masters, Blythe, 156 “Matchers,” 104 Matrix Advisors, 184 “Matthew Effect,” 52 McDonough, William J., 209 McKinsey, 87, 115, 152 Meade, Michael, 201 Media scrutiny, 136–137 Meditation, 62, 70 Medley, Richard, 43 Mentoring gap, 154–155 Meritocracy, 71, 80, 83, 213 Meriwether, John, 207–209 Merkel, Chancellor Angela banker interactions with, 174 at Davos, 114 in Euro crisis, 177 general references to, 39, 61, 193 Josef Ackermann and, 142–144 Merrill Lynch, 56, 179, 183 Merton, Robert, 52, 208 Metropolitan Museum of Art’s Costume Institute Benefit, 76 Metzler, Jakob von, 136 Microsoft, 153 Middle East, 171 Milgram, Stanley, 18 Miliband, Ed, 137 Milken, Lowell, 191 Milken, Mike, 63–64, 129, 190–193 Milken Institute, 190, 192 Min Zhu, 27 Mindich, Eric, 109, 170 “Mind-reading,” 149 Minimum wage, 211 Minorities discrimination against, 148 integration of, 226 old boys’ network exclusion of, 82 Misinformation, 41 MIT.

We will examine how the system should be recalibrated in order to create a more inclusive society with a fairer economy that benefits all. CHAPTER 12 Super-Crash: “Executive Contagion” THE CRASH OF A TITAN: JOHN MERIWETHER Few people can take credit for generating billions of dollars in losses and single-handedly bringing01he0.inancial system to the brink of collapse. John Meriwether of Long Term Capital Management (LTCM) is one of them. At a wine tasting at Chef Daniel Boulud’s DBGB in the East Village, hosted by my friend Jim, a financier and avid wine collector, I met the now infamous Meriwether. I arrived later than most of the other guests, who had gathered in the center of the private wood-paneled room featuring an elegant table set with a myriad of different wine glasses, shiny silverware, and sharply folded napkins.

Adam Lashinsky and Katie Benner, “A tale of money, sex and power: The Ellen Pao and Buddy Fletcher affair,” Fortune, October 25, 2012, http://fortune.com/2012/10/25/ellen-pao-buddy-fletcher/. 17. Maya Kosoff, “Ellen Pao Is Writing a Tell-All About Silicon Valley’s ‘Toxic Culture,’” Vanity Fair, June 8, 2016, http://www.vanityfair.com/news/2016/06/ellen-pao-memoir-silicon-valley-toxic-culture. CHAPTER 12 1. Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (New York: Random House, 2001), Kindle locations 575-6, Kindle edition. 2. Mitchell, Complexity, Kindle locations 4250-55. 3. Richard Dobbs, Susan Lund, Jonathan Woetzel, and Mina Mutafchieva, “Debt and (Not Much) Deleveraging,” McKinsey Global Institute, February 2015, http://www.mckinsey.com/global-themes/employment-and-growth/debt-and-not-much-deleveraging. 4. Stephen G. Cecchetti and Enisse Kharroubi, “Reassessing the Impact of Finance on Growth,” Bank for International Settlements, Working Papers No. 381, July 2012, http://www.bis.org/publ/work381.htm. 5.


pages: 117 words: 31,221

Fred Schwed's Where Are the Customers' Yachts?: A Modern-Day Interpretation of an Investment Classic by Leo Gough

Albert Einstein, banking crisis, Bernie Madoff, corporate governance, discounted cash flows, diversification, fixed income, index fund, Long Term Capital Management, Northern Rock, passive investing, Ralph Waldo Emerson, random walk, short selling, South Sea Bubble, The Nature of the Firm, the rule of 72, The Wealth of Nations by Adam Smith, transaction costs, young professional

This has come about because of a number of mathematical discoveries, most notably the Black Scholes model, for which its discoverers won a Nobel Prize, which enabled more accurate pricing of these exotic products. The most important thing you should know about derivatives is that they do not represent ‘real’ financial assets that you own. They are contracts – i.e. promises – that are ‘derived’ from real assets, indices or events. And promises can be broken. When Long Term Capital Management, one of the first firms to use derivatives on a massive scale, got into trouble, there was a serious danger of global financial meltdown if it reneged on the derivatives contracts it had taken out. A consortium of major banks had to step in to prop up the firm for long enough for it to ‘unwind’ its positions. So, derivatives are intrinsically dangerous because their market is potentially worth many times more than the actual value of the ‘real’ assets upon which they are based.

A Abramovich, Roman 112 accounts, comparing 36–7 AIM (Alternative Investment Market) 70 analysis fundamental analysis 54–5 technical analysis (TA) 40–1 analysts 95, 96 annual reports 36–7 annuities 61 Aristotle 26 Arthur Andersen 53 assets, living off 22–3 astrology, use in predicting share prices 41 Austen, Jane 22 average performance 34–5 average returns 105 B bankers and financial crisis 28–9 banks, merger activity 89 bargains, finding 92–5 Barlow Clowes affair 74, 75 Baruch, Bernard 76 ‘bear raiders’ 82–3 behavioural finance 104–5 benchmarks 35, 87 Bernard, Claude 34 Black Scholes model 32–3 blue chip companies 51, 53 Bogle, John 110 ‘bond washing’ 75 bonds investing in 10–11, 50–2, 53 in the US 80 book value 92 books about the stock market 112–13 booms 18–19 dot.com 30 excessive borrowing in 29 mergers and acquisitions in 88–9 regulators in 85 selling in 76–7 borrowing and the financial crisis 29 British Rail 66–7 Brown, Gordon 18 Buffett, Warren 13, 32, 48, 50, 52, 54, 62, 64, 66, 68, 70, 83, 90, 96, 100, 105, 110 bull markets, new issues in 57 businesses, start-up 106–7 business failure 106 buying high 64–5 C capital raising 24–5 spending 22–3 car manufacturers 67 charting 40–1 China, government bonds 51 ‘churning’ 71– 2 Cisco Systems 90 ‘closed-end’ funds 86 collapses 74–5 collective investment 86–7 companies mergers 88–9 raising capital 24–5 under threat 66–7 compensation for collapses 74–5 compound interest 102 compounding 111 costs of transactions 70–1 counter-cyclical investments 76–7 crashes 28–9 reacting to 108 regulators in 85 credit card debts, during a boom 19 crooks 72–3 see also fraud cycles, economic 19 D debts, during a boom 19 deflationary periods 103 derivatives 32–3, 85 descendants entrusting with money 59 investing for 16–17 Discounted Cash Flow (DCF) 94–5 diversification 48–9 dividend discount model 95 dot.com boom 30 Dow Jones Industrial Average (DJIA) 35 Duttweiler, Rudolph 42 E earnings management 90 Ebbers, Bernard 73 economic cycles 19 economy, growth rate 42–3 Einhorn, David 83 Einstein, Albert 102 Enron 53 equity investment 80–1 estimating returns 80–1 execution-only brokers 71 executives, benefitting from mergers 89 F fact finds 98 false information 72–3, 90, 91 family, building 99 fees, transaction 70–1 Fibonacci numbers 40 figures, ‘managing’ 90–1 financial crisis, who to blame 28–9 financial professionals 96, 98 commissions 72 and investment skills 47, 54–5 risk aversion 58 see also fund managers financial statements 91 Fisher, Irving 56 Fisher, Philip 94, 113 fluctuations in share prices 38–9 Foreman, George 60 Franklin, Benjamin 10 fraud 73, 74–5 and blue chip companies 53 FSA (Financial Services Authority) 14, 74, 83, 84 FTSE 100 64–5 fund managers 35, 54–5, 101 and tracker funds 62 see also financial professionals fundamental analysis 54–5 fundamentals 110 G Garland, Judy 98 ‘gilts’ 50–1 globalisation 78–9 Goldstein, Phil 82 Goldwyn, Sam 40 good stories about companies 42–3 government bonds 10–11, 50–2 in the US 80 Graham, Benjamin 92, 104, 113 growth rate of economies 42–3 Grubman, Jack 73 ‘gurus’ 96–7 H ‘head and shoulders’ pattern 40 hedge funds 33, 82–3, 100–1 Hendrix, Jimi 16 I Icelandic banks 11 income from capital 22–3 index investing 34–5, 62–3, 110, 111 Indonesia 76–7 government bonds 10–11 Industrial Revolution 78 inflation 61 and rate of return 103 Initial Public Offerings (IPOs) 56–7 innovations, investing in 30–1 insurance for investments 74 insurance companies 72 annuities 61 interest calculating 103 on interest 102 rates 11 international diversification 49 international investment 79 internet, investing in 30–1 investment mergers before88–9 collective 86–7 income 10–11 and inflation 61 international 79 long term 16–17, 64–5, 98–9, 102, 111 popular 30–1 risks in 44–5 short term 63 skill in 20–1 trusts 35, 48–9, 58–9, 86 IPOs (Initial Public Offerings) 56–7 J Johnson, Ross 89 K Keynes, J. M. 28 L Lehman Brothers 83 Lewis, Michael 9 life plans 98–9 lifespan, allowing for 60 liquidity 25 Livy (Roman historian) 108 Lloyds Names affair 45 Long Term Capital Management 32–3 long term investment 16–17, 98–9, 102, 111 returns on 64–5 losses 44–5 avoiding 74–5, 108–9 lottery wins 22–3 lump sums 23 M Mackay, Harvey 106 macro-management 101 Madoff, Bernie 72, 73, 75, 84, 113 manufacturers 67 market capitalisation 35 media reporting of financial crisis 28–9 Mencken, H. L. 44 mergers and acquisitions (M&As) 88–9 middle age 99 Milken, Michael 73 millionaires, behaviour of 46 Minogue, Kenneth 24 misinformation 72–3, 90, 91 Modern Portfolio Theory 49 modernity and globalisation 78–9 momentum 38–9 mutual funds 86 average returns 105 N Nabisco 89 ‘Names’ 45 new issues 56–7 newsletters 96–7 O Ogilvy, David 88 online brokers 71 ‘open-end’ funds 86 optimism 42–3 ‘options’ 32 OTC (Over The Counter) market 70 overseas markets and diversification 49 P passive investment 111 patterns, identifying 40–1 Patton, George 80 pension schemes 99 Pope, John 104 popular investments 30–1 positive news about companies 42–3 predicting by analysts 97 the market 40–1 returns 80–1 small changes 38–9 ‘present value’ 94 price/book ratio 92 price/earnings (P/E) ratio 55 price/equity to growth (PEG) ratio 93 price/sales ratio 93 probability 26–7 professional stock-pickers 20–1 professionals 96, 98 commissions 72 and investment skills 47, 54–5 risk aversion 58 profit and company size 105 hiding 91 prospectuses 35, 56–7, 87 public overspending 28–9 R Random Walk theory 27 ratio price/book 92 price/earnings (P/E) 55 price/equity to growth (PEG) 93 price/sales 93 reading about stock markets 112–13 ‘regression to the mean’ 105 regulators 84–5 retirement 99 planning for 60–1 returns and diversification 49 estimating 80–1 inflation-adjusted 103 on investments 58–9 long term 64–5 risk adjustment 80–1 and hedge funds 100–1 in large investments 44–5 perception of 108 relative 50–2 in short selling 82–3 in speculation 12–13 and variance 81 Rogers, Jim 36, 77 Rogers, Will 58 Rowe, David 38 Royal Mail 66–7 ‘rule of 72’ 103 rumours, affecting the market 83 Russia, government bonds 51 S Sarbanes-Oxley Act (2002) 85 Schwed, Fred, background 8–9 SEC (Securities and Exchange Commission) 14, 84 Seneca 46 Seven (bank) 41 Shakespeare, William 86 share analysts 37 shares popular 30–1 prices 14–15 releasing 25 short sellers 82–3 short-term fluctuations in share prices 38–9 short-term investing 63 size of company and profit 105 Soros, George 77, 101 South Sea Bubble 56, 109 speculation 12–13 spread betting companies 83 stages of life, planning for 98–9 start-up businesses 106–7 Steinherr, Alfred 20, 33 stock indices 34–5 stock markets share prices 14–15 speculation in 12–13 stock-picking 20–1 stockbrokers 71 T Taiwan 87 takeovers 88–9 tax on trust funds 58–9 technical analysis (TA) 40–1, 112 telecoms companies 108 Thinc Group 84 timing of investments 64–5 tracker funds 21, 62–3 tracking error 63 ‘traction’ 38–9 traders, investment skills 47 see also professionals transaction costs 70–1 trusts 35, 48–9 low returns 58–9 turnarounds 66–7 Twain, Mark 12, 14 U ‘unit trusts’ 86 US, government bonds 80 V Vanderbilt family 16 variance 81 volatility in the Far East 76–7 and risk 51–2, 58 W Wall Street crash 82, 104 Walsh, David 73 wealth passing down through generations 16–17 and relative risk 44–5 and skill in investment 46–7 Wells, H.


pages: 338 words: 106,936

The Physics of Wall Street: A Brief History of Predicting the Unpredictable by James Owen Weatherall

Albert Einstein, algorithmic trading, Antoine Gombaud: Chevalier de Méré, Asian financial crisis, bank run, beat the dealer, Benoit Mandelbrot, Black Swan, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, Brownian motion, business cycle, butterfly effect, buy and hold, capital asset pricing model, Carmen Reinhart, Claude Shannon: information theory, collateralized debt obligation, collective bargaining, dark matter, Edward Lorenz: Chaos theory, Edward Thorp, Emanuel Derman, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, George Akerlof, Gerolamo Cardano, Henri Poincaré, invisible hand, Isaac Newton, iterative process, John Nash: game theory, Kenneth Rogoff, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, martingale, Myron Scholes, new economy, Paul Lévy, Paul Samuelson, prediction markets, probability theory / Blaise Pascal / Pierre de Fermat, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk-adjusted returns, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Coase, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, statistical arbitrage, statistical model, stochastic process, The Chicago School, The Myth of the Rational Market, tulip mania, Vilfredo Pareto, volatility smile

During the financial meltdown, even sophisticated investors, such as the banks that produced securitized loans in the first place, appear to have been mistaken about how risky these products were. In other words, the models that were supposed to make these products risk-free for their manufacturers failed, utterly. Models have failed in other market disasters as well — perhaps most notably when Long-Term Capital Management (LTCM), a small private investment firm whose strategy team included Myron Scholes among others, imploded. LTCM had a successful run from its founding in 1994 until the early summer of 1998, when Russia defaulted on its state debts. Then, in just under four months, LTCM lost $4.6 billion. By September, its assets had disappeared. The firm was heavily invested in derivatives markets, with obligations to every major bank in the world, totaling about $1 trillion.

And whatever your political position on the role of financial markets in global geopolitics, Sornette believes that the very fact that financial markets and the people who run them do have so much social power is a sufficient reason to look closely at how they work. Since first predicting the October 1997 crash, Sornette has had a remarkable track record of identifying when market crashes will occur. He saw the log-periodic pattern in advance of the September 2008 crash, for instance, and was able to predict the timing. Similarly, the 1998 collapse in the Russian ruble that brought Long-Term Capital Management to its knees showed the signs of an impending crash — indeed, Sornette has claimed that even though the largely unanticipated Russian debt default may have triggered the market turmoil that summer, the crash showed the log-periodic precursors characteristic of herding behavior. This means that a market crash would likely have occurred during that period whether the ruble had collapsed or not.

.”: This story is based on an interview I performed with Clay Struve, as well as a published interview with Michael Greenbaum (Jung 2007), and Cone (1999). Greenbaum mentions that O’Connor was using jump diffusion models in the late 1970s; Struve confirmed it. Cone (1999), meanwhile, described how Struve saved O’Connor in October 1987. “Models have failed in other market disasters as well . . .”: For more on Long-Term Capital Management, see Lowenstein (2000). 6. The Prediction Company “When the Santa Fe Trail . . .”: For more on the Santa Fe Trail, see Duffus (1972). “A century and a half later, two men . . .”: The narrative history of the founding of the Prediction Company is from Bass (1999). Additional biographical details concerning the founders of the Prediction Company come from Bass (1985, 1999), Gleick (1987), Kelly (1994a, b), and Kaplan (2002), as well as interviews and e-mail exchanges with Doyne Farmer and others knowledgeable about the early history of the company.


pages: 405 words: 109,114

Unfinished Business by Tamim Bayoumi

algorithmic trading, Asian financial crisis, bank run, banking crisis, Basel III, battle of ideas, Ben Bernanke: helicopter money, Berlin Wall, Big bang: deregulation of the City of London, Bretton Woods, British Empire, business cycle, buy and hold, capital controls, Celtic Tiger, central bank independence, collapse of Lehman Brothers, collateralized debt obligation, credit crunch, currency manipulation / currency intervention, currency peg, Doha Development Round, facts on the ground, Fall of the Berlin Wall, financial deregulation, floating exchange rates, full employment, hiring and firing, housing crisis, inflation targeting, Just-in-time delivery, Kenneth Rogoff, liberal capitalism, light touch regulation, London Interbank Offered Rate, Long Term Capital Management, market bubble, Martin Wolf, moral hazard, oil shale / tar sands, oil shock, price stability, prisoner's dilemma, profit maximization, quantitative easing, race to the bottom, random walk, reserve currency, Robert Shiller, Robert Shiller, Rubik’s Cube, savings glut, technology bubble, The Great Moderation, The Myth of the Rational Market, the payments system, The Wisdom of Crowds, too big to fail, trade liberalization, transaction costs, value at risk

In addition, hedge funds created much of the demand for new products that investment banks created. The rocket scientists in the investment banks not only invented new trading strategies, they also dreamed up new assets to accomplish such trades. Given this symbiotic relationship, the investment banks increasingly provided hedge funds with cash to supplement their investor equity and finance larger trades. Not all went smoothly. In particular, in 1998 Long-Term Capital Management (LTCM) had to be rescued.23 LTCM was a high-profile hedge fund whose general partners included a former head of bond trading at Salmon Brothers (John Merriweather), a former vice-chair of the Federal Reserve (David Mullins), and two Nobel laureates in finance (Myron Schoales and Robert Merton). It also returned high profits for the first three years after its formation in 1994. However, by early 1998 LTCM was using huge amounts of borrowed money to bet that emerging market risk-spreads, which had spiked over the Asia crisis, would fall.

While it was true that investment banks had never been regulated for safety and soundness, the explosion in the size of the sector boosted the potential risks to the financial system from a failure. Assets of the broker-dealers at the core of the investment banking groups had increased steadily from just 2 percent the economy in 1980 to 10 percent in 1990 and over 20 percent by the early 2000s. The risks to the investment banking industry posed through financing reckless market behavior were well illustrated by the rescue of Long-Term Capital Management, which had managed to amass over a trillion dollars in assets on a narrow capital base. When it collapsed, the investment banks had to band together for a rescue. The second area for concern was the increasing participation of rapidly growing European universal banks in US markets. These firms further supported the expansion of investment banking and derivative markets and also provided a conduit to European banks to buy securitized assets with which they were less familiar.

Dermine (2002): Jean Dermine, “European Banking: Past, Present, and Future”, paper given at The Transformation of the European Financial System, Second ECB Central Banking Conference, Frankfurt am Main, October 24–25, 2002. Diamond and Dybvig (1983): Douglas W. Diamond and Philip H. Dybvig, “Bank Runs, Deposit Insurance, and Liquidity”, Journal of Political Economy, Vol. 91, No. 3 (June 1983), pp. 401–19. Dooley (1994): Michael P. Dooley, “A Retrospective on the Debt Crisis”, NBER Working Paper No. 4963, December 1994. Edwards (1999): Franklin R. Edwards, “Hedge Funds and the Collapse of Long-Term Capital Management”, Journal of Economic Perspectives, Vol. 13, No. 2 (Spring 1999), pp. 189–210. Eichengreen (1992): Barry Eichengreen, Golden Fetters: The Gold Standard and the Great Depression 1919–1939, Oxford University Press, Oxford, 1992. Eichengreen (2008): Barry Eichengreen, Globalizing Capital: A History of the International Monetary System, 2nd edn, Princeton University Press, 2008. El-Erian (2016): Mohamed A.


pages: 280 words: 73,420

Crapshoot Investing: How Tech-Savvy Traders and Clueless Regulators Turned the Stock Market Into a Casino by Jim McTague

algorithmic trading, automated trading system, Bernie Madoff, Bernie Sanders, Bretton Woods, buttonwood tree, buy and hold, computerized trading, corporate raider, creative destruction, credit crunch, Credit Default Swap, financial innovation, fixed income, Flash crash, High speed trading, housing crisis, index arbitrage, locking in a profit, Long Term Capital Management, margin call, market bubble, market fragmentation, market fundamentalism, Myron Scholes, naked short selling, pattern recognition, Ponzi scheme, quantitative trading / quantitative finance, Renaissance Technologies, Ronald Reagan, Sergey Aleynikov, short selling, Small Order Execution System, statistical arbitrage, technology bubble, transaction costs, Vanguard fund, Y2K

The Division of Risk, Strategy and Financial Innovation was staffed with risk specialists, economists, and even some physicists to anticipate threats to the markets posed by new and existing investment activities and products. Schapiro recruited University of Texas professor Henry Hu to head the division. A renaissance man with degrees in science and law, Hu in 1993 had written a forward-looking piece for the Yale Law Review predicting that big financial institutions would make significant mistakes employing relatively new products called derivatives. This was 5 years before the blowup of Long Term Capital Management, a hedge fund that had made interest rate bets using the exotic products and 15 years before insurer AIG would blow itself up dealing in the exotic products. Part of Hu’s thinking was that credit default swaps, which decoupled loans from the actual lender, led to “empty creditor” situations, undermining what it meant to be a debt holder. The SEC had been dominated by lawyers who were more interested in writing regulations than actually riding herd on the markets.

High-frequency traders eagerly embraced this kind of pattern-recognition software. The Quants, who predated the HFT industry by 20 years, often founded hedge funds as opposed to trading exclusively on their own dime. This practice invited regulatory scrutiny and the associated expenses whenever a member of the Quant fraternity had an exceptional meltdown. The SEC tried to regulate hedge funds in the wake of the Long Term Capital Management (LTCM) hedge fund debacle in 1998, but the courts threw out its rules. Congress eventually stepped in and required regulation for some of the larger hedge funds in the Dodd-Frank Financial reform Law of 2010. So a spotlight had been shone on that industry. Quants in the late 1990s and early 2000s learned the hard way what should have been fairly obvious—the longer one’s time horizon, the more difficult it is to predict the future.

., 108 Island (ECN), 144-145 Ivandjiiski, Krassimir, 42 Ivandjiiski, Dan, 41-42 J–K Johnson, Lyndon, 114 Johnson, Simon, 186 Junger, Sebastian, 67 justifiable trades, 88 Kanjilal, Debases, 189 Kanjorski, Paul, 81-83 Kaufman, Ted, 37, 47-61, 103, 183-187, 193-198, 208-210 Kay, Bradley, 231-232 Kim, Edward, 142 King, Elizabeth, 196 Kirilenko, Andrei, 171, 201 Kotok, David, 234 Kotz, David, 197 L latency, 167 layering, 210-212 Leibowitz, Larry, 42 Lemov, Michael, 114 Levitt, Arthur, 14, 35, 50, 110, 118, 140-144 Lewis, Michael, 191 life-cycle funds, 230 LIFFE (London International Financial Futures and Options Exchange), 30 limit orders, market orders versus, 224 Lincoln, Abraham, 48 liquidity during Flash Crash, 72-73 Liquidity Replenishment Point (LPR), 78 Liquidnet, 173-174 Lo, Andrew W., 160 London International Financial Futures and Options Exchange (LIFFE), 30 Long Term Capital Management, 98, 159 Loomis, Philip A., 121 LPR (Liquidity Replenishment Point), 78 Luddites, 150 Lukken, Walt, 28 M Madoff, Bernie, 56 Malyshev, Misha, 39 market manipulation, HFT (high-frequency traders) accused of, 39-45 market orders, limit orders versus, 224 market volatility. See volatility Markman, Jon, 4 Massey, Raymond, 49 Mathisson, Dan, 36, 141 Maulden, John, 234 Mayer, Martin, 127 McCaughan, Jim, 178, 229-230 McGinty, Tom, 197 Mecane, Joseph M., 159 Melton, Mark, 151 Merrill Lynch, 99, 189-190 Merrin, Seth, 173-174 Merton, Robert C., 159 Mikva, Ab, 53 Minner, Ruth Ann, 48 momentum ignition, 18, 23 Moss, John E., 113-122 Murphy, Eddie, 29 mutual funds, ETFs (exchange-traded funds) versus, 232 N Nagy, Chris, 8, 225 naked puts, 127-128 naked short selling, banning, 47-59 naked sponsored access, 226 Nanex, 200 Narang, Manoj, 152-156 NASD (National Assocation of Securities Dealers), 102 regulation after Black Monday (October 19, 1987), 136-137 NASDAQ on Black Monday (October 19, 1987), 133 initial public offerings (IPOs), 142-144 investigation of price fixing, 139 modernization of, 33 Regulation NMS changes to, 21 regulation of ATSs (Automatic Trading Systems), 139-144 SOES (Small Order Execution System), 136-138 National Association of Securities Dealers.


pages: 407 words: 114,478

The Four Pillars of Investing: Lessons for Building a Winning Portfolio by William J. Bernstein

asset allocation, Bretton Woods, British Empire, business cycle, butter production in bangladesh, buy and hold, buy low sell high, carried interest, corporate governance, cuban missile crisis, Daniel Kahneman / Amos Tversky, Dava Sobel, diversification, diversified portfolio, Edmond Halley, equity premium, estate planning, Eugene Fama: efficient market hypothesis, financial independence, financial innovation, fixed income, George Santayana, German hyperinflation, high net worth, hindsight bias, Hyman Minsky, index fund, invention of the telegraph, Isaac Newton, John Harrison: Longitude, Long Term Capital Management, loss aversion, market bubble, mental accounting, money market fund, mortgage debt, new economy, pattern recognition, Paul Samuelson, quantitative easing, railway mania, random walk, Richard Thaler, risk tolerance, risk/return, Robert Shiller, Robert Shiller, South Sea Bubble, stocks for the long run, stocks for the long term, survivorship bias, The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth, the rule of 72, transaction costs, Vanguard fund, yield curve, zero-sum game

Only after you’ve formulated a program that focuses on asset classes and the behavior of asset-class mixtures will you have any chance for overall success. A deficiency in any of the Four Pillars will torpedo this program with brutal dispatch. Here are a couple of examples of how a failure to master the Four Pillars can bring grief to even the most sophisticated investors: Big time players: The principals of Long-Term Capital Management, the firm that in 1998 almost single handedly crippled the world financial system with their highly leveraged speculation, had no trouble with Pillar One—investment theory—as they were in many cases its Nobel Prize-winning inventors. Their appreciation of Pillars Three and Four—psychology and the investment business—was also top drawer. Unfortunately, despite their corporate name, none of them had a working knowledge of Pillar Two—the long-term history of the capital markets.

Walter Bagehot To many readers, this section on booms and busts will seem out of place. After all, this book is a humble how-to tome; it has no pretension of being a documentary work. But of the four key areas of investment knowledge—theory, history, psychology, and investment industry practices—the lack of historical knowledge is the one that causes the most damage. Consider, for example, the principals of Long Term Capital Management, whose ignorance of the vagaries of financial history almost single-handedly brought the Western financial system to its knees in 1998. A knowledge of history is not essential in many fields. You can be a superb physician, accountant, or engineer and not know a thing about the origins and development of your craft. There are also professions where it is essential, like diplomacy, law, and military service.

When you adjust for risk, their performance looks better, but their compensation structure alone should give pause—managers are often paid a hefty percentage of returns, and in some years, total fees can easily exceed 10%. These are the kinds of margins that even Lynch and Buffett in their heydays would have trouble overcoming. Lastly, there is the risk of picking the wrong hedge fund. The list of institutions and wealthy investors shorn by Long-Term Capital Management’s flameout in 1998, which almost single-handedly devastated the world economy, constituted the cream of the nation’s A List. If it could happen to them, it could happen to anybody. My experience is that the wealthier the client, the more likely he is to be badly abused. Brokerage customers are judged by their ability to generate revenues for the firm. Small clients are naturally not accorded the time and effort given to larger ones (or “whales,” as the biggest are known in the brokerage business).


pages: 402 words: 110,972

Nerds on Wall Street: Math, Machines and Wired Markets by David J. Leinweber

AI winter, algorithmic trading, asset allocation, banking crisis, barriers to entry, Big bang: deregulation of the City of London, business cycle, butter production in bangladesh, butterfly effect, buttonwood tree, buy and hold, buy low sell high, capital asset pricing model, citizen journalism, collateralized debt obligation, corporate governance, Craig Reynolds: boids flock, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, Danny Hillis, demand response, disintermediation, distributed generation, diversification, diversified portfolio, Emanuel Derman, en.wikipedia.org, experimental economics, financial innovation, fixed income, Gordon Gekko, implied volatility, index arbitrage, index fund, information retrieval, intangible asset, Internet Archive, John Nash: game theory, Kenneth Arrow, load shedding, Long Term Capital Management, Machine translation of "The spirit is willing, but the flesh is weak." to Russian and back, market fragmentation, market microstructure, Mars Rover, Metcalfe’s law, moral hazard, mutually assured destruction, Myron Scholes, natural language processing, negative equity, Network effects, optical character recognition, paper trading, passive investing, pez dispenser, phenotype, prediction markets, quantitative hedge fund, quantitative trading / quantitative finance, QWERTY keyboard, RAND corporation, random walk, Ray Kurzweil, Renaissance Technologies, risk tolerance, risk-adjusted returns, risk/return, Robert Metcalfe, Ronald Reagan, Rubik’s Cube, semantic web, Sharpe ratio, short selling, Silicon Valley, Small Order Execution System, smart grid, smart meter, social web, South Sea Bubble, statistical arbitrage, statistical model, Steve Jobs, Steven Levy, Tacoma Narrows Bridge, the scientific method, The Wisdom of Crowds, time value of money, too big to fail, transaction costs, Turing machine, Upton Sinclair, value at risk, Vernor Vinge, yield curve, Yogi Berra, your tax dollars at work

It produced simpler, more reasonable models with better statistical and financial performance in the test periods. We tried to avoid data mining, but the market has only one past, and we knew what it was. The bias introduced by that knowledge cannot be removed. After they were developed, these models made money in some countries, but not in others. Arguably, there were structural changes in the markets that ran contrary to what any rearview model based on the past would predict. Long Term Capital Management, a veritable who’s who on Wall Street with multiple Nobel laureates as founders, had similar, though more spectacular, troubles. No matter how much we want to think otherwise, financial markets are not physics experiments. They reflect a shifting combination of economic forces and human emotion. Like all other facets of human 198 Nerds on Wall Str eet behavior, they are a mixture of the rational and the irrational, not necessarily the best target for the approach described here.

There was little or no leverage due to the institutional constraints we had for pension accounts, and our strong desire not to blow up our clients’ portfolios and our income stream by turning what would be a moderate drawdown into a disaster. Lehman Brothers’ leverage was widely reported to be more than 30:1 when they turned out the lights, and other firms were equally overextended, which, while not without precedent, proved particularly toxic when applied to what proved to be nearly incomprehensible securities. Robert Merton, who shared the Nobel Prize for economics in 1997, was also one of the founders of Long Term Capital Management, the firm at the center of a $5 billion crisis in 1998. At the time there was a sense of great peril, and the size of the rescue, which now seems quaint, seemed overwhelming. Merton wrote, As we all know, there have been financial “incidents” and even crises that cause some to raise questions about the innovations and scientific soundness of the financial theories used to engineer them.

Bottom line: this is akin to placing a burning match under a flammable carpet and pretending that it is not there. Still Mad, but Ever Hopeful It took great deal of imagination, in a negative sense, to create the Great Mess of ’08, and we will need a great deal of positive imagination to get out of it. The magnitude of the problem is staggering. Previous financial crises have involved dollar amounts that are lost in the roundoff for this one. Long Term Capital Management’s near failure was a $3.5 billion problem. The size of the federal rescue goes well beyond the $700 billion in the initial rescue plan. One estimate,9 including the 324 Nerds on Wall Str eet hidden tax breaks for banks and the Citigroup rescue, totals $4.62 trillion through November 2008, and compares this figure to total inflationadjusted dollar equivalents for virtually every major federal project in the history of the country, which add up to less than $4 trillion: Cost Inflation-Adjusted Cost Marshall Plan $12.7 billion $115.3 billion Louisiana Purchase $15 million $217 billion Race to the moon $36.4 billion $237 billion S&L crisis $153 billion $256 billion Korean War $54 billion $454 billion New Deal $32 billion (est


pages: 429 words: 120,332

Treasure Islands: Uncovering the Damage of Offshore Banking and Tax Havens by Nicholas Shaxson

Asian financial crisis, asset-backed security, bank run, battle of ideas, Bernie Madoff, Big bang: deregulation of the City of London, Bretton Woods, British Empire, business climate, call centre, capital controls, collapse of Lehman Brothers, computerized trading, corporate governance, corporate social responsibility, creative destruction, Credit Default Swap, David Ricardo: comparative advantage, Double Irish / Dutch Sandwich, failed state, financial deregulation, financial innovation, Fractional reserve banking, full employment, high net worth, income inequality, Kenneth Rogoff, laissez-faire capitalism, land reform, land value tax, light touch regulation, Long Term Capital Management, Martin Wolf, money market fund, New Journalism, Northern Rock, offshore financial centre, oil shock, old-boy network, out of africa, passive income, plutocrats, Plutocrats, Ponzi scheme, race to the bottom, regulatory arbitrage, reserve currency, Ronald Reagan, shareholder value, The Spirit Level, too big to fail, transfer pricing, Washington Consensus

The narcotics industry alone generates some $500 billion in annual sales worldwide2: To put this into perspective, that is twice the value of Saudi Arabia’s oil exports.3 The profits made by those at the top of the trade find their way into the banking system, the asset markets, and the political process through offshore facilities. You can only fit about $1 million cash into a briefcase. Without offshore, the illegal drugs trade would be more like a cottage industry. Financial deregulation and globalization? Offshore is the heart of the matter, as I will show. The rise of private equity and hedge funds? Offshore. Enron? Parmalat? Long Term Capital Management? Lehman Brothers? AIG? Offshore. Multinational corporations could never have grown so vast and powerful without the tax havens. Goldman Sachs is very, very much a creature of offshore. And every significant financial crisis in the world since the 1970s, including, as noted, the latest global economic crisis, is very much an offshore story. The decline of manufacturing industries in many advanced countries has many causes, but offshore is a big part of the story.

“A large part of the growth in OTC trading of derivative instruments may have involved offshore banks,” the IMF said.37 “The interbank nature of the offshore market implies that, in the event of financial distress, contagion is likely…. Offshore banks are likely to be highly leveraged, that is less solvent, than onshore banks.” The report, which contains plenty more along these lines, frets especially about lax offshore regulation. It was a direct warning, long before the crisis struck. That report followed soon after the implosion of the hedge fund Long Term Capital Management (LTCM), a classic slice-and-dice offshore structure that nearly destroyed the U.S. banking system in 1998 after the fund took on massive risks, covered by near-paranoid secrecy. LTCM’s managers were in Greenwich, Connecticut; the hedge fund was incorporated in Delaware; and the fund it managed was in the Cayman Islands. Yet none of the agonized analyses that followed took any serious interest in the offshore angle.38 And the pattern just keeps being repeated.

When nobody can find out what a company’s true financial position is until after the money has evaporated, trickery and bamboozlement abound. Financial markets seized up in 2007 because nobody knew, or trusted, what the other players in the market were doing, or what they were worth, or what or where their risks were. It is no coincidence that so many of those involved in great financial trickery, like Enron, or the empire of the fraudster Bernie Madoff, or Sir Allen Stanford’s Stanford Bank, or Long Term Capital Management, or Lehman Brothers, or AIG, were so thoroughly entrenched offshore. The secrecy jurisdictions specialize in bamboozlement. Along with the secrecy, and a curmudgeonly reluctance to co-operate with foreign jurisdictions, the offshore system provides endless incentives for corporations—especially financial ones—to festoon their affairs across jurisdictions, usually a complex mix of onshore and offshore, to fox the regulators.


pages: 823 words: 206,070

The Making of Global Capitalism by Leo Panitch, Sam Gindin

accounting loophole / creative accounting, active measures, airline deregulation, anti-communist, Asian financial crisis, asset-backed security, bank run, banking crisis, barriers to entry, Basel III, Big bang: deregulation of the City of London, bilateral investment treaty, Branko Milanovic, Bretton Woods, BRICs, British Empire, business cycle, call centre, capital controls, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, central bank independence, collective bargaining, continuous integration, corporate governance, creative destruction, Credit Default Swap, crony capitalism, currency manipulation / currency intervention, currency peg, dark matter, Deng Xiaoping, disintermediation, ending welfare as we know it, eurozone crisis, facts on the ground, financial deregulation, financial innovation, Financial Instability Hypothesis, financial intermediation, floating exchange rates, full employment, Gini coefficient, global value chain, guest worker program, Hyman Minsky, imperial preference, income inequality, inflation targeting, interchangeable parts, interest rate swap, Kenneth Rogoff, Kickstarter, land reform, late capitalism, liberal capitalism, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, manufacturing employment, market bubble, market fundamentalism, Martin Wolf, means of production, money market fund, money: store of value / unit of account / medium of exchange, Monroe Doctrine, moral hazard, mortgage debt, mortgage tax deduction, Myron Scholes, new economy, non-tariff barriers, Northern Rock, oil shock, precariat, price stability, quantitative easing, Ralph Nader, RAND corporation, regulatory arbitrage, reserve currency, risk tolerance, Ronald Reagan, seigniorage, shareholder value, short selling, Silicon Valley, sovereign wealth fund, special drawing rights, special economic zone, structural adjustment programs, The Chicago School, The Great Moderation, the payments system, The Wealth of Nations by Adam Smith, too big to fail, trade liberalization, transcontinental railway, trickle-down economics, union organizing, very high income, Washington Consensus, Works Progress Administration, zero-coupon bond, zero-sum game

But the depth of the contagion had already been registered on Wall Street, as a massive flight to the safety of US Treasury bonds after the Russian default precipitated a sharp upward revaluation of risk in bond and foreign-exchange markets, and in the derivative markets based on them. With the US commercial paper market in corporate debt already in turmoil, word quickly got out that the formerly remarkably profitable US hedge fund Long Term Capital Management (founded by two prestigious economists who had won Nobel prizes for their econometric contributions to the development of derivative markets) suddenly faced collapse. With the massive losses LTCM took on the $125 billion portfolio of securities it had amassed with money borrowed from many of Wall Street’s biggest banks, its default on a trillion dollars in over-the-counter derivatives contracts appeared imminent.77 Since it could not be known who would be left holding the bag if all the counterparties tried to liquidate their positions with LTCM, “this was a classic set up for a run: losses were likely, but nobody knew who would get burned.”78 Reflecting the concern that credit markets generally might freeze up, Wall Street’s leading CEOs were once again summoned to William McDonough’s office at the New York Federal Reserve.

Morgan’s ability to summon fellow bankers to his library and insist that “people who normally spend their lives trying to out-compete each other” look at the broader picture. There “simply was no other substitute for the New York Fed” in the crisis: The head of a securities firm or a bank is not paid to be a patriot; he or she is paid to serve the best interests of the shareholders, so the most that one could do in a position like mine is to say the public interest may well be served by Long Term Capital Management not failing . . . Now if somebody has had many years of experience like me, the people you’re talking to at least think, well, this guy knows what he is talking about; he’s been through some of these firefights himself, and so we’re not dealing with somebody who doesn’t understand how we think or what we can do.79 With the political implications of bailing out a private hedge fund ruling out public funds being brought into play in this instance (as they very much had been in the Korean bailout less than nine months earlier), and with the pressure on them from the Fed by most accounts rather heavier than McDonough suggests, fourteen of Wall Street’s leading financial institutions agreed to organize a creditors’ consortium to take over LCTM and the responsibility to meet its obligations.

The US Federal Reserve was indeed acting as the world central bank in the context of the crisis, trying to ensure thereby that interbank rates would decrease and normal mechanisms for access to dollar funding would be restored. For its part, the US Treasury organized, first, a consortium of international banks and investment funds, and then an overlapping consortium that included mortgage companies and financial securitizers, to take concrete measures to calm the markets. As they had done a decade earlier during the Long Term Capital Management (LTCM) crisis, Treasury officials convened the CEOs of the nation’s ten largest commercial banks in September 2007, with the goal of determining whether there were “market-based solutions that could help reduce the possibility of a disorderly solution in the marketplace.”37 Sovereign wealth funds of other countries were also encouraged to invest directly in Wall Street banks to beef up their capital.


pages: 145 words: 43,599

Hawai'I Becalmed: Economic Lessons of the 1990s by Christopher Grandy

Bretton Woods, business climate, business cycle, dark matter, endogenous growth, inventory management, Jones Act, Long Term Capital Management, market bubble, Maui Hawaii, minimum wage unemployment, open economy, purchasing power parity, Silicon Valley, Telecommunications Act of 1996

The declining yen meant that Japanese purchasing power in Hawai‘i weakened further. By July 1997, when the Thai baht collapsed, the Fed’s maximum target for the U.S. federal funds rate (the rate at which banks lend to each other) stood at 5.5%, having been raised a quarter of a percentage point in March. The Fed held to the 5.5% rate for 13 more months. Then, in September 1998, following the collapse of Long-Term Capital Management, a prominent U.S. hedge fund, the Fed lowered the target rate by a quarter point. The Fed continued lowering the rate in quarter-point increments for the next two months until the federal funds target stood at 4.75% in November. This action probably contributed to the continued expansion of the stock market, consumption, and the U.S. economy. To some degree, the Fed’s actions bolstered the Asian economies as the United States served as importer of last resort.

., 8n. 1 Keynesian fiscal policy, 27, 36–37, 38, 39, 44n. 5 King, Charles, 65 Koki, Stan, 82, 84 Krueger, Alan, 98 Krugman, Paul, 30–31, 33n. 18 Kuwait, 23 La Croix, Sumner, ix, x Laffer curve, 26 Land Use Commission. See LUC land use regulation, 1, 4, 18, 48, 51–52, 79, 104, 105 Laney, Leroy, 43 Leppert, Thomas, 66 lessons of 1990s, 7, 101, 104, 108–110 Lingle, Linda, 5, 77, 79–81, 82, 84–85, 106, 119–122 Long-Term Capital Management, 74 Loui, Patricia, 65 low-income tax credit, 67, 99, 115 LUC (Land Use Commission), 18, 51, 52, 58n. 13, 67, 70, 116 Lucas, Robert, 102n. 8 mainland economy, 30, 34, 56, 74, 82, 91, 96, 99; recession, 3, 6, 23, 26–30, 33n. 17, 36, 105, 112–113; unemployment, 26, 30, 41, 56, 99 Mak, James, ix, x, 53, 54 Malaysia, 33n. 18, 71, 72, 73, 93 Malcolm, Donald, 65 maritime regulation, 48, 50–51, 79, 105, 111 mass transit.


pages: 185 words: 43,609

Zero to One: Notes on Startups, or How to Build the Future by Peter Thiel, Blake Masters

Airbnb, Albert Einstein, Andrew Wiles, Andy Kessler, Berlin Wall, cleantech, cloud computing, crony capitalism, discounted cash flows, diversified portfolio, don't be evil, Elon Musk, eurozone crisis, income inequality, Jeff Bezos, Lean Startup, life extension, lone genius, Long Term Capital Management, Lyft, Marc Andreessen, Mark Zuckerberg, minimum viable product, Nate Silver, Network effects, new economy, paypal mafia, Peter Thiel, pets.com, profit motive, Ralph Waldo Emerson, Ray Kurzweil, self-driving car, shareholder value, Silicon Valley, Silicon Valley startup, Singularitarianism, software is eating the world, Steve Jobs, strong AI, Ted Kaczynski, Tesla Model S, uber lyft, Vilfredo Pareto, working poor

Crony capitalism and massive foreign debt brought the Thai, Indonesian, and South Korean economies to their knees. The ruble crisis followed in August ’98 when Russia, hamstrung by chronic fiscal deficits, devalued its currency and defaulted on its debt. American investors grew nervous about a nation with 10,000 nukes and no money; the Dow Jones Industrial Average plunged more than 10% in a matter of days. People were right to worry. The ruble crisis set off a chain reaction that brought down Long-Term Capital Management, a highly leveraged U.S. hedge fund. LTCM managed to lose $4.6 billion in the latter half of 1998, and still had over $100 billion in liabilities when the Fed intervened with a massive bailout and slashed interest rates in order to prevent systemic disaster. Europe wasn’t doing that much better. The euro launched in January 1999 to great skepticism and apathy. It rose to $1.19 on its first day of trading but sank to $0.83 within two years.

Jobs, Steve, 5.1, 5.2, 6.1, 6.2, 14.1 Jones, Jim Joplin, Janis justice Justice Department, U.S. Kaczynski, Ted Karim, Jawed Karp, Alex, 11.1, 12.1 Kasparov, Garry Katrina, Hurricane Kennedy, Anthony Kesey, Ken Kessler, Andy Kurzweil, Ray last mover, 11.1, 13.1 last mover advantage lean startup, 2.1, 6.1, 6.2 Levchin, Max, 4.1, 10.1, 12.1, 14.1 Levie, Aaron lifespan life tables LinkedIn, 5.1, 10.1, 12.1 Loiseau, Bernard Long-Term Capital Management (LTCM) Lord of the Rings (Tolkien) luck, 6.1, 6.2, 6.3, 6.4 Lucretius Lyft MacBook machine learning Madison, James Madrigal, Alexis Manhattan Project Manson, Charles manufacturing marginal cost marketing Marx, Karl, 4.1, 6.1, 6.2, 6.3 Masters, Blake, prf.1, 11.1 Mayer, Marissa Medicare Mercedes-Benz MiaSolé, 13.1, 13.2 Michelin Microsoft, 3.1, 3.2, 3.3, 4.1, 5.1, 14.1 mobile computing mobile credit card readers Mogadishu monopoly, monopolies, 3.1, 3.2, 3.3, 5.1, 7.1, 8.1 building of characteristics of in cleantech creative dynamism of new lies of profits of progress and sales and of Tesla Morrison, Jim Mosaic browser music recording industry Musk, Elon, 4.1, 6.1, 11.1, 13.1, 13.2, 13.3 Napster, 5.1, 14.1 NASA, 6.1, 11.1 NASDAQ, 2.1, 13.1 National Security Agency (NSA) natural gas natural secrets Navigator browser Netflix Netscape NetSecure network effects, 5.1, 5.2 New Economy, 2.1, 2.2 New York Times, 13.1, 14.1 New York Times Nietzsche, Friedrich Nokia nonprofits, 13.1, 13.2 Nosek, Luke, 9.1, 14.1 Nozick, Robert nutrition Oedipus, 14.1, 14.2 OfficeJet OmniBook online pet store market Oracle Outliers (Gladwell) ownership Packard, Dave Page, Larry Palantir, prf.1, 7.1, 10.1, 11.1, 12.1 PalmPilots, 2.1, 5.1, 11.1 Pan, Yu Panama Canal Pareto, Vilfredo Pareto principle Parker, Sean, 5.1, 14.1 Part-time employees patents path dependence PayPal, prf.1, 2.1, 3.1, 4.1, 4.2, 4.3, 5.1, 5.2, 5.3, 8.1, 9.1, 9.2, 10.1, 10.2, 10.3, 10.4, 11.1, 11.2, 12.1, 12.2, 14.1 founders of, 14.1 future cash flows of investors in “PayPal Mafia” PCs Pearce, Dave penicillin perfect competition, 3.1, 3.2 equilibrium of Perkins, Tom perk war Perot, Ross, 2.1, 12.1, 12.2 pessimism Petopia.com Pets.com, 4.1, 4.2 PetStore.com pharmaceutical companies philanthropy philosophy, indefinite physics planning, 2.1, 6.1, 6.2 progress without Plato politics, 6.1, 11.1 indefinite polling pollsters pollution portfolio, diversified possession power law, 7.1, 7.2, 7.3 of distribution of venture capital Power Sellers (eBay) Presley, Elvis Priceline.com Prince Procter & Gamble profits, 2.1, 3.1, 3.2, 3.3 progress, 6.1, 6.2 future of without planning proprietary technology, 5.1, 5.2, 13.1 public opinion public relations Pythagoras Q-Cells Rand, Ayn Rawls, John, 6.1, 6.2 Reber, John recession, of mid-1990 recruiting, 10.1, 12.1 recurrent collapse, bm1.1, bm1.2 renewable energy industrial index research and development resources, 12.1, bm1.1 restaurants, 3.1, 3.2, 5.1 risk risk aversion Romeo and Juliet (Shakespeare) Romulus and Remus Roosevelt, Theodore Royal Society Russia Sacks, David sales, 2.1, 11.1, 13.1 complex as hidden to non-customers personal Sandberg, Sheryl San Francisco Bay Area savings scale, economies of Scalia, Antonin scaling up scapegoats Schmidt, Eric search engines, prf.1, 3.1, 5.1 secrets, 8.1, 13.1 about people case for finding of looking for using self-driving cars service businesses service economy Shakespeare, William, 4.1, 7.1 Shark Tank Sharma, Suvi Shatner, William Siebel, Tom Siebel Systems Silicon Valley, 1.1, 2.1, 2.2, 2.3, 5.1, 5.2, 6.1, 7.1, 10.1, 11.1 Silver, Nate Simmons, Russel, 10.1, 14.1 singularity smartphones, 1.1, 12.1 social entrepreneurship Social Network, The social networks, prf.1, 5.1 Social Security software engineers software startups, 5.1, 6.1 solar energy, 13.1, 13.2, 13.3, 13.4 Solaria Solyndra, 13.1, 13.2, 13.3, 13.4, 13.5 South Korea space shuttle SpaceX, prf.1, 10.1, 11.1 Spears, Britney SpectraWatt, 13.1, 13.2 Spencer, Herbert, 6.1, 6.2 Square, 4.1, 6.1 Stanford Sleep Clinic startups, prf.1, 1.1, 5.1, 6.1, 6.2, 7.1 assigning responsibilities in cash flow at as cults disruption by during dot-com mania economies of scale and foundations of founder’s paradox in lessons of dot-com mania for power law in public relations in sales and staff of target market for uniform of venture capital and steam engine Stoppelman, Jeremy string theory strong AI substitution, complementarity vs.


pages: 302 words: 84,428

Mastering the Market Cycle: Getting the Odds on Your Side by Howard Marks

activist fund / activist shareholder / activist investor, Albert Einstein, business cycle, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, financial innovation, fixed income, if you build it, they will come, income inequality, Isaac Newton, job automation, Long Term Capital Management, margin call, money market fund, moral hazard, new economy, profit motive, quantitative easing, race to the bottom, Richard Feynman, Richard Thaler, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, secular stagnation, short selling, South Sea Bubble, stocks for the long run, superstar cities, The Chicago School, The Great Moderation, transaction costs, VA Linux, Y2K, yield curve

Eventually, something will intrude, exposing securities’ imperfections and too-high prices. Prices will decline. Investors will like them less at $60 than they did at $100. Fear of losing the remaining $60 will overtake the urge to make back the lost $40. Risk aversion eventually will reassert itself (and usually go to excess). How about some quantification of this cycle? In mid-1998, just before the collapse of Long-Term Capital Management brought investors other than techies to their senses, only $12.5 billion of non-defaulted bonds yielded more than 20% (one possible threshold for the label “distressed debt”). Because investors weren’t very worried about risk, they demanded ultra-high returns from relatively few non-defaulted bonds; the word “blithe” might best describe their attitude. But Long-Term’s demise awakened investors to the existence of risk, and a year later, the amount of bonds yielding more than 20% had more than tripled to $38.7 billion.

Timing and extent are never predictable, but the occurrence of cycles is the closest thing I know to inevitable. (“The Race to the Bottom,” February 2007) The Impact of the Credit Cycle One of the main points in this book is the extent to which events within one cycle have influence in other fields and on other kinds of cycles. Nowhere is this clearer than in the credit cycle. In “Genius Isn’t Enough” on the subject of Long-Term Capital Management (October 1998), I wrote “Look around the next time there’s a crisis; you’ll probably find a lender.” Over-permissive providers of capital frequently aid and abet financial bubbles. There have been numerous recent examples where loose capital markets contributed to booms that were followed by famous collapses: real estate in 1989–92; emerging markets in 1994–98; Long-Term Capital in 1998; the movie exhibition industry in 1999–2000; venture capital funds and telecommunications companies in 2000–01.

See Global Financial Crisis of 2007–08 Crutchley, John- Paul, 124 cycles, 3 causation and progression, 30–32, 283, 297–98 cessation of, 178, 180, 285–88, 290 cycle of success, 270–71 definitions of, 40–41 elements of, 18–19, 25–27, 208–10 excess and corrections, 29, 85–86, 293, 299, 307–9 interaction of, 32–33, 167, 186–89, 199–201 listening to, 3–5, 309 major cycles, 267 midpoint and aberrations, 24–29, 266, 296–97 regularity and irregularity, 40–42, 172, 217, 244–45 timing and extent, 24, 39, 145, 282, 295–96 understanding, 17, 22–24, 118, 239, 314–15 See also credit cycle “Death of Equities, The,” 49, 277–78 D Demosthenes, 222, 227, 284 Dimson, Elroy, 13–14, 239 distressed debt investments, 161–62 credit crunch and, 164–66 role of high yield bonds, 163–64 understanding opportunities, 163, 166–67, 241–42, 282 Dow 36,000 (Glassman & Hassett), 219 Dowd, Timothy, 255 Drexel Burnham, 165 Drunkard’s Walk, The (Mlodinow), 42 E economic cycles, 46–47, 64–66, 167 long and short term, 29–30 repetition and fluctuation, 24–25, 97, 135 short-term, 47, 58, 61 economic forecasts, 61–63, 208 Economics and Portfolio Strategy, 13 Economist, The, 141 Eichholtz, Piet, 182 Einstein, Albert, 36 Ellis, Charlie, 5 emotion/psychology, 3, 31, 34, 37, 167 “bubble” and “crash,” 196–98 contrarianism, 133, 135, 142, 234, 244, 301–4 credulousness and skepticism, 90–91, 133, 227 definition of insanity, 36 effect on economic cycles, 83–86, 97–99, 211, 228, 289–92, 298–299 emotionalism or objectivity, 95–96 euphoria and depression, 89, 94, 99, 125, 211, 222, 305, 312 extremes, 113–16, 265 fear, effect on consumption, 59 fear and/or greed, 87–89, 92–93, 114, 221–22, 233–35, 303 humility and confidence, 271–73 investment psychology, 40–42, 93–94, 186–88, 190–91, 214–15, 244 optimism and pessimism, 89–90, 133, 299–301, 302–3 “silver bullet,” 227 F falling knives, 8, 156, 202, 235–36 Federal Reserve Bank, 68, 119, 180, 231 Feynman, Richard, 289 Financial Times, 122, 124 Frank, Barney, 151 Friedman, Milton, 62 fundamentals, 185–87, 189, 209 valuation metrics, 211 future prediction macro prediction, 10 opinions and likelihood, 15, 102, 208, 263–65 qualitative awareness, 214–15 South Sea Bubble, 195–96 G Galbraith, John Kenneth, 5, 34, 63, 125, 178–79, 222 Geithner, Timothy, 155, 239, 287 Glass-Steagall Act, 120, 128 Global Financial Crisis of 2007–08, 36, 59, 119–22, 127–32, 147–57, 180, 233 bear market stages, 193–94 effect on real estate market, 177 lessons from, 239–40 Treasury guarantee of commercial paper, 139–40, 155, 233 Goldman, William, 43 Goldman Sachs, 155 government deficits and national debt, 71–73 economic management tools, 71–73 Graduate School of Business, University of Chicago, 103 Graham, Ben, 189 Greenblatt, Joel, 5 Greenspan, Alan, 217 gross domestic product (GDP) consumption, 59–60 definition of, 47 recession (negative growth), 48 See also productivity H high yield bonds, 44, 106, 108, 131–32, 157, 281–82 history and memory, 34, 42, 178 Arab oil embargo, 292 blue chips or small-capitalization, 274 brevity of, 222 convertible arbitrage, 275 growth and tech stocks, 274 mortgage defaults, 229 one house in Amsterdam, 181–82 permanent prosperity, 288–89 poor performance of stocks, 276–77 projections of the future, 286–87, 311–12 History of the Peloponnesian War (Thucydides), 37–38 Hoover, Herbert, 287 I intrinsic value, 11, 92, 133, 194, 200, 205 when to buy, 237 investing aggressive or defensive, 248, 250–53, 259–60, 295 asset selection, 248, 255–59 bargains or popularity, 273–78 capitulation, 34–35, 194–95 cycle positioning, 248, 250, 252, 254–55, 312–14 definition of, 101–2, 262 fluctuation in, 186–87 growth stocks, 197–98 long or short securities sales, 8 market cycle, return, 204–6 overpayment, 144, 169, 179 philosophy, 4–5, 197, 207 security analysis and value investing, 11 skill or luck, 249, 253–54, 258–59, 272–73 “weighing machine,” 189 See also fundamentals; psychology investment indices, 232t, 238t “it’s different this time,” 37, 197–99 J Jain, Ajit, 5, 276 Janjigian, Jahan, 280 junk bonds. See high yield bonds K Karsh, Bruce, 6, 161, 231, 235, 282 Kass, Doug, 5 Kaufman, Henry, 273 Kaufman, Peter, 5, 271 Keele, Larry, 6 Keynes, John Maynard, 72, 240–41 Klarman, Seth, 5 L Lehman Brothers bankruptcy, 59, 129, 154–55, 233, 235, 237 listen, definition, 3–4 Lombardi, Vince, 1 long term trends, 48–51, 63–64 Long-Term Capital Management, 117, 146 M market assessment guide to, 212–14 qualitative awareness, 216 valuation, 215, 220 market bottoms definition of, 235–37 identifying, 242, 308–9 market efficiency, 110 Marks, Howard—memos “bubble.com,” 220 “Ditto,” 171 “Everyone Knows,” 100 “First Quarter Performance,” 83 “Genius Isn’t Enough,” 146 “Happy Medium, The,” 86–87, 90–91, 116–17, 147 “It Is What It Is,” 212 “It’s All Good,” 84 “Limits to Negativism, The,” 128–29, 133, 233–34 “Long View, The,” 29–30, 48 Most Important Thing, The, 1–2, 5, 7, 23, 39, 134, 208, 212–14, 290–92 “Now It’s All Bad?”


pages: 318 words: 85,824

A Brief History of Neoliberalism by David Harvey

affirmative action, Asian financial crisis, Berlin Wall, Bretton Woods, business climate, business cycle, capital controls, centre right, collective bargaining, creative destruction, crony capitalism, debt deflation, declining real wages, deglobalization, deindustrialization, Deng Xiaoping, Fall of the Berlin Wall, financial deregulation, financial intermediation, financial repression, full employment, George Gilder, Gini coefficient, global reserve currency, illegal immigration, income inequality, informal economy, labour market flexibility, land tenure, late capitalism, Long Term Capital Management, low-wage service sector, manufacturing employment, market fundamentalism, mass immigration, means of production, Mexican peso crisis / tequila crisis, Mont Pelerin Society, mortgage tax deduction, neoliberal agenda, new economy, Pearl River Delta, phenotype, Ponzi scheme, price mechanism, race to the bottom, rent-seeking, reserve currency, Ronald Reagan, Silicon Valley, special economic zone, structural adjustment programs, the built environment, The Chicago School, transaction costs, union organizing, urban renewal, urban sprawl, Washington Consensus, Winter of Discontent

The state has to step in and replace ‘bad’ money with its own supposedly ‘good’ money—which explains the pressure on central bankers to maintain confidence in the soundness of state money. State power has often been used to bail out companies or avert financial failures, such as the US savings and loans crisis of 1987–8, which cost US taxpayers an estimated $150 billion, or the collapse of the hedge fund Long Term Capital Management in 1997–8, which cost $3.5 billion. Internationally, the core neoliberal states gave the IMF and the World Bank full authority in 1982 to negotiate debt relief, which meant in effect to protect the world’s main financial institutions from the threat of default. The IMF in effect covers, to the best of its ability, exposures to risk and uncertainty in international financial markets.

The second and much broader wave of financial crises began in Thailand in 1997 with the devaluation of the baht in the wake of the collapse of a speculative property market. The crisis first spread to Indonesia, Malaysia, and the Philippines, and then to Hong Kong, Taiwan, Singapore, and South Korea. Estonia and Russia were then hit hard, and shortly afterwards Brazil fell apart, with serious and long-lasting consequences for Argentina. Even Australia, New Zealand, and Turkey were affected. Only the US seemed immune, although even there a hedge fund, Long Term Capital Management (with two Nobel prizewinning economists as key advisers), which had bet the wrong way on Italian currency movements, had to be bailed out to the tune of $3.5 billion. The whole ‘East Asian regime’ of accumulation facilitated by ‘developmental states’ was being put to the test in 1997–8. The social effects were devastating: As the crisis progressed, unemployment soared, GDP plummeted, banks closed.

The stock market crash of 1987 deleted nearly 30 per cent of asset values, and at the trough of the crash that followed the bursting of the new economy bubble in the late 1990s more that $8 trillion in paper assets was lost, before the recovery to former levels. The bank and savings and loan failures of 1987 cost nearly $200 billion to remedy, and in that year matters became so bad that William Isaacs, chairman of the Federal Deposit Insurance Corporation, warned that ‘the US may be headed towards the nationalization of banking’. And the huge bankruptcies of Long Term Capital Management, Orange County, and others who speculated and lost, followed by the collapse of several major companies in 2001–2 in the midst of astonishing accounting lapses, not only cost the public dear but also demonstrated how fragile and fictitious much of neoliberal financialization has become. The fragility is by no means confined to the US, of course. Most countries, including China, face financial volatility and uncertainty.


pages: 413 words: 117,782

What Happened to Goldman Sachs: An Insider's Story of Organizational Drift and Its Unintended Consequences by Steven G. Mandis

activist fund / activist shareholder / activist investor, algorithmic trading, Berlin Wall, bonus culture, BRICs, business process, buy and hold, collapse of Lehman Brothers, collateralized debt obligation, commoditize, complexity theory, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, disintermediation, diversification, Emanuel Derman, financial innovation, fixed income, friendly fire, Goldman Sachs: Vampire Squid, high net worth, housing crisis, London Whale, Long Term Capital Management, merger arbitrage, Myron Scholes, new economy, passive investing, performance metric, risk tolerance, Ronald Reagan, Saturday Night Live, Satyajit Das, shareholder value, short selling, sovereign wealth fund, The Nature of the Firm, too big to fail, value at risk

But first with the transition to LLC and then with an IPO, they would be freed from this liability, which a number feared would lead to a stronger appetite for growth and risk and would quicken change. They had already seen evidence of greater risk-taking even before the IPO. In my interviews, many of the partners pointed to their personal liability as having been a constraining factor on “doing stupid things.” Some pointed to the risk Goldman took in bailing out the hedge fund Long-Term Capital Management (LTCM) in 1998 as an early case of taking on more risk than the firm had traditionally been comfortable with. LTCM was a speculative hedge fund that used a lot of leverage and faced failure that year. As LTCM teetered, Wall Street feared that its failure could have a ripple effect and cause catastrophic losses throughout the financial system. Unable to raise more money on its own, LTCM had its back against the wall.

One report quotes Robert Khuzami, the SEC’s enforcement director, as saying, “[H]igher-risk trading and business strategies require higher-order controls” and that “Goldman failed to implement policies and procedures that adequately controlled the risk that research analysts could preview upcoming ratings changes with select traders and clients.” Goldman agreed to pay the penalty, split between the SEC and FINRA, and to revise its policies.9 There are older examples as well. One is of allegations that Goldman mishandled information related to the Long-Term Capital Management (LTCM) books when Goldman was analyzing how it could potentially bail out LTCM in 1998. Roger Lowenstein writes in his account of the collapse of LTCM, When Genius Failed: In Greenwich, Goldman’s sleuths, who had the run of the office, left no stone unturned … A key member of the Goldman team … [who] appeared to be downloading Long-Term’s positions, which the fund had so zealously guarded, from Long-Term’s own computers directly into an oversized laptop (a detail that Goldman later denied).

At the time of its acquisition, CC had approximately $2 billion in assets under management, primarily as a fund of hedge funds: a fund investing in a variety of hedge funds to diversify risk. It was part of GSAM’s continued push into higher-margin, more-sophisticated products for its clients. The firm merges J. Aron with fixed income to create the division known as FICC, to be run by Blankfein (O, C). 1998: Long-Term Capital Management (LTCM), a hedge fund, is about to fail. Wall Street fears that LTCM is so big that its failure would cause a chain reaction in numerous markets, causing significant losses throughout the financial system. Goldman, AIG, and Berkshire Hathaway offer to buy out the fund’s partners for $250 million, to inject $3.75 billion, and to operate LTCM within Goldman’s own trading division. Many of the partners worry about the risk they would assume (O).


pages: 316 words: 117,228

The Code of Capital: How the Law Creates Wealth and Inequality by Katharina Pistor

"Robert Solow", Andrei Shleifer, Asian financial crisis, asset-backed security, barriers to entry, Bernie Madoff, bilateral investment treaty, bitcoin, blockchain, Bretton Woods, business cycle, business process, Capital in the Twenty-First Century by Thomas Piketty, Carmen Reinhart, central bank independence, collateralized debt obligation, colonial rule, conceptual framework, Corn Laws, corporate governance, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, cryptocurrency, Donald Trump, double helix, Edward Glaeser, Ethereum, ethereum blockchain, facts on the ground, financial innovation, financial intermediation, fixed income, Francis Fukuyama: the end of history, full employment, global reserve currency, Hernando de Soto, income inequality, intangible asset, investor state dispute settlement, invisible hand, joint-stock company, joint-stock limited liability company, Joseph Schumpeter, Kenneth Rogoff, land reform, land tenure, London Interbank Offered Rate, Long Term Capital Management, means of production, money market fund, moral hazard, offshore financial centre, phenotype, Ponzi scheme, price mechanism, price stability, profit maximization, railway mania, regulatory arbitrage, reserve currency, Ronald Coase, Satoshi Nakamoto, secular stagnation, self-driving car, shareholder value, Silicon Valley, smart contracts, software patent, sovereign wealth fund, The Nature of the Firm, The Wealth of Nations by Adam Smith, Thorstein Veblen, time value of money, too big to fail, trade route, transaction costs, Wolfgang Streeck

Nonetheless, a few creditors realized that they had to do more to protect themselves and included provisions in their contracts with a subsidiary that disallowed the ploughing back of all profit to the parent.36 Had all creditors done so, the great Lehman family gamble never would have taken off. Last, but not least, some creditors may have bet that the government would not allow Lehman to fail. Few governments have the stomach to allow big banks or highly interdependent financial intermediaries to fail, unless they are pushed to do so by outsiders, such as the International Monetary Fund on which these governments depend for their own survival. When Long Term Capital Management, the hedge fund that boasted several Nobel Prize laureates among its founders and managers, tumbled in 1998, for example, the US Federal Reserve organized a private bailout; and in March 2008, the New York Fed provided a substantial dowry when Bear Stearns was forced into a shotgun marriage with JP Morgan Chase. As a wedding present, the Fed lent $30 billion to Chase to purchase Bear Stearns and waived the obligation to pay back these loans should Bear Stearns’s own assets prove to be insufficient.37 In Lehman’s case, the calculus that the Fed would always stand by as the rescuer of last resort for large financial intermediaries did not work out.

In nineteenth-century France, the Péreire brothers created a new type of financial intermediary, the Crédit Mobilier. They hoped to realize their dream of “banking without money.”58 More than a century later, Robert Merton, co-recipient of the 1997 Nobel Memorial Prize in Economic Science for his contribution to Option Pricing Theory, lived out a similar dream about “returns without investments,” by co-founding the hedge fund Long-Term Capital Management (LTCM).59 It is not without irony that the Péreire brothers, who were followers of the socialist spiritual movement known as Saint-Simonianism, and a contemporary economist who is deeply versed in the art of mathematic modeling financial assets, sought to realize the same dream. Sadly, for them and for the rest of us, not many dreams come true. The Péreire brothers’ claim to fame is their invention of banking based on continuous refinancing of outstanding debt.60 The Crédit Mobilier was established in 1852 after intense lobbying to obtain the necessary banking license.61 The bank was organized as a joint stock company.

For a new, illuminating account of the Euro crisis in the context of the global financial crisis, see Adam Tooze, Crashed: How a Decade of Financial Crises Changed the World (New York: Viking, 2018), Part III, pp. 319ff. 67. A detailed history of the evolution of option pricing theory can be found in Donald MacKenzie, An Engine, Not a Camera: How Financial Models Shape Markets (Cambridge, MA: MIT Press, 2006). 68. Franklin R. Edwards, “Hedge-Funds and the Collapse of Long Term Capital Management,” Journal of Economic Perspectives 13, no. 2 (1999):189–210, p. 199. 69. Perry Mehrling, “Minsky and Modern Finance: The Case of LongTerm Capital Management,” Journal of Portfolio Management Winter 2000 (2000):81–89. 70. The banks involved in the rescue included Goldman Sachs, Merrill Lynch, J. P. Morgan, Morgan Stanley, Dean Witter, the Travelers Group, Union Bank of Switzerland, Barclays, Bankers Trust, Chase Manhattan, Credit Suisse First Boston, Deutsche Bank, Lehman Brothers, Paribas, and Société Générale.


pages: 726 words: 172,988

The Bankers' New Clothes: What's Wrong With Banking and What to Do About It by Anat Admati, Martin Hellwig

Andrei Shleifer, asset-backed security, bank run, banking crisis, Basel III, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, bonus culture, break the buck, business cycle, Carmen Reinhart, central bank independence, centralized clearinghouse, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, diversified portfolio, en.wikipedia.org, Exxon Valdez, financial deregulation, financial innovation, financial intermediation, fixed income, George Akerlof, Growth in a Time of Debt, income inequality, information asymmetry, invisible hand, Jean Tirole, joint-stock company, joint-stock limited liability company, Kenneth Rogoff, Larry Wall, light touch regulation, London Interbank Offered Rate, Long Term Capital Management, margin call, Martin Wolf, money market fund, moral hazard, mortgage debt, mortgage tax deduction, negative equity, Nick Leeson, Northern Rock, open economy, peer-to-peer lending, regulatory arbitrage, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, Satyajit Das, shareholder value, sovereign wealth fund, technology bubble, The Market for Lemons, the payments system, too big to fail, Upton Sinclair, Yogi Berra

See bank lending; bank loans; borrowing lobbying, bank, 192–207; on Basel III, 96, 97, 187, 194, 315n79; campaign contributions in, 203, 205, 324n46; on capital regulation, 96, 97, 99, 310n51; on Dodd-Frank Act, 3, 231n13, 326n60; effectiveness of, 3, 193–94, 213–14, 231n12, 324n46; fallacies in (See fallacies); after financial crisis of 2007–2009, 1; and home-team bias, 195, 205, 324n44, 326n59; “level playing field” rhetoric in, 194–99; liquidity narrative in, 330n12; reasons for success of, 2, 213–14; regulatory capture by, 194, 203–7; and revolving doors, 203, 204–5, 324n44, 325n56; in savings and loan crisis of 1980s, 55, 252n35; on single-counterparty credit limit proposal, 268n24; as source of funds for politicians, 193–94; spending on, 229n4, 324n46, 326n60; on Volcker Rule, 3, 231n10, 231n13, 270n34 London Economics, on covered-bond markets, 255n48 London interbank offered rate. See LIBOR Long Term Capital Management (LTCM), as systemically important financial institution, 72, 90, 219 long-term refinancing operations (LTRO), 138, 289n16 looting, of savings banks, 252n33 Lopez, Robert S., 250n16 LoPucki, Lynn, 245n12, 247n19 Lowenstein, Roger, 261n46, 262n53 low-income families, mortgages for, 323n38. See also subprime mortgage(s) Lown, Cara S., 249n15, 253n38 Lowrey, Annie, 327n66 LTCM. See Long Term Capital Management LTCM crisis of 1998, 72; bailout in, 72, 74, 90, 219; contagion in, 72, 258n20, 261n45; unanticipated risks in, 73 LTRO. See long-term refinancing operations Lustig, Hanno, 291n32, 291n34 Luxembourg, bank bailouts by, 237n38 lying, culture of, 328n5.

For example, large gambles involving complicated formulas and trading strategies were one reason that a small change in interest rates set by the Federal Reserve gave a large shock to the financial system in 1994; the size of the shock came as a surprise because most people were unaware how sensitive the positions of many derivatives investors were to the Federal Reserve’s policy.44 Another early example of this risk magnification was seen in the so-called LTCM crisis of 1998, named after the hedge fund Long Term Capital Management (LTCM). With $4.7 billion in equity and $125 billion in debt at the end of 1997, LTCM was a relatively small institution. However, when LTCM incurred large losses in 1998, the Federal Reserve was afraid that an LTCM bankruptcy might trigger a chain reaction, pushing other institutions into insolvency as well. LTCM had huge derivatives positions, and the fear that LTCM’s partners in these contracts might suffer greatly from an LTCM bankruptcy was exacerbated by significant legal uncertainty about the treatment of these con-tracts.45 Moreover, because investors were afraid of a major financial crisis, attempts to sell LTCM’s assets might have caused the prices of these assets to fall dramatically, with potentially disastrous effects on the many other institutions that had been following strategies similar to those of LTCM.

Banks choose this method if it allows them to worsen the position of senior creditors. In Chapter 11 we discuss how this form of “deleveraging” worked in Europe in the fall of 2011. 20. As we discuss later in the chapter, the fear of a systemic chain reaction associated with asset liquidations and price declines was also an important reason that in 1998 the Federal Reserve did not want the insolvent hedge fund Long Term Capital Management (LTCM) to be put into bankruptcy. A historical example of how liquidation sales in bankruptcy triggered contagion in a crisis is analyzed by Schnabel and Shin (2004). 21. This role of expectations in the developments of 2007–2008 is noted by BIS (2008). 22. See Reinhart and Rogoff (2009, Table A.3.1). Their Table A.4.1 gives a brief historical account of each crisis. The only two banking crises between 1940 and 1970 occurred in India following that country’s independence in 1947 and in Brazil in connection with a downturn of the Brazilian economy in 1963. 23.


pages: 159 words: 45,073

GDP: A Brief but Affectionate History by Diane Coyle

"Robert Solow", Asian financial crisis, Berlin Wall, big-box store, Bretton Woods, BRICs, business cycle, clean water, computer age, conceptual framework, crowdsourcing, Diane Coyle, double entry bookkeeping, en.wikipedia.org, endogenous growth, Erik Brynjolfsson, Fall of the Berlin Wall, falling living standards, financial intermediation, global supply chain, happiness index / gross national happiness, hedonic treadmill, income inequality, income per capita, informal economy, Johannes Kepler, John von Neumann, Kevin Kelly, Long Term Capital Management, mutually assured destruction, Nathan Meyer Rothschild: antibiotics, new economy, Occupy movement, purchasing power parity, Robert Shiller, Robert Shiller, Ronald Reagan, shareholder value, Silicon Valley, Simon Kuznets, The Wealth of Nations by Adam Smith, Thorstein Veblen, University of East Anglia, working-age population

On one side of the Atlantic, there was a good deal of agonizing among economic policymakers: computers were available for any business in any country to use, so why did the productivity benefits of the computer revolution appear to be confined to the United States? On the American side of the Atlantic, there was a sense of triumphalism about the superiority of the U.S. economy and its “New Paradigm,” with its Silicon Valley heroes and soaring stock market. Shocks like the 1995 Mexican near-default, the 1997–1998 Asian financial crisis and the collapse of Long Term Capital Management, and even the technology stock crash of 2001 and the horrors of 9/11 that year, were shrugged off after brief periods of crisis management. The economy appeared to be strong enough to weather anything, and GDP continued to expand for years to come, after a mild and brief downturn in 2001. The questions about GDP raised by the New Economy episode still stand. GDP has never measured service-sector activity well, and services have been growing constantly as a proportion of what we spend our money on.

See also production boundary Landes, David, 63 Layard, Richard, 112 legal traditions, 134 Leontief, Wassily, 29 Lewis, C. S., The Lion, the Witch and the Wardrobe, 112 life expectancy, 61, 74, 117 lighting, 86 The Limits to Growth, 60, 70 living standards: British, 46; in communist countries, 57, 67; in developing countries, 54; GDP as indicator of, 140; postwar Western, 62–63, 69; PPP and, 49–52 Long Term Capital Management, 90 Love Canal, 69 low-income countries. See developing/low-income countries Luxembourg, 25 luxury taxes, 112 MacArthur, Douglas, 71 Macmillan, Harold, 46 macroeconomics, 19–21, 23 Maddison, Angus, 11–12, 34, 79–80, 96 Mandel, Michael, 130 Mao Zedong, 67 Marshall, Alfred, 11, 12 Marshall, George, 18 Marshall Aid, 18–19, 42, 47, 57 Marx, Karl, 10 Material Product System, 47.


pages: 545 words: 137,789

How Markets Fail: The Logic of Economic Calamities by John Cassidy

"Robert Solow", Albert Einstein, Andrei Shleifer, anti-communist, asset allocation, asset-backed security, availability heuristic, bank run, banking crisis, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Black-Scholes formula, Blythe Masters, Bretton Woods, British Empire, business cycle, capital asset pricing model, centralized clearinghouse, collateralized debt obligation, Columbine, conceptual framework, Corn Laws, corporate raider, correlation coefficient, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, crony capitalism, Daniel Kahneman / Amos Tversky, debt deflation, different worldview, diversification, Elliott wave, Eugene Fama: efficient market hypothesis, financial deregulation, financial innovation, Financial Instability Hypothesis, financial intermediation, full employment, George Akerlof, global supply chain, Gunnar Myrdal, Haight Ashbury, hiring and firing, Hyman Minsky, income per capita, incomplete markets, index fund, information asymmetry, Intergovernmental Panel on Climate Change (IPCC), invisible hand, John Nash: game theory, John von Neumann, Joseph Schumpeter, Kenneth Arrow, Kickstarter, laissez-faire capitalism, Landlord’s Game, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, margin call, market bubble, market clearing, mental accounting, Mikhail Gorbachev, money market fund, Mont Pelerin Society, moral hazard, mortgage debt, Myron Scholes, Naomi Klein, negative equity, Network effects, Nick Leeson, Northern Rock, paradox of thrift, Pareto efficiency, Paul Samuelson, Ponzi scheme, price discrimination, price stability, principal–agent problem, profit maximization, quantitative trading / quantitative finance, race to the bottom, Ralph Nader, RAND corporation, random walk, Renaissance Technologies, rent control, Richard Thaler, risk tolerance, risk-adjusted returns, road to serfdom, Robert Shiller, Robert Shiller, Ronald Coase, Ronald Reagan, shareholder value, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical model, technology bubble, The Chicago School, The Great Moderation, The Market for Lemons, The Wealth of Nations by Adam Smith, too big to fail, transaction costs, unorthodox policies, value at risk, Vanguard fund, Vilfredo Pareto, wealth creators, zero-sum game

In 1994, Orange County was forced into bankruptcy after its treasurer, Bob Citron, took the county’s $7.6 billion investment pool, borrowed more money from Wall Street firms, and invested it in some derivative securities known as “inverse floaters.” A year later, the misplaced bets of a single derivatives trader, Nick Leeson, brought down the venerable Barings Bank. In 1998, the giant (and unregulated) hedge fund Long-Term Capital Management, which was a big player in many derivatives markets, had to be propped up and then wound down by a consortium of Wall Street banks, with the Fed playing a coordinating role. The demise of Long-Term Capital, which had two economics Nobel winners as partners—Robert Merton and Myron Scholes—demonstrated the limitations of counterparty regulation. When the secretive firm opened its books to its Wall Street lenders and counterparties, many of them were astonished to discover that its leverage ratio was close to thirty to one, and that its derivatives exposures totaled about $1.4 trillion.

VAR models take account of these offsetting effects. In estimating the worst-case losses of entire portfolios, or balance sheets, the models reward those that are widely diversified and punish those that are heavily invested in one or two assets. Unfortunately, during periods of great stress, the relationships between different asset classes tend to change dramatically. As the big hedge fund Long-Term Capital Management discovered to its cost during the international financial crisis of 1998, many assets that seem to have little or nothing in common suddenly move in the same direction. Prior to the blowup, for example, the correlation coefficient between certain bonds issued by the governments of the Philippines and Bulgaria was just 0.04: as the crisis unfolded, their correlation coefficient rose to 0.84.

With this sort of leverage, a mere 4 percent drop in the value of a firm’s assets can wipe out its entire capital base. Bear was the smallest of the top Wall Street banks, and its leading figures—such as its chairman, Jimmy Cayne, a championship bridge player, and its former CEO Alan “Ace” Greenberg, who at the age of eighty still came to work every day—had reputations as mavericks. In 1998, with Long-Term Capital Management on the brink of collapse, Bear had been the only Wall Street firm that refused to participate in the rescue. (As LTCM’s prime broker, it argued that it already had a big exposure to the firm.) In the period since 2000, Bear had established itself in the fast-growing hedge fund business, acting as the prime broker to dozens of funds, including some of the biggest. At the end of 2007, it had more than $60 billion in hedge fund deposits on its books, which it used to help pay for its own operations.


How I Became a Quant: Insights From 25 of Wall Street's Elite by Richard R. Lindsey, Barry Schachter

Albert Einstein, algorithmic trading, Andrew Wiles, Antoine Gombaud: Chevalier de Méré, asset allocation, asset-backed security, backtesting, bank run, banking crisis, Black-Scholes formula, Bonfire of the Vanities, Bretton Woods, Brownian motion, business cycle, business process, butter production in bangladesh, buy and hold, buy low sell high, capital asset pricing model, centre right, collateralized debt obligation, commoditize, computerized markets, corporate governance, correlation coefficient, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, currency manipulation / currency intervention, discounted cash flows, disintermediation, diversification, Donald Knuth, Edward Thorp, Emanuel Derman, en.wikipedia.org, Eugene Fama: efficient market hypothesis, financial innovation, fixed income, full employment, George Akerlof, Gordon Gekko, hiring and firing, implied volatility, index fund, interest rate derivative, interest rate swap, John von Neumann, linear programming, Loma Prieta earthquake, Long Term Capital Management, margin call, market friction, market microstructure, martingale, merger arbitrage, Myron Scholes, Nick Leeson, P = NP, pattern recognition, Paul Samuelson, pensions crisis, performance metric, prediction markets, profit maximization, purchasing power parity, quantitative trading / quantitative finance, QWERTY keyboard, RAND corporation, random walk, Ray Kurzweil, Richard Feynman, Richard Stallman, risk-adjusted returns, risk/return, shareholder value, Sharpe ratio, short selling, Silicon Valley, six sigma, sorting algorithm, statistical arbitrage, statistical model, stem cell, Steven Levy, stochastic process, systematic trading, technology bubble, The Great Moderation, the scientific method, too big to fail, trade route, transaction costs, transfer pricing, value at risk, volatility smile, Wiener process, yield curve, young professional

What they didn’t understand is the unwritten rule that overrides all the other rules: If you screw enough people, eventually they will get you back. Have people learned since then? No, as the recent Citibank European government bond debacle, complete with a juvenile name for the strategy (Dr. Evil), demonstrates. JWPR007-Lindsey May 7, 2007 17:9 Julian Shaw 241 But the most spectacular example of all is Long Term Capital Management. Here we had the two most famous living quants supposedly helping to run an enormous hedge fund, which got blown to pieces when credit spreads blew out. Jorion provides a devastating analysis of LTCM’s risk management mistakes.7 Incidentally, LTCM demonstrated an enduring belief, that there are lots of really smart people who could make tons of money if only they weren’t inhibited by pesky regulators, unimaginative boards, and overbearing risk-management departments.

My insight was later recognized in Pensions & Investments by Editorial Director Michael Clowes, who noted that I was “one of the first to warn that portfolio insurance . . . probably would be destabilizing” (“More to say about crash,” July 12, 1999), and in the Wall Street Journal, where Roger Lowenstein (“Why Stock Options Are Really Dynamite,” November 6, 1997) said that I had “predicted before the 1987 crash that portfolio insurance would trigger chain-reaction selling.” After the crash, I saw the same dynamics behind portfolio insurance roiling the markets over and over again in other guises, including synthetic put options and the relative value arbitrage strategies pursued by hedge funds such as Long-Term Capital Management (LTCM). Prior to the collapse of LTCM, I had expressed my concerns in two Pensions & Investments pieces (Barry Burr, “Nobel-Winning Strategy Criticized,” December 8, 1997, and Bruce Jacobs, “Option Replication and the Market’s Fragility,” June 15, 1998), taking issue with Nobel laureates Merton Miller and Myron Scholes (an LTCM partner). I last debated Rubinstein on the subject as a participant in Derivatives Strategy’s “2000 Hall of Fame Roundtable: Portfolio Insurance Revisited.”

Li, “On Default Correlation: A Copula Function Approach,” http://www.riskmetrics.com/copulaovv.html. 6. Some of this “higher correlation in extremes” is fallacious. Boyer, Gibson, and Loretan show that the correlation of big market moves will measure higher even if the underlying correlation that generates the returns is constant: http://www.federalreserve.gov/pubs/ifdp/ 1997/597/default.htm. 7. Phillipe Jorion, “Risk Management Lessons from Long-Term Capital Management” http://papers.ssrn.com/sol3/papers.cfm?abstract id=169449. 8. Many people could have written this book but they didn’t. Hull’s genius was to pitch it at exactly the right level for the working quant. 9. Preprint http://math.nyu.edu/research/carrp/papers/pdf/faq2.pdf, to appear in Journal of Derivatives. Chapter 18 1. As I write this essay, Chester has taken a leave from his academic post at Carnegie Mellon University, in order to serve as chief economist at the Securities and Exchange Commission.


pages: 309 words: 95,495

Foolproof: Why Safety Can Be Dangerous and How Danger Makes Us Safe by Greg Ip

Affordable Care Act / Obamacare, Air France Flight 447, air freight, airport security, Asian financial crisis, asset-backed security, bank run, banking crisis, break the buck, Bretton Woods, business cycle, capital controls, central bank independence, cloud computing, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency peg, Daniel Kahneman / Amos Tversky, diversified portfolio, double helix, endowment effect, Exxon Valdez, financial deregulation, financial innovation, Financial Instability Hypothesis, floating exchange rates, full employment, global supply chain, hindsight bias, Hyman Minsky, Joseph Schumpeter, Kenneth Rogoff, lateral thinking, London Whale, Long Term Capital Management, market bubble, money market fund, moral hazard, Myron Scholes, Network effects, new economy, offshore financial centre, paradox of thrift, pets.com, Ponzi scheme, quantitative easing, Ralph Nader, Richard Thaler, risk tolerance, Ronald Reagan, Sam Peltzman, savings glut, technology bubble, The Great Moderation, too big to fail, transaction costs, union organizing, Unsafe at Any Speed, value at risk, William Langewiesche, zero-sum game

I asked a Fed governor that fall: should the Fed repeatedly intervene when the market was in trouble? Well, I remember her answering, it’s a central bank’s duty to act when the financial system is threatened. In the following decades, I saw a fiscal crisis convulse interest rates and the dollar in my native Canada, an exchange rate crisis erupt in Europe in 1992, the Asian financial crisis, the near failure of Long-Term Capital Management in 1998, and then the rise and fall of the technology bubble. By 2007, I was looking for the next crisis everywhere: in home prices, leveraged buyouts, the trade deficit. I was not, however, looking for catastrophe. I had by now developed a deep respect for the authorities’ ability to counteract mayhem; I assumed that the economy, though it might get bumped around a bit, would come out okay.

At the market’s nadir many suffered crippling losses on the stocks they had bought that then went down in value. Subsequent reforms created circuit breakers to halt sudden drops in the markets, while the dealers who handled stock trading were required to bulk up their capital. Stock markets faced numerous bear markets over the subsequent decades, but not since 1987 have they again come close to total meltdown. In 1998, when Russia defaulted and Long-Term Capital Management, a giant hedge fund, threatened to fail and inflict chaos on the markets, the Fed cut interest rates three times and brokered a bailout of LTCM by the banks that were its principal creditors. The Fed was alarmed at how little it, and the banks it oversaw, knew about LTCM, and so it began instructing banks to keep much closer tabs on the leverage its hedge fund customers were allowed to accumulate.

When inflation was high and volatile, the Fed would drag its feet about cutting interest rates even if unemployment was high, fearing a rapid reacceleration in price pressure. But once inflation became anchored at such a low level, the Fed felt far more comfortable cutting interest rates when threats to growth materialized. This became apparent when the Fed briefly slashed interest rates in the fall of 1998 to deal with the turmoil of Long-Term Capital Management. Inflation barely budged. It cut them even further and faster in 2001 and 2002, after the collapsing dot-com bubble and then the 9/11 terrorist attacks. The 2001 recession was the mildest since the Second World War. With steady growth and stable inflation, the 1990s became known as the “Goldilocks” economy: not too hot, not too cold. In 2002 economists Mark Watson and James Stock came up with a grander label.


pages: 297 words: 91,141

Market Sense and Nonsense by Jack D. Schwager

3Com Palm IPO, asset allocation, Bernie Madoff, Brownian motion, buy and hold, collateralized debt obligation, commodity trading advisor, computerized trading, conceptual framework, correlation coefficient, Credit Default Swap, credit default swaps / collateralized debt obligations, diversification, diversified portfolio, fixed income, high net worth, implied volatility, index arbitrage, index fund, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, market fundamentalism, merger arbitrage, negative equity, pattern recognition, performance metric, pets.com, Ponzi scheme, quantitative trading / quantitative finance, random walk, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Shiller, selection bias, Sharpe ratio, short selling, statistical arbitrage, statistical model, survivorship bias, transaction costs, two-sided market, value at risk, yield curve

Although hedge funds experienced a substantial decline, during the exact same period both the S&P 500 and NASDAQ indexes lost more than half their value. How is it that an investment with a one-time worst loss of 22 percent is considered much riskier than one that has lost more than double that amount on two separate occasions during the same time frame? Perhaps no single event contributed more to the lasting distorted perception of the risk in hedge fund investment than the collapse of Long-Term Capital Management (LTCM), no doubt the most famous hedge fund failure in history.2 In its first four years of operation, this multibillion-dollar hedge fund generated steady profits, quadrupling the starting net asset value. Then in a five-month period (May to September 1998), it all unraveled, with the net asset value of the fund plunging a staggering 92 percent. Moreover, LTCM’s positions had been enormously leveraged, placing the banks and brokerage firms that provided the credit at enormous risk.

Although biased for all the reasons we detailed, sector indexes can be used in comparisons with each other based on the implicit simplifying assumption that they will be about equally impacted by these biases. Indeed, we used such comparisons in the hedge fund performance analysis in Chapter 3. Chapter 15 The Leverage Fallacy Leverage can be dangerous. There is no shortage of hedge funds that have collapsed as a result of excessive leverage, with Long-Term Capital Management, detailed in Chapter 13, being the classic example. Investors have learned the lesson that leverage is dangerous rather than leverage can be dangerous. In this sense, they are much like the cat that sits on a hot stove. As Mark Twain observed, “She will never sit down on a hot stove-lid again—and that is well; but also she will never sit down on a cold one any more.” Investors always seem to ask hedge funds the question: “How much leverage do you use?”

Treasury bills types of Hedge funds investment about advantages of hidden risk managed futures perception vs. reality rationale for single fund risk Hedge selling Hedgers Hedging Hidden risk Hidden risk evaluation qualitative assessment quantitative measures High-water mark Housing bubble (mid-2000s) Hseigh, David Hulbert Financial Digest Human emotions Idiosyncratic risk Illiquid portfolio Illiquid trades Illiquidity risk Incentive fees Index funds Indicators contrarian credit quality of differentiation of diversification of future performance futures market as interest rates merger arbitrage past as past returns return levels risk volatility Inflation Information availability efficient use of Initial public offerings (IPO) Insider trading Institutional investors Interest rates Internet bubble In-the-money options Inverse correlated fund Inverse relationship Investment analysis Investment decisions Investment durations Investment insights correlation diversification hedge fund of funds hedge funds leverage managed accounts past performance portfolio allocations portfolio considerations portfolio rebalancing pro-forma statistics track records volatility Investment principle Investment size, maximum Investment strategies Investment timing Investor behavior Investor fees Investor requirements IPO price Irrational behavior Irrational choices Jones, Alfred Winslow Junk bonds Kahneman, Daniel Knowledge use Kudlow, Larry Lack, Simon Lagged shifts in supply Leverage about danger from investor performance and and risk Leverage risk Leveraged EFTs Leveraged/rebalanced funds Liar loans Life, Liberty and Property (Jones) Limit orders Linear relationships Liquidation selling Liquidations Liquidity of futures Liquidity crunch Liquidity risk Lockups London interbank offered rate (LIBOR) London Metal Exchange Long bias position Long only hedge funds Long-Term Capital Management (LTCM) Long-term investment Look-back period Loomis, Carol J. Lowenstein, Roger Luck Mad Money Madoff scandal Managed accounts advantages of vs. funds in hedge funds individual vs. indirect management objections to Managed futures Management fees Manager performance Managers hedge funds vs. CTA risk taking vs. skill MAR. See Minimum acceptable return (MAR) ratio Marcus, Michael Margin Margin calls Marginal production loss Market bubbles Market direction Market neutral fund Market overvaluation Market panics Market price delays and inventory model of Market price response Market pricing theory Market psychology Market risk Market sector convertible arbitrage hedge funds and CTA funds hidden risk long-only funds market dependency past and future correlation performance impact by strategy Market timing skill Market-based risk Maximum drawdown (MDD) Mean reversion Mean-reversion strategy Merger arbitrage funds Mergers, cyclical tendency Metrics Minimum acceptable return (MAR) ratio and Calmar ratio Mispricing Mocking Monetary policy Mortgage standards Mortgage-backed securities (MBSs) Mortgages Multifund portfolio, diversified Mutual fund managers, vs. hedge fund managers Mutual funds National Futures Association (NFA) Negative returns Negative Sharpe ratio, and volatility Net asset valuation (NAV) Net exposure New York Stock Exchange (NYSE) Newsletter recommendation NINJA loans Normal distribution Normally distributed returns Notional funding October 1987 market crash Offsetting positions Option ARM Option delta Option premium Option price, underlying market price Option timing Optionality Out-of-the-money options Outperformance Pairs trading Palm Palm IPO Palm/3 Com Past high-return strategies Past performance back-adjusted return measures evaluation of going forward with incomplete information visual performance evaluation Past returns about and causes of future performance hedge funds high and low return periods implications of investment insights market sector past highest return strategy relevance of sector selection select funds and sources of Past track records Performance-based fees Portfolio construction principles Portfolio fund risk Portfolio insurance Portfolio optimization past returns volatility as risk measure Portfolio optimization software Portfolio rebalancing about clarification effect of reason for test for Portfolio risks Portfolio volatility Price aberrations Price adjustment timing Price bubble Price change distribution The price in not always right dot-com mania Pets.com subprime investment Pricing models Prime broker Producer short covering Professional management Profit incentives Pro-forma statistics Pro-forma vs. actual results Program sales Prospect theory Puts Quantitative measures beta correlation monthly average return Ramp-up period underperformance Random selection Random trading Random walk process Randomness risk Rare events Rating agencies Rational behavior Redemption frequency notice penalties Redemption liquidity Relative velocity Renaissance Medallion fund Return periods, high and low long term investment S&P performance Return retracement ratio (RRR) Return/risk performance Return/risk ratios vs. return Returns comparison measures relative vs. absolute objective Reverse merger arbitrage Risk assessment of for best strategy and leverage measurement vs. failure to measure measures of perception of vs. volatility Risk assessment Risk aversion Risk evaluation Risk management Risk management discipline Risk measurement vs. no risk measurement Risk mismeasurement asset risk vs. failure to measure hidden risk hidden risk evaluation investment insights problem source value at risk (VaR) volatility as risk measure volatility vs. risk Risk reduction Risk types Risk-adjusted allocation Risk-adjusted return Risk/return metrics Risk/return ratios Rolling window return charts Rubin, Paul Rubinstein, Mark Rukeyser, Louis S&P 500, vs. financial newsletters S&P 500 index S&P returns study of Sasseville, Caroline Schwager Analytics Module SDR Sharpe ratio Sector approach Sector funds Sector past performance Securities and Exchange Commission (SEC) Select funds, past returns and Selection bias Semistrong efficiency Shakespearian monkey argument Sharpe ratio back-adjusted return measures vs.


pages: 355 words: 92,571

Capitalism: Money, Morals and Markets by John Plender

activist fund / activist shareholder / activist investor, Andrei Shleifer, asset-backed security, bank run, Berlin Wall, Big bang: deregulation of the City of London, Black Swan, bonus culture, Bretton Woods, business climate, business cycle, Capital in the Twenty-First Century by Thomas Piketty, central bank independence, collapse of Lehman Brothers, collective bargaining, computer age, Corn Laws, corporate governance, creative destruction, credit crunch, Credit Default Swap, David Ricardo: comparative advantage, deindustrialization, Deng Xiaoping, discovery of the americas, diversification, Eugene Fama: efficient market hypothesis, eurozone crisis, failed state, Fall of the Berlin Wall, fiat currency, financial innovation, financial intermediation, Fractional reserve banking, full employment, God and Mammon, Gordon Gekko, greed is good, Hyman Minsky, income inequality, inflation targeting, information asymmetry, invention of the wheel, invisible hand, Isaac Newton, James Watt: steam engine, Johann Wolfgang von Goethe, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Meriwether, joint-stock company, Joseph Schumpeter, labour market flexibility, liberal capitalism, light touch regulation, London Interbank Offered Rate, London Whale, Long Term Capital Management, manufacturing employment, Mark Zuckerberg, market bubble, market fundamentalism, mass immigration, means of production, Menlo Park, money market fund, moral hazard, moveable type in China, Myron Scholes, Nick Leeson, Northern Rock, Occupy movement, offshore financial centre, paradox of thrift, Paul Samuelson, plutocrats, Plutocrats, price stability, principal–agent problem, profit motive, quantitative easing, railway mania, regulatory arbitrage, Richard Thaler, rising living standards, risk-adjusted returns, Robert Gordon, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, shareholder value, short selling, Silicon Valley, South Sea Bubble, spice trade, Steve Jobs, technology bubble, The Chicago School, The Great Moderation, the map is not the territory, The Wealth of Nations by Adam Smith, Thorstein Veblen, time value of money, too big to fail, tulip mania, Upton Sinclair, Veblen good, We are the 99%, Wolfgang Streeck, zero-sum game

And it poses a serious challenge to the efficient markets hypothesis. Another reason prices can diverge from fundamentals for a considerable period is that arbitrage, whereby investors simultaneously buy and sell identical or similar financial instruments which are temporarily mis-priced and thus bring prices back into line, is rarely free of risk. This was amply demonstrated by the near-collapse in 1998 of Long-Term Capital Management, a hedge fund run by former Salomon Brothers trader John Meriwether, which counted two distinguished finance academics, Robert Merton and Myron Scholes, on its strength. LTCM used complex mathematical models to exploit minute divergences in the relative value of different bonds. It was betting on the idea that the valuations would inevitably converge by buying the underpriced security and selling the overpriced security in the hope of making a small margin on the trade when convergence took place.

id=o00JAAAA QAAJ&pg=PA76&lpg=PA76&dq=Defoe 81 Irrational Exuberance, second edition, Princeton University Press, 2005. 82 See, for example, ‘From Efficient Markets Theory to Behavioral Finance’, Cowles Foundation for Research in Economics at Yale University, Paper No. 1055, 2003. 83 The title also caused serious concern to academics at the London School of Economics, who feared that it would deter potential sources of funds in the financial sector. Paul Woolley – who had accumulated a fair-sized fortune as a fund manager – made the title an absolute condition of his financing of the centre. The LSE backed down and took the money. 84 When Genius Failed: The Rise and Fall of Long-Term Capital Management, Random House Trade Paperbacks, 2000. 85 Dogs and Demons: The Fall of Modern Japan, Farrar, Straus & Giroux and Penguin Books, 2001. 86 ‘Letter from Chicago: After the Blow-up’, 11 January 2010. 87 In Going Off the Rails: Global Capital and the Crisis of Legitimacy, John Wiley, 2003, I argued that Federal Reserve chairman Alan Greenspan’s asymmetric and morally hazardous approach to monetary policymaking, which involved the repeated extension of a safety net to markets, was undermining capitalism’s immune system; the use of highly complex financial instruments meant that central banks and bank supervisors were over-dependent on experts in private banks to monitor the plumbing of the system and that supervision had been semi-privatised by default; financial institutions’ risk management was fundamentally flawed; financial innovation had failed to come up with any way of hedging against liquidity risk in banking; and the system’s pro-cyclicality was being exacerbated by the Basel capital adequacy regime.

H. 1 Laws (Plato) 1, 2 Lay, Kenneth 1 Lazard Brothers 1 Le Rêve (Picasso) 1 Leeson, Nick 1 Lehman Brothers 1, 2, 3, 4, 5, 6 Lenin 1, 2 Leonardo da Vinci 1 Letters on the Aesthetic Education of Mankind (Friedrich Schiller) 1 Lettres Philosophiques (Voltaire) 1 Lewis, John Spedan 1 Lewis, Michael 1, 2 Lewis, Sinclair 1 Liar’s Poker (Michael Lewis) 1 liberal internationalism 1, 2, 3 limited liability 1, 2, 3, 4 Little Dorrit (Dickens) 1, 2 Livermore, Jesse 1 Lloyd George, David 1 ‘Locksley Hall’ (Tennyson) 1 London Interbank Offered Rate 1 Long-Term Capital Management (hedge fund) 1 Louis XIV of France 1, 2 Lowenstein, Roger 1 Lucas, Robert 1 Lunar Society 1 McDonald’s theory of conflict 1 McDonough, William 1 Machiavelli 1, 2 Mackay, Charles 1, 2, 3, 4 McKenna, Reginald 1, 2 McKinley, William 1 Madame Nui’s toad 1 Maddison, Angus 1 madness of crowds 1 Madouros, Vasileios 1 Major Barbara (George Bernard Shaw) 1 Making of the English Working Class (E.


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Trade Wars Are Class Wars: How Rising Inequality Distorts the Global Economy and Threatens International Peace by Matthew C. Klein

Albert Einstein, Asian financial crisis, asset allocation, asset-backed security, Berlin Wall, Bernie Sanders, Branko Milanovic, Bretton Woods, British Empire, business climate, business cycle, capital controls, centre right, collective bargaining, currency manipulation / currency intervention, currency peg, David Ricardo: comparative advantage, deglobalization, deindustrialization, Deng Xiaoping, Donald Trump, Double Irish / Dutch Sandwich, Fall of the Berlin Wall, falling living standards, financial innovation, financial repression, fixed income, full employment, George Akerlof, global supply chain, global value chain, illegal immigration, income inequality, intangible asset, invention of the telegraph, joint-stock company, land reform, Long Term Capital Management, Malcom McLean invented shipping containers, manufacturing employment, Martin Wolf, mass immigration, Mikhail Gorbachev, money market fund, mortgage debt, New Urbanism, offshore financial centre, oil shock, open economy, paradox of thrift, passive income, reserve currency, rising living standards, Robert Shiller, Robert Shiller, Ronald Reagan, savings glut, Scramble for Africa, sovereign wealth fund, The Nature of the Firm, The Wealth of Nations by Adam Smith, Tim Cook: Apple, trade liberalization, Wolfgang Streeck

By November, losses on Argentine bonds—including the ones it had been unable to sell to outside investors—nearly bankrupted Baring Brothers. The Bank of England responded by assembling a consortium of private banks to rescue Baring because of fears that its collapse would bring down the British financial system. (Something similar occurred in 1998 when the Federal Reserve Bank of New York organized a bailout of the hedge fund Long-Term Capital Management after Russia’s sovereign default.) The intervention was insufficient to prevent a broader financial panic, however. British lenders responded to the Argentine crisis by slashing foreign lending, which contributed to a series of international panics around the world for the next three years.26 The Argentina crisis was eventually resolved, and international lending to Latin America resumed until World War I.

See United Kingdom entrepreneurship: in China, 101, 116 and container shipping, 25 in Japan, 72 and savings and investment, 72 in United Kingdom, 11 in United States, 13, 25 Eurodollar market, 61–62 Europe and European Union: banking glut in, 62–65, 63f class inequalities in, 4–5 current account balances in, 229–30 and German surpluses, 159–60, 165f and global value chains, 28 Maastricht Treaty (1992), 140, 146 and Marshall Plan, 22 policy choices for, 229–31 Stability and Growth Pact (1997), 146, 170 surpluses in, 170–73, 173f Treaty on Stability, Coordination, and Governance in the Economic and Monetary Union (2012), 170 European Central Bank (ECB), 146, 148, 156, 164, 171, 217 European Exchange Rate Mechanism, 196 European Investment Bank, 231 exchange rate regimes: in China, 108–10, 199–200 European Exchange Rate Mechanism, 196 in Germany, 137 and gold standard, 185–89, 219, 220 in New Zealand, 195 in Sweden, 195 in Taiwan, 197 in United Kingdom, 196, 218–19 and United States, 20, 189–201 Facebook, 35 Fannie Mae, 203, 205 Federal Reserve (U.S.): and Asian Financial Crisis (1997), 198 on China’s current account balance, 123 and dollar as reserve asset, 191 and global financial crisis (2008), 63 and gold standard, 188, 193 and less-developed-country lending boom, 62 and Long-Term Capital Management bailout, 60 on U.S. manufacturing, 77 Feldstein, Martin, 180 finance. See global finance fiscal policy: in European Union, 231 in Germany, 147, 167, 170, 173 in United States, 180–85, 182f, 210 foreign exchange. See exchange rate regimes Foxconn, 33–34 France: colonial territories of, 6, 17, 21 corporate tax avoidance in, 33 and EU banking glut, 63 and German Empire (1870s), 93–94, 95–96 and global credit boom (1820s), 47, 51 and global financial crisis (1873), 55, 56 and gold standard, 187–88 tariffs in, 16 U.S. corporation income in, 37.

See also specific countries League of Nations, 21 Lenin, Vladimir, 73 less-developed-country lending boom, 61–62 Leverkusen Bridge (Germany), 168 Li Keqiang, 104 List, Friedrich, 15–16, 17, 71, 122 Lithuania, budget surpluses in, 170 living standards: in China, 101, 105, 106–7, 111, 129, 211 in Germany, 135, 138–39, 152, 158–59 in Indonesia, 198 in Japan, 75 and savings and investment, 66, 68–70, 75–76, 80, 86, 231 in South Korea, 76, 197 in United Kingdom, 219 Long-Term Capital Management, 60 Louis Napoleon (emperor), 55, 92–93 Luxembourg: budget surpluses in, 170 as tax haven, 35 Maastricht Treaty (1992), 140, 146 MacGregor, Gregor, 49 Made in China 2025 agenda, 121, 124 Madison, James, 14 Malaysia: and Asian Financial Crisis (1997), 198 savings and investment in, 197 Malta, budget surpluses in, 170 Manifest Destiny, 18 manufacturing: in China, 110, 112, 115, 122–23, 125 and economic development, 72, 73, 77, 77f and GATT, 23 in Germany, 140, 141–42 and global value chains, 27 and savings and investment, 72, 73, 77, 77f tariffs on, 16–17 and transportation costs, 24–25 in United States, 14–15, 23, 178–79, 210–11, 212–13, 214, 227 Marichal, Carlos, 57 Marshall Plan, 22 Martin, Philippe, 164 Mazière, Lothar de, 136 Mazowiecki, Tadeusz, 133 MBS (mortgage-backed securities), 64, 204–5 McLean, Malcom, 26 mercantilism, 41 Merkel, Angela, 152, 170 Mexico: bilateral trade imbalances in, 98–100 and global credit boom (1820s), 49 U.S. corporation income in, 37 U.S. exports to, 28 Microsoft, 34, 35, 38 Milhaupt, Curtis J., 122 Monroe, Arthur, 95 Morgenthau, Henry, 22 mortgage-backed securities (MBS), 64, 204–5 Nahles, Andrea, 150 Naughton, Barry, 106 Navarro, Peter, 97–100 Netherlands: banking industry in, 231 budget surpluses in, 170 colonial territories of, 6 current account balance in, 96 and EU banking glut, 63 exports from, 147 and global credit boom (1820s), 51 policy choices in, 230 savings and investment in, 69–70, 225 tariffs in, 17 as tax haven, 35 U.S. corporation income in, 37 U.S. exports to, 29–30 Neuer Markt (Germany), 144–45 New York Stock Exchange, 57, 58 New Zealand: capital controls in, 223 colonial interests in, 17 exchange rate regime in, 195 Nixon, Richard, 194, 219 North Korea, savings and investment in, 76 Norway, current account balance in, 87 Odendahl, Christian, 152 Ohno, Kenichi, 72 Open Door Policy (U.S.), 18–19 Party of Democratic Socialism (Germany), 135, 136 People’s Bank of China (PBOC), 109, 110, 119, 199 Peru: global credit boom (1820s) in, 49 guano exports of, 56 Pfizer, 35 pharmaceutical industry, 34–35 Philippines: and Asian Financial Crisis (1997), 198 savings and investment in, 197 Philippon, Thomas, 164 Poland: end of communism in, 132–33 exports from, 147 and global value chains, 28 manufacturing in, 142 Polish United Workers’ Party (PZPR), 132–33 Portugal: banking industry in, 231 and EU banking glut, 63 external debt in, 163 German surpluses absorbed by, 4 and global credit boom (1820s), 49 and global value chains, 28 Internet access speeds in, 169 savings and investment in, 171 productivity: in China, 105, 106, 109, 114–15, 117–18, 127 in Germany, 138, 141, 166 and global trade, 11, 12–13, 31 and Hamilton’s “Report on the Subject of Manufactures,” 12–13 and savings and investment, 69, 71, 75–76 in United States, 210–11 property rights, 111, 117, 129 protectionism, 17, 71.


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Obliquity: Why Our Goals Are Best Achieved Indirectly by John Kay

Andrew Wiles, Asian financial crisis, Berlin Wall, bonus culture, British Empire, business process, Cass Sunstein, computer age, corporate raider, credit crunch, Daniel Kahneman / Amos Tversky, discounted cash flows, discovery of penicillin, diversification, Donald Trump, Fall of the Berlin Wall, financial innovation, Gordon Gekko, greed is good, invention of the telephone, invisible hand, Jane Jacobs, lateral thinking, Long Term Capital Management, Louis Pasteur, market fundamentalism, Myron Scholes, Nash equilibrium, pattern recognition, Paul Samuelson, purchasing power parity, RAND corporation, regulatory arbitrage, shareholder value, Simon Singh, Steve Jobs, Thales of Miletus, The Death and Life of Great American Cities, The Predators' Ball, The Wealth of Nations by Adam Smith, ultimatum game, urban planning, value at risk

The models aided the practiced judgment of foresters but did not replace it. Good decision making is pragmatic and eclectic. Oblique approaches rely on a tool kit of models and narratives rather than any simple or single account. To fit the world into a single model or narrative fails to acknowledge the universality of uncertainty and complexity. The reputation of financial economics has never recovered from the blow of the virtual collapse of Long-Term Capital Management, a sophisticated practitioner of the risk models outlined in chapter twelve, and the involvement of two Nobel Prize winners, Robert C. Merton and Myron Scholes. The fund built huge positions on the basis of estimated mispricings, relying on its models to control its exposures. When the Asian financial crisis blew up in 1997, the fund managers extended their positions. They believed their own models.

Keynes, John Maynard Khan, Genghis Khmer Rouge Klein, Gary Kubrick, Stanley lactose lateral thinking leadership Le Corbusier Lehman Brothers Lenin, V. I. leprosy Levitt, Theodore Lewis, Michael Liar’s Poker (Lewis) life expectancy Lincoln, Abraham Lindblom, Charles literacy rate Litton Industries Lives of the Painters (Vasari) loans lobsters local goals logic London Business School London Underground Long-Term Capital Management McDonnell Douglas Machiavelli, Niccolò MacIntyre, Alasdair McKeen, John McNamara, Robert Maginot Line Malaya Mallory, George Malthusianism management management consultants man-and-dog problem manuals maps market capitalization market economies market fundamentalism market research market segments Marks, Simon Marks & Spencer marriage Marxism mass production materialism mathematics Mean Business (Dunlap) Merck Merck, George Merton, Robert C.


pages: 327 words: 103,336

Everything Is Obvious: *Once You Know the Answer by Duncan J. Watts

active measures, affirmative action, Albert Einstein, Amazon Mechanical Turk, Black Swan, business cycle, butterfly effect, Carmen Reinhart, Cass Sunstein, clockwork universe, cognitive dissonance, coherent worldview, collapse of Lehman Brothers, complexity theory, correlation does not imply causation, crowdsourcing, death of newspapers, discovery of DNA, East Village, easy for humans, difficult for computers, edge city, en.wikipedia.org, Erik Brynjolfsson, framing effect, Geoffrey West, Santa Fe Institute, George Santayana, happiness index / gross national happiness, high batting average, hindsight bias, illegal immigration, industrial cluster, interest rate swap, invention of the printing press, invention of the telescope, invisible hand, Isaac Newton, Jane Jacobs, Jeff Bezos, Joseph Schumpeter, Kenneth Rogoff, lake wobegon effect, Laplace demon, Long Term Capital Management, loss aversion, medical malpractice, meta analysis, meta-analysis, Milgram experiment, natural language processing, Netflix Prize, Network effects, oil shock, packet switching, pattern recognition, performance metric, phenotype, Pierre-Simon Laplace, planetary scale, prediction markets, pre–internet, RAND corporation, random walk, RFID, school choice, Silicon Valley, social intelligence, statistical model, Steve Ballmer, Steve Jobs, Steve Wozniak, supply-chain management, The Death and Life of Great American Cities, the scientific method, The Wisdom of Crowds, too big to fail, Toyota Production System, ultimatum game, urban planning, Vincenzo Peruggia: Mona Lisa, Watson beat the top human players on Jeopardy!, X Prize

Publishers, producers, and marketers—experienced and motivated professionals in business with plenty of skin in the game—have just as much difficulty predicting which books, movies, and products will become the next big hit as political experts have in predicting the next revolution. In fact, the history of cultural markets is crowded with examples of future blockbusters—Elvis, Star Wars, Seinfeld, Harry Potter, American Idol—that publishers and movie studios left for dead while simultaneously betting big on total failures.4 And whether we consider the most spectacular business meltdowns of recent times—Long-Term Capital Management in 1998, Enron in 2001, WorldCom in 2002, the near-collapse of the entire financial system in 2008—or spectacular success stories like the rise of Google and Facebook, what is perhaps most striking about them is that virtually nobody seems to have had any idea what was about to happen. In September 2008, for example, even as Lehman Brothers’ collapse was imminent, Treasury and Federal Reserve officials—who arguably had the best information available to anyone in the world—failed to anticipate the devastating freeze in global credit markets that followed.

“The Dynamics of Informational Cascades: The Monday Demonstrations in Leipzig, East Germany, 1989–91.” World Politics 47 (1):42–101. Lombrozo, Tania. 2006. “The Structure and Function of Explanations.” Trends in Cognitive Sciences 10 (10):464–70. ———. 2007. “Simplicity and Probability in Causal Explanation.” Cognitive Psychology 55 (3):232–57. Lowenstein, Roger, 2000. When Genius Failed: The Rise and Fall of Long-Term Capital Management. New York: Random House. Lukes, Steven. 1968. “Methodological Individualism Reconsidered.” British Journal of Sociology 19 (2):119–29. Luo, Michael. 2004. “ ‘Excuse Me. May I Have Your Seat?’ ” New York Times, Sept. 14. Lyons, Russell. 2010. “The Spread of Evidence-Poor Medicine via Flawed Social-Network Analysis.” Working paper, Indiana University. Mackay, Charles. 1932. Extraordinary Popular Delusions and the Madness of Crowds.

General information about production in cultural industries is given in Caves (2000) and Bielby and Bielby (1994). 5. In early 2010, the market capitalization of Google was around $160B, but it has fluctuated as high as $220B. See Makridakis, Hogarth, and Gaba (2009a) and Taleb (2007) for lengthier descriptions of these and other missed predictions. See Lowenstein (2000) for the full story of Long-Term Capital Management. 6. Newton’s quote is taken from Janiak (2004, p. 41). 7. The Laplace quote is taken from http://en.wikipedia.org/wiki/Laplace’s-demon. 8. Lumping all processes into two coarse categories is a vast oversimplification of reality, as the “complexity” of a process is not a sufficiently well understood property to be assigned anything like a single number. It’s also a somewhat arbitrary one, as there’s no clear definition of when a process is complex enough to be called complex.


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Fooled by Randomness: The Hidden Role of Chance in Life and in the Markets by Nassim Nicholas Taleb

Antoine Gombaud: Chevalier de Méré, availability heuristic, backtesting, Benoit Mandelbrot, Black Swan, commoditize, complexity theory, corporate governance, corporate raider, currency peg, Daniel Kahneman / Amos Tversky, discounted cash flows, diversified portfolio, endowment effect, equity premium, fixed income, global village, hedonic treadmill, hindsight bias, Kenneth Arrow, Long Term Capital Management, loss aversion, mandelbrot fractal, mental accounting, meta analysis, meta-analysis, Myron Scholes, Paul Samuelson, quantitative trading / quantitative finance, QWERTY keyboard, random walk, Richard Feynman, road to serfdom, Robert Shiller, Robert Shiller, selection bias, shareholder value, Sharpe ratio, Steven Pinker, stochastic process, survivorship bias, too big to fail, Turing test, Yogi Berra

Now, I explained the point to a cab driver who laughed at the fact that someone ever thought that there was any scientific method to understanding markets and predicting their attributes. Somehow when one gets involved in financial economics, owing to the culture of the field, one becomes likely to forget these basic facts (pressure to publish to keep one’s standing among the other academics). An immediate result of Dr. Markowitz’s theory was the near collapse of the financial system in the summer of 1998 (as we saw in Chapters 1 and 5) by Long Term Capital Management (“LTCM”), a Greenwich, Connecticut, fund that had for principals two of Dr. Markowitz’s colleagues,“Nobels”as well. They are Drs. Robert Merton (the one in Chapter 3 trouncing Shiller) and Myron Scholes. Somehow they thought they could scientifically “measure” their risks. They made absolutely no allowance in the LTCM episode for the possibility of their not understanding markets and their methods being wrong.

: Two strains of literature. (1) The recent “stranger to ourselves” line of research in psychology (Wilson 2002). (2) The literature on “immune neglect,” Wilson, Meyers and Gilbert (2001) and Wilson, Gilbert and Centerbar (2003). Literally, people don’t learn from their past reactions to good and bad things. Literature on bubbles: There is a long tradition, see Kindleberger (2001), MacKay (2002), Galbraith (1991), Chancellor (1999), and of course Shiller (2000). Shiller with a little work may be convinced to do a second edition. Long-term capital management: See Lowenstein (2000). Stress and randomness: Sapolsky (1998) is a popular, sometimes hilarious presentation. The author specializes among other things on the effect of glucocorticoids released at times of stress on the atrophy of the hycocampus, hampering the formation of new memory and brain plasticity. More technical, Sapolsky (2003). Brain asymmetries with gains/losses: See Gehring and Willoughby (2002).

Lannon, 2000, A General Theory of Love. New York: Vintage Books. Lichtenstein, S., B. Fischhoff, and L. Phillips, 1977, “Calibration of Probabilities: The State of the Art.” In Kahneman, Slovic, and Tversky (1982). Loewenstein, G. F., E. U. Weber, C. K. Hsee, and E. S. Welch, 2001, “Risk As Feelings.” Psychological Bulletin, 127, 267–286. Lowenstein, Roger, 2000, When Genius Failed: The Rise and Fall of Long-Term Capital Management. New York: Random House. Lucas, Robert E., 1978, “Asset Prices in an Exchange Economy.” Econometrica, 46, 1429–1445. Luce, R. D., and H. Raiffa, 1957, Games and Decisions: Introduction and Critical Survey. New York: Dover. Machina, M. J., and M. Rothschild, 1987, “Risk.” In Eatwell, J., Milgate, M., and Newman P., eds., 1987, The New Palgrave: A Dictionary of Economics. London: Macmillan.


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Singularity Rising: Surviving and Thriving in a Smarter, Richer, and More Dangerous World by James D. Miller

23andMe, affirmative action, Albert Einstein, artificial general intelligence, Asperger Syndrome, barriers to entry, brain emulation, cloud computing, cognitive bias, correlation does not imply causation, crowdsourcing, Daniel Kahneman / Amos Tversky, David Brooks, David Ricardo: comparative advantage, Deng Xiaoping, en.wikipedia.org, feminist movement, Flynn Effect, friendly AI, hive mind, impulse control, indoor plumbing, invention of agriculture, Isaac Newton, John von Neumann, knowledge worker, Long Term Capital Management, low skilled workers, Netflix Prize, neurotypical, Norman Macrae, pattern recognition, Peter Thiel, phenotype, placebo effect, prisoner's dilemma, profit maximization, Ray Kurzweil, recommendation engine, reversible computing, Richard Feynman, Rodney Brooks, Silicon Valley, Singularitarianism, Skype, statistical model, Stephen Hawking, Steve Jobs, supervolcano, technological singularity, The Coming Technological Singularity, the scientific method, Thomas Malthus, transaction costs, Turing test, twin studies, Vernor Vinge, Von Neumann architecture

I believe that many will come to expect the Singularity, but even if I’m wrong, Singularity expectations will still have a massive impact on the economy if a few thousand hedge fund managers and venture capitalists become Singularity predictors. Hedge funds take money from rich people and invest in financial instruments such as stocks and bonds. These funds collectively control trillions of dollars in assets. In 1998, the hedge fund Long Term Capital Management had, all by itself, financial positions of around $1.3 trillion.323 Because of the huge sums involved, hedge funds attract the best and brightest as employees. Consider a hedge fund that has convinced rich people to invest $100 billion with it. The hedge fund then uses this $100 billion to borrow $900 billion from banks, allowing the fund to make financial bets totaling $1 trillion.

Pretend that if this fund were run by the second-most-qualified person on Earth, it would earn a 10 percent yearly return, but if the fund were managed by the best person, it would have a 10.2 percent return. This difference amounts to $2 billion a year, meaning that the fund would greatly benefit from employing the best manager for a salary of $1 billion a year, a salary that would tempt almost anyone. Hedge funds do sometimes screw up. Long Term Capital Management, for example, lost billions in 1998, and the US government so feared what would happen to the world economy if the fund imploded that it arranged a bailout. The ever-present possibility of failure motivates hedge funds to eagerly seek out all relevant information. Hence, if a very smart, rational, and well-informed person should be able to see a signpost to the Singularity, then you can bet that several hedge fund managers will read and act on such a sign.

., 124 Khan, Genghis, 22, 24, 77–78 Khrushchev, Nikita, 220 Kling, Arnold, 107 Kool-Aid, 38 Korean study on autism, 91 Krishna (Hindu God), 3 Kurzweil, Ray billions of nanobots in our brains will record real-time data on how our brains work, 11 computing power, limits to exponential growth in, 6 computing speed, exponential improvements in, 4 Cryonics Institute, 214 on exponential growth, 1 Fantastic Voyage: Live Long Enough to Live Forever, 179 humans will be fantastically productive and earn higher wages, 189 investor and Singularity writer, 35 mankind will colonize the universe at maximum speed allowed by the laws of physics, 9 merger of man and machine, 188 quote, 164 resources of the solar system, mankind will use significant percentage of, 9 rocks, reorganization of, x Singularity by 2045, 200 Singularity by a steady merger of man and machines, 23 The Singularity is Near, 3, 207 Singularity will probably be utopian, 179 Transcend: Nine Steps to Living Well Forever, 179 ultimate laptop computer operations per second, 6 Kurzweilian Merger babysitters, earnings of, 134–35 dangers of, 21 human brains will provide starter software for a Singularity, 8–10 opportunities to correct mistakes, 22 property rights expectations, 190 rate of return expectations, 190 savings, cumulative effect on, 190 wealth expectations, 190 Kurzweilian scenario, 189 L landed aristocracy, 147 landowning nobility, 137 land resale value, 181–82 language processing skills, 64–65 laser rifle, 204 lawn mower, perfect, 24 Legg, Shane, 13 Lesbian feminists, 195 libertarian AI, 41 libertarian government, ideal, 41 libertarianism, 40–41 libertarian ultra-intelligent ruler, 40–41 life span, 180, 212 life span of products, 183 liquid nitrogen preserved body, 139. See also cryonics Long Term Capital Management, 185 long-term planning, 79 lottery tickets, IQ, 113 Louis XIV, King, 165, 167 Ludd, Ned, 131 Luddites, 131 Lumosity (brain fitness website), 113, 115 Lumosity games, 113–14 M Macbeth (Shakespeare), 21, 175 machine intelligence, ix, x, xv, xvii, 13, 21, 119 machine-learning software, xi Mafia, 217 maggot-free, 166 magic wands, 137 magnetic resonance imaging, 91 Malthus, Thomas, xv, 141 Malthusian emulation society, 149 Malthusian trap, 141–45 Mandarin, 8, 193 Manhattan Project, xii manic state, 93 mankind’s annihilation, 45 mankind’s short-term survival prospects, 199 Mao Zedong, 122 marginal costs of production, 168 marijuana, 105 market economy, 132 marriage decision, 83 marriage market, 194 Mars, 138 Martian land, 138 Marxist dictate, 41 “massive embryo selection,” 94—95 McCabe, Tom, 90, 163, 215 media content, 182 Medicare costs, 116 Medicare taxes, 157 memes, 80, 97 memory drugs, 108.


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Economists and the Powerful by Norbert Haring, Norbert H. Ring, Niall Douglas

"Robert Solow", accounting loophole / creative accounting, Affordable Care Act / Obamacare, Albert Einstein, asset allocation, bank run, barriers to entry, Basel III, Bernie Madoff, British Empire, buy and hold, central bank independence, collective bargaining, commodity trading advisor, corporate governance, creative destruction, credit crunch, Credit Default Swap, David Ricardo: comparative advantage, diversified portfolio, financial deregulation, George Akerlof, illegal immigration, income inequality, inflation targeting, information asymmetry, Jean Tirole, job satisfaction, Joseph Schumpeter, Kenneth Arrow, knowledge worker, law of one price, light touch regulation, Long Term Capital Management, low skilled workers, mandatory minimum, market bubble, market clearing, market fundamentalism, means of production, minimum wage unemployment, moral hazard, new economy, obamacare, old-boy network, open economy, Pareto efficiency, Paul Samuelson, pension reform, Ponzi scheme, price stability, principal–agent problem, profit maximization, purchasing power parity, Renaissance Technologies, rolodex, Sergey Aleynikov, shareholder value, short selling, Steve Jobs, The Chicago School, the payments system, The Wealth of Nations by Adam Smith, too big to fail, transaction costs, ultimatum game, union organizing, Vilfredo Pareto, working-age population, World Values Survey

The techniques that hedge funds and brokers use to take advantage of weaker or less informed market participants work just as well against others of their kind if they are unlucky enough to run into a tight spot. In the words of former stockbroker and hedge fund manager Jim Cramer (2002): “When you smell blood in the water, you become a shark… when you know that one of your number is in trouble…you try to figure out what he owns and you start shorting those stocks.” A famous victim was hedge fund Long-Term Capital Management (LTCM). The troubles of this huge fund during the 1997/1998 Asian Crisis brought the world financial system to the brink of a collapse. Economists have found evidence that LTCM’s problems were exacerbated by brokers and business partners who had information about the short positions that the fund urgently needed to close and engaged in large-scale front running against the hedge fund.

Derivatives will continue to cause billions of dollars in losses by hundreds of derivatives victims, along the way destroying reputations, twisting lives and emptying bank books. And Wall Street will continue to argue that there is no compelling reason to regulate derivatives. Greenspan, Summers and Rubin cannot credibly claim that they remained unaware of the possible consequences. Already in the fall of 1998, the hedge fund Long-Term Capital Management (LTCM) was suddenly near bankruptcy. LTCM had piled a hundred billion dollars of debt and more than a trillion dollars of derivatives on top of a few billion dollars of equity from investors and had sold massive amounts of options (a type of derivative). LTCM’s derivatives positions were so large that a relatively small decline in the world financial markets was enough to wipe out its capital (Partnoy 1997/2009).

D. 13 American Economic Association ix, 10, 17, 20, 26–7, 44 American Economic Review 8, 20, 26–7 American International Group (AIG) 70, 90–91 Anglo-Saxon economics ix Arrow, Kenneth 7, 23–4, 212; see also impossibility theorem (Arrow’s) asset bubble 104 asymmetric information: see information, asymmetric AT&T 147 authoritarianism 24, 210 average cost 148, 151 Bank of America 77, 86, 94 barriers to entr