Long Term Capital Management

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

Abraham Wald, Albert Einstein, Bayesian statistics, Bear Stearns, 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 engineering, 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 free rate, risk tolerance, risk/return, Robert Solow, 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.

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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. The organization was also brand new, so it did not suffer from organizational creep as had other older companies in the business. Long Term Capital Management was designed to operate lean, which was going to be an essential element for its strategy – to be able to trade quickly and at very low cost, so that it could make arbitrage profits based on perceived price discrepancies measured in cents rather than nickels or dimes.

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These differences in liquidity may be slightly more pronounced even between two trading centers located in different time zones and thousands of miles apart. Long Term Capital Management developed a strategy to capitalize on these differences. It could even do so with almost no invested capital, by buying the thinly traded slightly aged bonds and at the same time short selling the new issue bonds to raise the funds. This way, it could afford to trade very The Nobel Prize, Life, and Legacy 169 large volumes of each, and make perhaps only pennies per bond, but over millions of bond contracts. These strategies were wildly successful at first. Because Long Term Capital Management had to front little money on these covered transactions, its equity grew to almost $5 billion within four years and it had borrowed to purchase contracts worth almost $130 billion.

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

activist fund / activist shareholder / activist investor, Airbnb, Albert Einstein, AOL-Time Warner, asset allocation, Bear Stearns, behavioural economics, bitcoin, Bretton Woods, buy and hold, buy low sell high, Carl Icahn, cognitive bias, cognitive dissonance, Credit Default Swap, cryptocurrency, Daniel Kahneman / Amos Tversky, endowment effect, financial engineering, financial innovation, fixed income, global macro, hindsight bias, index fund, initial coin offering, invention of the wheel, Isaac Newton, Jim Simons, John Bogle, John Meriwether, Kickstarter, Long Term Capital Management, loss aversion, low interest rates, Market Wizards by Jack D. Schwager, mega-rich, merger arbitrage, multilevel marketing, Myron Scholes, Paul Samuelson, Pershing Square Capital Management, quantitative easing, Reminiscences of a Stock Operator, Renaissance Technologies, Richard Thaler, Robert Shiller, short squeeze, Snapchat, Stephen Hawking, Steve Jobs, Steve Wozniak, stocks for the long run, subprime mortgage crisis, transcontinental railway, two and twenty, value at risk, Vanguard fund, Y Combinator

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.

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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.

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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.

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

Alan Greenspan, Andrei Shleifer, Asian financial crisis, asset-backed security, automated trading system, bank run, barriers to entry, Bear Stearns, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Bonfire of the Vanities, book value, 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, deal flow, do well by doing good, Elliott wave, Eugene Fama: efficient market hypothesis, failed state, Fall of the Berlin Wall, financial deregulation, financial engineering, financial innovation, financial intermediation, fixed income, full employment, German hyperinflation, High speed trading, index fund, Jim Simons, John Bogle, John Meriwether, junk bonds, Kenneth Rogoff, Kickstarter, Long Term Capital Management, low interest rates, machine translation, margin call, market bubble, market clearing, market fundamentalism, Market Wizards by Jack D. Schwager, Mary Meeker, merger arbitrage, Michael Milken, money market fund, moral hazard, Myron Scholes, natural language processing, Network effects, new economy, Nikolai Kondratiev, operational security, pattern recognition, Paul Samuelson, pre–internet, proprietary trading, public intellectual, quantitative hedge fund, quantitative trading / quantitative finance, random walk, Renaissance Technologies, Richard Thaler, risk-adjusted returns, risk/return, Robert Mercer, rolodex, Savings and loan crisis, Sharpe ratio, short selling, short squeeze, Silicon Valley, South Sea Bubble, sovereign wealth fund, statistical arbitrage, statistical model, survivorship bias, tail risk, technology bubble, The Great Moderation, The Myth of the Rational Market, the new new thing, too big to fail, transaction costs, two and twenty, uptick rule

Thus, a position with a standard deviation of six basis points would not fall by more than about fifteen basis points in 99 percent of cases, or on ninety-nine days out of a hundred. 19. 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.

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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.

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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.

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

Albert Einstein, Alvin Toffler, Atul Gawande, backtesting, Bear Stearns, beat the dealer, Bernie Madoff, Black Swan, buy and hold, buy low sell high, California energy crisis, capital asset pricing model, Carl Icahn, 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, Future Shock, game design, global macro, hindsight bias, housing crisis, index fund, Isaac Newton, Jim Simons, John Bogle, John Meriwether, John Nash: game theory, linear programming, Long Term Capital Management, managed futures, mandelbrot fractal, margin call, market bubble, market fundamentalism, market microstructure, Market Wizards by Jack D. Schwager, mental accounting, money market fund, Myron Scholes, Nash equilibrium, new economy, Nick Leeson, Ponzi scheme, prediction markets, random walk, Reminiscences of a Stock Operator, Renaissance Technologies, Richard Feynman, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, shareholder value, Sharpe ratio, short selling, South Sea Bubble, Stephen Hawking, survivorship bias, systematic trading, Teledyne, 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

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.

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., 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.

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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.

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

Alan Greenspan, banking crisis, Bear Stearns, Bernie Madoff, Bernie Sanders, business cycle, California energy crisis, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, do well by doing good, facts on the ground, financial deregulation, fixed income, Glass-Steagall Act, housing crisis, invisible hand, Long Term Capital Management, low interest rates, mega-rich, mortgage debt, new economy, old-boy network, Ponzi scheme, profit motive, Ralph Nader, rolling blackouts, Ronald Reagan, Savings and loan crisis, 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.

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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.

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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.

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

affirmative action, Alan Greenspan, asset-backed security, automated trading system, bank run, banking crisis, Basel III, Bear Stearns, Bernie Madoff, Black-Scholes formula, Bob Litterman, 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, currency risk, delta neutral, discounted cash flows, diversification, diversified portfolio, family office, financial engineering, financial innovation, financial intermediation, fixed income, Flash crash, full employment, Gini coefficient, Glass-Steagall Act, global macro, 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 interest rates, low skilled workers, managed futures, margin call, market design, market fundamentalism, merger arbitrage, Mexican peso crisis / tequila crisis, Mitch Kapor, money market fund, moral hazard, mortgage debt, Myron Scholes, National best bid and offer, negative equity, Northern Rock, Occupy movement, oil shock, price stability, proprietary trading, quantitative easing, quantitative hedge fund, quantitative trading / quantitative finance, Ralph Waldo Emerson, regulatory arbitrage, Renaissance Technologies, risk free rate, risk tolerance, risk-adjusted returns, Robert Shiller, Ronald Reagan, Sam Peltzman, Savings and loan crisis, Sharpe ratio, short selling, sovereign wealth fund, speech recognition, statistical arbitrage, statistical model, survivorship bias, systematic trading, tail risk, The Great Moderation, too big to fail, transaction costs, value at risk, yield curve, zero-coupon bond

Livingston, Jessica. Founders at Work. Stories of Startups’ Early Days. Apress, 2007. Lockhart, James B. “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.

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The Ballooning Debt The Banks Small Business Borrowing The Markets Appendix L: The Policy Reaction I: If You're Dodd, I'll be Frank Systemic Risk The Banking Industry Derivatives Hedge Funds and Private Equity Securitization Credit Rating Agencies Insurance Industry Consumer and Investment Protection Corporate Governance and Executive Compensation Last Thoughts Appendix M: The Policy Reaction II: Basel's Back: Three Strikes and You're Out Increased Capital Requirements for Banks New Liquidity Requirements Other Changes Some Thoughts on Basel III Appendix N: The Policy Reaction III: The Federal Reserve The Fed’s Business Unconventional Policies Quantitative Easing The Federal Hedge Fund Appendix O: The Policy Reaction IV: Fiscal Stimulus and Housing Capital Injections into the Banking System Supporting the Housing Market Stimulating the Economy Appendix P: A Simple Model of Banks A Simple Bank Credit Risk Management A Bank and Mark-to-Market Accounting Simple Answer to Puzzles Glossary Bibliography About the Author Index Additional Praise for The Crisis of Crowding “What causes systemic risk in economic markets? What are the signals that there could be problems? How do you prevent systemic risk? And how should we change our risk management practices to take this risk into account? 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.

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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 instability created by crowded trades, interconnected financial institutions, and too much debt is the recurring theme. For those interested in understanding the quantitative approach to investment, the section of the book focused on LTCM is a very useful reference.

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

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

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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.

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

Admiral Zheng, Alan Greenspan, An Inconvenient Truth, Andrei Shleifer, Asian financial crisis, asset allocation, asset-backed security, Atahualpa, bank run, banking crisis, banks create money, Bear Stearns, Black Monday: stock market crash in 1987, 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, classic study, 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, equity risk premium, financial engineering, financial innovation, financial intermediation, fixed income, floating exchange rates, Fractional reserve banking, Francisco Pizarro, full employment, Future Shock, German hyperinflation, Greenspan put, Herman Kahn, 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, James Carville said: "I would like to be reincarnated as the bond market. You can intimidate everybody.", John Meriwether, joint-stock company, joint-stock limited liability company, Joseph Schumpeter, junk bonds, Kenneth Arrow, Kenneth Rogoff, knowledge economy, labour mobility, Landlord’s Game, liberal capitalism, London Interbank Offered Rate, Long Term Capital Management, low interest rates, market bubble, market fundamentalism, means of production, Mikhail Gorbachev, Modern Monetary Theory, Money creation, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, mortgage debt, mortgage tax deduction, Myron Scholes, Naomi Klein, National Debt Clock, negative equity, Nelson Mandela, Nick Bostrom, 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, risk free rate, Robert Shiller, rolling blackouts, Ronald Reagan, Savings and loan crisis, savings glut, seigniorage, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, spice trade, stocks for the long run, structural adjustment programs, subprime mortgage crisis, tail risk, technology bubble, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, Thomas Bayes, Thomas Malthus, Thorstein Veblen, tontine, too big to fail, transaction costs, two and twenty, undersea cable, value at risk, W. E. B. Du Bois, Washington Consensus, Yom Kippur War

., 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. 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.

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‘Not Even a Cat to Rescue’, The Economist, 20 April 2006. 68 See the classic study by Fritz Stern, Gold and Iron: Bismarck, Bleichröder and the Building of the German Empire (Harmondsworth, 1987). 69 George Soros, The Alchemy of Finance: Reading the Mind of the Market (New York, 1987), pp. 27-30. 70 Robert Slater, Soros: The Life, Times and Trading Secrets of the World’s Greatest Investor (New York, 1996), pp. 48f. 71 George Soros, The New Paradigm for Financial Markets: The Credit Crash of 2008 and What It Means (New York, 2008), p. x. 72 Slater, Soros, p. 78. 73 Ibid., pp. 105, 107ff. 74 Ibid., p. 172. 75 Ibid., pp. 177, 182, 188. 76 Ibid., p. 10. 77 Ibid., 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.

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(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.

Why Aren't They Shouting?: A Banker’s Tale of Change, Computers and Perpetual Crisis by Kevin Rodgers

Alan Greenspan, algorithmic trading, bank run, banking crisis, Basel III, Bear Stearns, Berlin Wall, Big bang: deregulation of the City of London, bitcoin, Black Monday: stock market crash in 1987, Black-Scholes formula, buy and hold, buy low sell high, call centre, capital asset pricing model, collapse of Lehman Brothers, Credit Default Swap, currency peg, currency risk, diversification, Fall of the Berlin Wall, financial innovation, Financial Instability Hypothesis, fixed income, Flash crash, Francis Fukuyama: the end of history, Glass-Steagall Act, Hyman Minsky, implied volatility, index fund, interest rate derivative, interest rate swap, invisible hand, John Meriwether, latency arbitrage, law of one price, light touch regulation, London Interbank Offered Rate, Long Term Capital Management, Minsky moment, money market fund, Myron Scholes, Northern Rock, Panopticon Jeremy Bentham, Ponzi scheme, prisoner's dilemma, proprietary trading, quantitative easing, race to the bottom, risk tolerance, risk-adjusted returns, Silicon Valley, systems thinking, technology bubble, The Myth of the Rational Market, The Wisdom of Crowds, Tobin tax, too big to fail, value at risk, vertical integration, Y2K, zero-coupon bond, zero-sum game

n=PET&s=RWTC&f=D 20 Central Bank of Russia statistics website, http://www.cbr.ru/eng/statistics/print.aspx?file=b_sector/interest_rates_98_e.htm&pid=procstavnew&sid=svodProcStav 21‘An Historical Document: Long-Term Capital Management CEO John Meriwether Asks for Money’, Grasping Reality with the Invisible Hand, http://delong.typepad.com/sdj/2005/06/an_historical_d.html 22 ‘Long-Term Capital Management, Report to Congressional Requesters’, United States General Accounting Office, October 1999, http://www.gao.gov/assets/230/228446.pdf Chapter 6 1 ‘Weather risk market remains buoyant, claims Clemmons’, Paul Lyon, Risk.net, 24 October 2002, http://m.risk.net/risk-magazine/news/1503229/weather-risk-market-remains-buoyant-claims-clemmons 2 Presentation to Merrill Lynch European Banking & Insurance Conference London, Anshu Jain, 8 October 2002, https://www.db.com/ir/en/download/1382.pdf 3 Stern Business School, NYU, datasets, http://pages.stern.nyu.edu/~adamodar/New_Home_Page/datafile/histretSP.html 4 US Treasury data, http://www.treasury.gov/resource-center/data-chart-center/interest-rates/Pages/Historic-LongTerm-Rate-Data-Visualization.aspx 5 2015 Investor Company Handbook, Investment Company Institute, May 2015, Chapter 2, http://www.icifactbook.org/fb_ch2.html#popularity 6 ‘Studies on Stock and Bond Picking Performance’, Mark Hebner, Index Fund Advisors, May 2013, https://www.ifa.com/articles/studies_on_stock_picking_performance/ 7 ‘Speculators Have Discovered Palladium and Sugar’, William Baldwin, Forbes, March 2011, http://www.forbes.com/forbes/2011/0411/investing-william-baldwin-investment-strategies-palladium-sugar.html 8 Presentation to Merrill Lynch European Banking & Insurance Conference London, Anshu Jain, 8 October 2002, Slide 17, https://www.db.com/ir/en/download/1382.pdf 9 Ibid., Slide 14. 10 Market Surveys Data, 1987–2010, ISDA, 2010, http://www.isda.org/statistics/pdf/ISDA-Market-Survey-annual-data.pdf 11 ‘Introducing CCOs’, Credit magazine, February 2005, http://www.risk.net/credit/feature/1510254/introducing-ccos 12 ‘CDO Evaluator Applies Correlation and Monte Carlo Simulation to the Art of Determining Portfolio Quality’, Sten Bergman, Standard and Poor’s, 12 November 2001, http://www.globalriskguard.com/resources/crderiv/sp_portf_qual.pdf 13 ‘“The Formula That Killed Wall Street”?

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I worked in my speciality of FX until 1997, then I moved over to the newly created Emerging Markets department. With my angel-of-death-like ability to be close to the centre of any trouble, I was soon caught up in one of the market’s greatest ever crises as first Asia, then Russia, then a huge hedge fund called Long-Term Capital Management dragged the banking industry to the brink of disaster in 1998. The market was saved by intervention by the Federal Reserve and, in the chaos, Bankers Trust was purchased by German giant Deutsche Bank. It was here, at Deutsche, from 1999 onwards, that I was to spend the rest of my career.

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With that, he turned the corner and drove out of sight. CHAPTER 2 Whales Don’t Eat Elephants Triangle Man and the Clackatron It was spring 1999 and I was bored. The takeover of my employer Bankers Trust by Deutsche Bank had been agreed late the previous year after the Russia crisis and the collapse of a major hedge fund called Long-Term Capital Management (LTCM) but had not yet been consummated. Like every other trader in Bankers, I had been given strict instructions by management on how I could help the process, namely do as little as possible and don’t screw up. My boss Ron, a crop-haired and intense Israeli ex-paratrooper, packed around 20 of us emerging markets traders and salespeople into a cramped, anonymous, overheated meeting room to explain.

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

Alan Greenspan, Albert Einstein, Alvin Toffler, behavioural economics, Bernie Madoff, Black Swan, business cycle, buy and hold, commodity trading advisor, correlation coefficient, delayed gratification, disinformation, diversified portfolio, en.wikipedia.org, Eugene Fama: efficient market hypothesis, family office, full employment, global macro, Jim Simons, Lao Tzu, Long Term Capital Management, managed futures, market bubble, market microstructure, Market Wizards by Jack D. Schwager, Mikhail Gorbachev, moral hazard, Myron Scholes, Nick Leeson, oil shock, Ponzi scheme, prediction markets, quantitative trading / quantitative finance, random walk, Reminiscences of a Stock Operator, Sharpe ratio, systematic trading, the scientific method, three-martini lunch, 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?

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., 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.

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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.

The Quants by Scott Patterson

Alan Greenspan, Albert Einstein, AOL-Time Warner, asset allocation, automated trading system, Bear Stearns, beat the dealer, Benoit Mandelbrot, Bernie Madoff, Bernie Sanders, Black Monday: stock market crash in 1987, Black Swan, Black-Scholes formula, Blythe Masters, Bonfire of the Vanities, book value, Brownian motion, buttonwood tree, buy and hold, buy low sell high, capital asset pricing model, Carl Icahn, 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, Dr. Strangelove, Edward Thorp, Emanuel Derman, Eugene Fama: efficient market hypothesis, financial engineering, Financial Modelers Manifesto, fixed income, Glass-Steagall Act, global macro, 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, Jim Simons, job automation, John Meriwether, John Nash: game theory, junk bonds, Kickstarter, law of one price, Long Term Capital Management, Louis Bachelier, low interest rates, mandelbrot fractal, margin call, Mark Spitznagel, merger arbitrage, Michael Milken, military-industrial complex, money market fund, Myron Scholes, NetJets, new economy, offshore financial centre, old-boy network, Paul Lévy, Paul Samuelson, Ponzi scheme, proprietary trading, 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, Savings and loan crisis, Sergey Aleynikov, short selling, short squeeze, 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

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.

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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.

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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.

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

Alan Greenspan, asset-backed security, bank run, banking crisis, Bear Stearns, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black Monday: stock market crash in 1987, Black-Scholes formula, Blythe Masters, Celtic Tiger, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, Daniel Kahneman / Amos Tversky, diversified portfolio, double entry bookkeeping, Exxon Valdez, Fall of the Berlin Wall, financial deregulation, financial engineering, financial innovation, fixed income, George Akerlof, Glass-Steagall Act, greed is good, Greenspan put, hedonic treadmill, hindsight bias, housing crisis, Hyman Minsky, intangible asset, interest rate swap, invisible hand, James Carville said: "I would like to be reincarnated as the bond market. You can intimidate everybody.", Jane Jacobs, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Meriwether, junk bonds, Kickstarter, laissez-faire capitalism, light touch regulation, liquidity trap, Long Term Capital Management, loss aversion, low interest rates, 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, off-the-grid, Own Your Own Home, Ponzi scheme, quantitative easing, reserve currency, Right to Buy, risk-adjusted returns, Robert Shiller, Ronald Reagan, Savings and loan crisis, shareholder value, South Sea Bubble, statistical model, Tax Reform Act of 1986, The Great Moderation, the payments system, too big to fail, tulip mania, Tyler Cowen, value at risk

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.

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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.

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., 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.”

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

"World Economic Forum" Davos, Alan Greenspan, AOL-Time Warner, bank run, Bear Stearns, Blythe Masters, Bonfire of the Vanities, book value, business logic, 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, Glass-Steagall Act, Greenspan put, housing crisis, interest rate swap, Jeff Bezos, John Meriwether, junk bonds, Kickstarter, laissez-faire capitalism, Long Term Capital Management, margin call, market bubble, Michael Milken, money market fund, moral hazard, negative equity, Nelson Mandela, Northern Rock, profit motive, proprietary trading, 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

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.

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(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.”

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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.

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

Abraham Maslow, Alan Greenspan, 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, currency risk, diversification, diversified portfolio, family office, financial engineering, fixed income, glass ceiling, Glass-Steagall Act, global macro, Greenspan put, high batting average, implied volatility, index fund, inflation targeting, interest rate derivative, inventory management, inverted yield curve, John Meriwether, junk bonds, land bank, Long Term Capital Management, low interest rates, managed futures, margin call, market bubble, Market Wizards by Jack D. Schwager, Maui Hawaii, Mexican peso crisis / tequila crisis, moral hazard, Myron Scholes, new economy, Nick Leeson, Nixon triggered the end of the Bretton Woods system, oil shale / tar sands, oil shock, out of africa, panic early, paper trading, Paul Samuelson, Peter Thiel, price anchoring, proprietary trading, purchasing power parity, Reminiscences of a Stock Operator, reserve currency, risk free rate, risk tolerance, risk-adjusted returns, risk/return, rolodex, Sharpe ratio, short selling, Silicon Valley, tail risk, The Wisdom of Crowds, too big to fail, transaction costs, value at risk, Vision Fund, 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.

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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.

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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.

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

accounting loophole / creative accounting, Alan Greenspan, Albert Einstein, Asian financial crisis, asset-backed security, Bear Stearns, beat the dealer, Black Swan, Black-Scholes formula, Bretton Woods, BRICs, Brownian motion, business logic, 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, currency risk, disinformation, disintermediation, diversification, diversified portfolio, Edward Thorp, Eugene Fama: efficient market hypothesis, Everything should be made as simple as possible, financial engineering, financial innovation, fixed income, Glass-Steagall Act, Haight Ashbury, high net worth, implied volatility, index arbitrage, index card, index fund, interest rate derivative, interest rate swap, Isaac Newton, job satisfaction, John Bogle, John Meriwether, junk bonds, locking in a profit, Long Term Capital Management, low interest rates, 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, Nixon triggered the end of the Bretton Woods system, offshore financial centre, oil shock, Parkinson's law, placebo effect, Ponzi scheme, proprietary trading, purchasing power parity, quantitative trading / quantitative finance, random walk, regulatory arbitrage, Right to Buy, risk free rate, risk-adjusted returns, risk/return, Salesforce, Satyajit Das, shareholder value, short selling, short squeeze, 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.

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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).

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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.

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

Alan Greenspan, asset-backed security, bank run, banking crisis, Basel III, Bear Stearns, behavioural economics, Black Swan, Black-Scholes formula, bonus culture, book value, 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, currency risk, delayed gratification, diversification, Edmond Halley, facts on the ground, fear index, financial innovation, fixed income, George Akerlof, Glass-Steagall Act, Greenspan put, implied volatility, index fund, interest rate derivative, interest rate swap, Isaac Newton, John Meriwether, junk bonds, 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, proprietary trading, regulatory arbitrage, rent-seeking, Richard Thaler, risk free rate, risk tolerance, risk/return, Ronald Reagan, Salesforce, Savings and loan crisis, seminal paper, shareholder value, short selling, statistical model, subprime mortgage crisis, 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.

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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.

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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.

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

Alan Greenspan, Andy Kessler, AOL-Time Warner, barriers to entry, Bear Stearns, 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, Carl Icahn, commoditize, corporate governance, corporate raider, crony capitalism, cross-subsidies, deal flow, equity risk premium, financial deregulation, financial engineering, financial innovation, fixed income, Glass-Steagall Act, Gordon Gekko, high net worth, information retrieval, interest rate derivative, invisible hand, John Meriwether, junk bonds, Long Term Capital Management, low interest rates, Martin Wolf, Michael Milken, new economy, Nick Leeson, offshore financial centre, pensions crisis, proprietary trading, regulatory arbitrage, risk free rate, Sand Hill Road, shareholder value, short selling, Silicon Valley, South Sea Bubble, statistical model, systematic bias, 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.

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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.

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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.

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

"Friedman doctrine" OR "shareholder theory", "World Economic Forum" Davos, Abraham Maslow, Affordable Care Act / Obamacare, Airbnb, airline deregulation, Alan Greenspan, Albert Einstein, augmented reality, basic income, Bear Stearns, behavioural economics, Bernie Sanders, Black-Scholes formula, Blitzscaling, buy and hold, capital controls, Carl Icahn, computerized trading, Cornelius Vanderbilt, corporate governance, cryptocurrency, Daniel Kahneman / Amos Tversky, data science, deal flow, dematerialisation, diversified portfolio, Donald Trump, Elon Musk, Eugene Fama: efficient market hypothesis, Fairchild Semiconductor, financial deregulation, financial innovation, fixed income, future of work, George Akerlof, gig economy, Glass-Steagall Act, Henry Ford's grandson gave labor union leader Walter Reuther a tour of the company’s new, automated factory…, Ida Tarbell, index fund, information asymmetry, invisible hand, Irwin Jacobs, Joi Ito, Joseph Schumpeter, junk bonds, Kenneth Arrow, Kickstarter, life extension, Long Term Capital Management, Mark Zuckerberg, Mary Meeker, mass immigration, means of production, Metcalfe’s law, Michael Milken, money market fund, Mont Pelerin Society, moral hazard, Myron Scholes, Neal Stephenson, new economy, Norman Mailer, obamacare, PalmPilot, Paul Samuelson, Performance of Mutual Funds in the Period, Peter Thiel, price mechanism, principal–agent problem, profit maximization, proprietary trading, prudent man rule, public intellectual, quantitative trading / quantitative finance, Ralph Nader, Richard Thaler, road to serfdom, Robert Bork, Robert Metcalfe, rolodex, Ronald Coase, Ronald Reagan, Sand Hill Road, Savings and loan crisis, shareholder value, short selling, Silicon Valley, Silicon Valley ideology, Silicon Valley startup, Snow Crash, Social Responsibility of Business Is to Increase Its Profits, Steve Jobs, TaskRabbit, TED Talk, The Nature of the Firm, the payments system, the strength of weak ties, 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

… Are some hedge funds too big to fail?” 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.

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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.

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“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.

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

"Friedman doctrine" OR "shareholder theory", Abraham Wald, activist fund / activist shareholder / activist investor, Alan Greenspan, Albert Einstein, Andrei Shleifer, AOL-Time Warner, asset allocation, asset-backed security, bank run, beat the dealer, behavioural economics, Benoit Mandelbrot, Big Tech, Black Monday: stock market crash in 1987, Black-Scholes formula, book value, Bretton Woods, Brownian motion, business cycle, buy and hold, capital asset pricing model, card file, Carl Icahn, Cass Sunstein, collateralized debt obligation, compensation consultant, complexity theory, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, democratizing finance, Dennis Tito, discovery of the americas, diversification, diversified portfolio, Dr. Strangelove, Edward Glaeser, Edward Thorp, endowment effect, equity risk premium, Eugene Fama: efficient market hypothesis, experimental economics, financial innovation, Financial Instability Hypothesis, fixed income, floating exchange rates, George Akerlof, Glass-Steagall Act, Henri Poincaré, Hyman Minsky, implied volatility, impulse control, index arbitrage, index card, index fund, information asymmetry, invisible hand, Isaac Newton, John Bogle, John Meriwether, John Nash: game theory, John von Neumann, joint-stock company, Joseph Schumpeter, junk bonds, Kenneth Arrow, libertarian paternalism, linear programming, Long Term Capital Management, Louis Bachelier, low interest rates, mandelbrot fractal, market bubble, market design, Michael Milken, Myron Scholes, New Journalism, Nikolai Kondratiev, Paul Lévy, Paul Samuelson, pension reform, performance metric, Ponzi scheme, power law, prediction markets, proprietary trading, prudent man rule, 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, rolodex, Ronald Reagan, seminal paper, shareholder value, Sharpe ratio, short selling, side project, Silicon Valley, Skinner box, Social Responsibility of Business Is to Increase Its Profits, South Sea Bubble, statistical model, stocks for the long run, tech worker, 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, Two Sigma, Tyler Cowen, value at risk, Vanguard fund, Vilfredo Pareto, volatility smile, Yogi Berra

“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.

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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.”

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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.

All the Devils Are Here by Bethany McLean

Alan Greenspan, Asian financial crisis, asset-backed security, bank run, Bear Stearns, behavioural economics, Black-Scholes formula, Blythe Masters, break the buck, buy and hold, call centre, Carl Icahn, collateralized debt obligation, corporate governance, corporate raider, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, diversification, Dr. Strangelove, Exxon Valdez, fear of failure, financial innovation, fixed income, Glass-Steagall Act, high net worth, Home mortgage interest deduction, interest rate swap, junk bonds, Ken Thompson, laissez-faire capitalism, Long Term Capital Management, low interest rates, margin call, market bubble, market fundamentalism, Maui Hawaii, Michael Milken, money market fund, moral hazard, mortgage debt, Northern Rock, Own Your Own Home, Ponzi scheme, proprietary trading, quantitative trading / quantitative finance, race to the bottom, risk/return, Ronald Reagan, Rosa Parks, Savings and loan crisis, shareholder value, short selling, South Sea Bubble, statistical model, stock buybacks, tail risk, Tax Reform Act of 1986, telemarketer, the long tail, too big to fail, value at risk, zero-sum game

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.

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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.

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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.

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

active measures, Alan Greenspan, Asian financial crisis, asset-backed security, bank run, banking crisis, Basel III, Bear Stearns, Bernie Madoff, Black Monday: stock market crash in 1987, Black Swan, Boeing 747, 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, cross-border payments, currency peg, currency risk, 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, Glass-Steagall Act, Herman Kahn, Honoré de Balzac, Hyman Minsky, index fund, inflation targeting, information asymmetry, invisible hand, Isaac Newton, Japanese asset price bubble, joint-stock company, junk bonds, large denomination, law of one price, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, low interest rates, margin call, market bubble, Mary Meeker, Michael Milken, 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, short selling, Silicon Valley, South Sea Bubble, special drawing rights, Suez canal 1869, 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

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.

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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.

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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.

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

Abraham Maslow, accounting loophole / creative accounting, Alan Greenspan, AOL-Time Warner, Asian financial crisis, bank run, Bear Stearns, book value, Bretton Woods, business cycle, capital controls, Carl Icahn, collapse of Lehman Brothers, collateralized debt obligation, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, desegregation, disintermediation, diversified portfolio, Donald Trump, financial deregulation, fixed income, floating exchange rates, Frederick Winslow Taylor, full employment, George Akerlof, Glass-Steagall Act, Greenspan put, Hyman Minsky, income inequality, index fund, inflation targeting, inventory management, invisible hand, John Bogle, John Meriwether, junk bonds, Kitchen Debate, laissez-faire capitalism, locking in a profit, Long Term Capital Management, low interest rates, market bubble, Mary Meeker, Michael Milken, minimum wage unemployment, MITM: man-in-the-middle, Money creation, money market fund, Mont Pelerin Society, moral hazard, mortgage debt, Myron Scholes, new economy, Nixon triggered the end of the Bretton Woods system, North Sea oil, Northern Rock, oil shock, Paul Samuelson, Philip Mirowski, Phillips curve, price stability, quantitative easing, Ralph Nader, rent control, road to serfdom, Robert Bork, Robert Shiller, Ronald Coase, Ronald Reagan, Ronald Reagan: Tear down this wall, scientific management, shareholder value, short selling, Silicon Valley, Simon Kuznets, tail risk, Tax Reform Act of 1986, 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

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.

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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.

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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.

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, Japanese asset price bubble, knowledge economy, liberal capitalism, liberal world order, Long Term Capital Management, low interest rates, market bubble, Meghnad Desai, Mexican peso crisis / tequila crisis, moral hazard, Nick Leeson, Nixon triggered the end of the Bretton Woods system, oil shock, open economy, Post-Keynesian economics, price mechanism, price stability, Real Time Gross Settlement, rent-seeking, short selling, special drawing rights, structural adjustment programs, Tobin tax, transaction costs, Washington Consensus

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.

…

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).

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

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

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.

…

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.

…

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, behavioural economics, Black Monday: stock market crash in 1987, Bob Litterman, book value, business cycle, buy and hold, buy low sell high, capital asset pricing model, commodity trading advisor, computerized trading, creative destruction, currency risk, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, diversification, diversified portfolio, endowment effect, equity premium, equity risk premium, Eugene Fama: efficient market hypothesis, financial engineering, 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, Performance of Mutual Funds in the Period, price anchoring, price stability, random walk, Richard Thaler, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, seminal paper, Sharpe ratio, short selling, short squeeze, Silicon Valley, South Sea Bubble, statistical model, survivorship bias, systematic trading, tail risk, technology bubble, The Wealth of Nations by Adam Smith, transaction costs, yield curve, Yogi Berra, zero-sum game

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.

…

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.

…

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.

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

"World Economic Forum" Davos, Airbus A320, Apple's 1984 Super Bowl advert, bank run, banking crisis, Bear Stearns, Black Monday: stock market crash in 1987, bonus culture, call centre, Captain Sullenberger Hudson, collapse of Lehman Brothers, collateralized debt obligation, compensation consultant, corporate governance, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, financial engineering, financial innovation, fixed income, glass ceiling, Glass-Steagall Act, high net worth, junk bonds, Ken Thompson, Long Term Capital Management, mass affluent, Mexican peso crisis / tequila crisis, Michael Milken, Nelson Mandela, plutocrats, Ronald Reagan, six sigma, sovereign wealth fund, technology bubble, too big to fail, US Airways Flight 1549, yield curve

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.

…

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.

…

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.

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

affirmative action, Andrei Shleifer, asset-backed security, bank run, banking crisis, Bear Stearns, behavioural economics, 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, Future Shock, 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, junk bonds, Long Term Capital Management, loss aversion, market bubble, market clearing, mental accounting, Michael Milken, 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, Phillips curve, plutocrats, Post-Keynesian economics, price stability, profit maximization, public intellectual, purchasing power parity, random walk, Richard Thaler, Robert Shiller, Robert Solow, Ronald Reagan, Savings and loan crisis, seminal paper, 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, W. E. B. Du Bois, We are all Keynesians now, working-age population, Y2K, Yom Kippur War

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.

…

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.

The Little Book of Hedge Funds by Anthony Scaramucci

Alan Greenspan, Andrei Shleifer, asset allocation, Bear Stearns, Bernie Madoff, business process, carried interest, corporate raider, Credit Default Swap, diversification, diversified portfolio, Donald Trump, Eugene Fama: efficient market hypothesis, fear of failure, financial engineering, fixed income, follow your passion, global macro, Gordon Gekko, high net worth, index fund, it's over 9,000, John Bogle, John Meriwether, Long Term Capital Management, mail merge, managed futures, margin call, mass immigration, merger arbitrage, Michael Milken, money market fund, Myron Scholes, NetJets, Ponzi scheme, profit motive, proprietary trading, quantitative trading / quantitative finance, random walk, Renaissance Technologies, risk-adjusted returns, risk/return, Ronald Reagan, Saturday Night Live, Sharpe ratio, short selling, short squeeze, Silicon Valley, tail risk, Thales and the olive presses, Thales of Miletus, the new new thing, too big to fail, transaction costs, two and twenty, uptick rule, Vanguard fund, Y2K, Yogi Berra, zero-sum game

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.

…

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.

A Man for All Markets by Edward O. Thorp

"RICO laws" OR "Racketeer Influenced and Corrupt Organizations", 3Com Palm IPO, Alan Greenspan, Albert Einstein, asset allocation, Bear Stearns, beat the dealer, Bernie Madoff, Black Monday: stock market crash in 1987, Black Swan, Black-Scholes formula, book value, Brownian motion, buy and hold, buy low sell high, caloric restriction, caloric restriction, 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 engineering, financial innovation, Garrett Hardin, George Santayana, German hyperinflation, Glass-Steagall Act, Henri Poincaré, high net worth, High speed trading, index arbitrage, index fund, interest rate swap, invisible hand, Jarndyce and Jarndyce, Jeff Bezos, John Bogle, John Meriwether, John Nash: game theory, junk bonds, Kenneth Arrow, Livingstone, I presume, Long Term Capital Management, Louis Bachelier, low interest rates, margin call, Mason jar, merger arbitrage, Michael Milken, Murray Gell-Mann, Myron Scholes, NetJets, Norbert Wiener, PalmPilot, passive investing, Paul Erdős, Paul Samuelson, Pluto: dwarf planet, Ponzi scheme, power law, 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, rolodex, Sharpe ratio, short selling, Silicon Valley, Stanford marshmallow experiment, statistical arbitrage, stem cell, stock buybacks, stocks for the long run, survivorship bias, tail risk, The Myth of the Rational Market, The Predators' Ball, the rule of 72, The Wisdom of Crowds, too big to fail, Tragedy of the Commons, uptick rule, 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!).

…

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.

…

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.

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

affirmative action, Alan Greenspan, 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 engineering, 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, money market fund, Murray Gell-Mann, Netflix Prize, pattern recognition, Performance of Mutual Funds in the Period, Philip Mirowski, placebo effect, Ponzi scheme, power law, prediction markets, presumed consent, Richard Thaler, Robert Shiller, statistical model, Steven Pinker, systems thinking, the long tail, The Wisdom of Crowds, ultimatum game, vertical integration

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.

…

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.

…

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.

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

Alan Greenspan, Albert Einstein, Andrei Shleifer, Atul Gawande, availability heuristic, beat the dealer, behavioural economics, 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, equity risk 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, John Bogle, 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, Performance of Mutual Funds in the Period, Pierre-Simon Laplace, power law, quantitative trading / quantitative finance, random walk, Reminiscences of a Stock Operator, Richard Florida, Richard Thaler, Robert Shiller, shareholder value, statistical model, Steven Pinker, stocks for the long run, Stuart Kauffman, survivorship bias, systems thinking, The Wisdom of Crowds, transaction costs, traveling salesman, value at risk, wealth creators, women in the workforce, zero-sum game

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.

…

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.

…

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.

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, Bear Stearns, behavioural economics, Bernie Madoff, Black Swan, buy and hold, Carl Icahn, centralized clearinghouse, clean water, compensation consultant, 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 engineering, financial innovation, financial intermediation, fixed income, Flash crash, Glass-Steagall Act, income inequality, index fund, information asymmetry, invisible hand, John Bogle, Kenneth Arrow, Kickstarter, light touch regulation, London Whale, Long Term Capital Management, moral hazard, Myron Scholes, Northern Rock, passive investing, Paul Volcker talking about ATMs, payment for order flow, performance metric, Ponzi scheme, post-work, principal–agent problem, rent-seeking, Ronald Coase, seminal paper, 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.

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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.

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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.

The End of Wall Street by Roger Lowenstein

"World Economic Forum" Davos, Alan Greenspan, Asian financial crisis, asset-backed security, bank run, banking crisis, Bear Stearns, benefit corporation, Berlin Wall, Bernie Madoff, Black Monday: stock market crash in 1987, 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, financial engineering, fixed income, geopolitical risk, Glass-Steagall Act, Greenspan put, high net worth, Hyman Minsky, interest rate derivative, invisible hand, junk bonds, Ken Thompson, Kenneth Rogoff, London Interbank Offered Rate, Long Term Capital Management, low interest rates, margin call, market bubble, Martin Wolf, Michael Milken, 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 and loan crisis, 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.

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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.

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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.

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

"World Economic Forum" Davos, affirmative action, Alan Greenspan, Andy Kessler, Asian financial crisis, Bear Stearns, Berlin Wall, book value, break the buck, BRICs, business cycle, Carl Icahn, collapse of Lehman Brothers, collateralized debt obligation, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, deal flow, Dr. Strangelove, Emanuel Derman, Fall of the Berlin Wall, fear of failure, financial engineering, fixed income, Glass-Steagall Act, Goldman Sachs: Vampire Squid, housing crisis, indoor plumbing, invisible hand, junk bonds, Ken Thompson, London Interbank Offered Rate, Long Term Capital Management, low interest rates, margin call, market bubble, Michael Milken, Mikhail Gorbachev, money market fund, moral hazard, naked short selling, NetJets, Northern Rock, oil shock, paper trading, proprietary trading, risk tolerance, Robert Shiller, rolodex, Ronald Reagan, Savings and loan crisis, savings glut, shareholder value, short selling, sovereign wealth fund, supply-chain management, too big to fail, uptick rule, 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.

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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.

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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.

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

"World Economic Forum" Davos, Affordable Care Act / Obamacare, Alan Greenspan, Albert Einstein, asset allocation, asset-backed security, bank run, banking crisis, barriers to entry, Bayesian statistics, Bear Stearns, behavioural economics, Ben Bernanke: helicopter money, Benoit Mandelbrot, Berlin Wall, Bernie Sanders, Big bang: deregulation of the City of London, bitcoin, Black Monday: stock market crash in 1987, Black Swan, blockchain, Boeing 747, Bonfire of the Vanities, Bretton Woods, Brexit referendum, 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, currency risk, Daniel Kahneman / Amos Tversky, David Ricardo: comparative advantage, debt deflation, Deng Xiaoping, disintermediation, distributed ledger, diversification, diversified portfolio, driverless car, 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, Glass-Steagall Act, global macro, 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, junk bonds, Kenneth Rogoff, labor-force participation, large denomination, liquidity trap, Long Term Capital Management, low interest rates, machine readable, mandelbrot fractal, margin call, market bubble, Mexican peso crisis / tequila crisis, Minsky moment, Money creation, money market fund, mutually assured destruction, Myron Scholes, Naomi Klein, nuclear winter, obamacare, offshore financial centre, operational security, Paul Samuelson, Peace of Westphalia, Phillips curve, Pierre-Simon Laplace, plutocrats, prediction markets, price anchoring, price stability, proprietary trading, public intellectual, quantitative easing, RAND corporation, random walk, reserve currency, RFID, risk free rate, risk-adjusted returns, Robert Solow, Ronald Reagan, Savings and loan crisis, Silicon Valley, sovereign wealth fund, special drawing rights, stock buybacks, stocks for the long run, tech billionaire, 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, We are all Keynesians now, Westphalian system

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.

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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.

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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.

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

Alan Greenspan, American ideology, Andrei Shleifer, Asian financial crisis, asset-backed security, bank run, banking crisis, Bear Stearns, Bernie Madoff, Black Monday: stock market crash in 1987, Bonfire of the Vanities, bonus culture, book value, break the buck, business cycle, business logic, 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, currency risk, Edward Glaeser, Eugene Fama: efficient market hypothesis, financial deregulation, financial engineering, financial innovation, financial intermediation, financial repression, fixed income, George Akerlof, Glass-Steagall Act, Gordon Gekko, greed is good, Greenspan put, Home mortgage interest deduction, Hyman Minsky, income per capita, information asymmetry, interest rate derivative, interest rate swap, junk bonds, Kenneth Rogoff, laissez-faire capitalism, late fees, light touch regulation, Long Term Capital Management, low interest rates, market bubble, market fundamentalism, Martin Wolf, Michael Milken, money market fund, moral hazard, mortgage tax deduction, Myron Scholes, Paul Samuelson, Ponzi scheme, price stability, profit maximization, proprietary trading, race to the bottom, regulatory arbitrage, rent-seeking, Robert Bork, Robert Shiller, Ronald Reagan, Saturday Night Live, Satyajit Das, Savings and loan crisis, sovereign wealth fund, Tax Reform Act of 1986, The Myth of the Rational Market, too big to fail, transaction costs, Tyler Cowen, value at risk, yield curve

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.

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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).

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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.

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

3D printing, Alan Greenspan, bank run, banking crisis, Bear Stearns, 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, Glass-Steagall Act, 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, low interest rates, market bubble, market clearing, means of production, Meghnad Desai, Mexican peso crisis / tequila crisis, mortgage debt, Myron Scholes, negative equity, Northern Rock, oil shale / tar sands, oil shock, open economy, Paul Samuelson, Phillips curve, Post-Keynesian economics, price stability, purchasing power parity, pushing on a string, quantitative easing, reserve currency, rising living standards, risk/return, Robert Shiller, Robert Solow, Ronald Reagan, savings glut, secular stagnation, seigniorage, Silicon Valley, Simon Kuznets, subprime mortgage crisis, 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.

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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.

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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.

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

Alan Greenspan, asset-backed security, Bear Stearns, book value, call centre, collateralized debt obligation, corporate governance, corporate raider, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, deal flow, Deng Xiaoping, diversification, Financial Instability Hypothesis, fixed income, Glass-Steagall Act, Hyman Minsky, Irwin Jacobs, Jim Simons, John Meriwether, junk bonds, Long Term Capital Management, low interest rates, margin call, merger arbitrage, Michael Milken, money market fund, moral hazard, mortgage debt, mutually assured destruction, Myron Scholes, New Journalism, Northern Rock, proprietary trading, Renaissance Technologies, Rod Stewart played at Stephen Schwarzman birthday party, Savings and loan crisis, savings glut, shareholder value, sovereign wealth fund, stock buybacks, too big to fail, traveling salesman, uptick rule, vertical integration, Y2K, yield curve

“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.

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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.

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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.

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

"World Economic Forum" Davos, Alan Greenspan, Asian financial crisis, bank run, Bear Stearns, behavioural economics, 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, cross-border payments, currency manipulation / currency intervention, currency peg, currency risk, Daniel Kahneman / Amos Tversky, deal flow, Deng Xiaoping, diversification, diversified portfolio, Dr. Strangelove, 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, Great Leap Forward, guns versus butter model, high net worth, income inequality, interest rate derivative, it's over 9,000, John Meriwether, Kenneth Rogoff, laissez-faire capitalism, liquidity trap, Long Term Capital Management, low interest rates, mandelbrot fractal, margin call, market bubble, Mexican peso crisis / tequila crisis, Money creation, money market fund, money: store of value / unit of account / medium of exchange, Myron Scholes, Network effects, New Journalism, Nixon shock, Nixon triggered the end of the Bretton Woods system, offshore financial centre, oil shock, one-China policy, open economy, paradox of thrift, Paul Samuelson, power law, price mechanism, price stability, private sector deleveraging, proprietary trading, quantitative easing, race to the bottom, RAND corporation, rent-seeking, reserve currency, Ronald Reagan, short squeeze, sovereign wealth fund, special drawing rights, special economic zone, subprime mortgage crisis, 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, vertical integration, War on Poverty, Washington Consensus, zero-sum game

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.

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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.

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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.

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

Bear Stearns, Berlin Wall, bioinformatics, Black-Scholes formula, book value, Brownian motion, buy and hold, capital asset pricing model, Claude Shannon: information theory, Dennis Ritchie, Donald Knuth, Emanuel Derman, financial engineering, fixed income, Gödel, Escher, Bach, haute couture, hiring and firing, implied volatility, interest rate derivative, Jeff Bezos, John Meriwether, John von Neumann, Ken Thompson, law of one price, linked data, Long Term Capital Management, moral hazard, Murray Gell-Mann, Myron Scholes, PalmPilot, Paul Samuelson, pre–internet, proprietary trading, 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.

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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.

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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.

Chaos Kings: How Wall Street Traders Make Billions in the New Age of Crisis by Scott Patterson

"World Economic Forum" Davos, 2021 United States Capitol attack, 4chan, Alan Greenspan, Albert Einstein, asset allocation, backtesting, Bear Stearns, beat the dealer, behavioural economics, Benoit Mandelbrot, Bernie Madoff, Bernie Sanders, bitcoin, Bitcoin "FTX", Black Lives Matter, Black Monday: stock market crash in 1987, Black Swan, Black Swan Protection Protocol, Black-Scholes formula, blockchain, Bob Litterman, Boris Johnson, Brownian motion, butterfly effect, carbon footprint, carbon tax, Carl Icahn, centre right, clean tech, clean water, collapse of Lehman Brothers, Colonization of Mars, commodity super cycle, complexity theory, contact tracing, coronavirus, correlation does not imply causation, COVID-19, Credit Default Swap, cryptocurrency, Daniel Kahneman / Amos Tversky, decarbonisation, disinformation, diversification, Donald Trump, Doomsday Clock, Edward Lloyd's coffeehouse, effective altruism, Elliott wave, Elon Musk, energy transition, Eugene Fama: efficient market hypothesis, Extinction Rebellion, fear index, financial engineering, fixed income, Flash crash, Gail Bradbrook, George Floyd, global pandemic, global supply chain, Gordon Gekko, Greenspan put, Greta Thunberg, hindsight bias, index fund, interest rate derivative, Intergovernmental Panel on Climate Change (IPCC), Jeff Bezos, Jeffrey Epstein, Joan Didion, John von Neumann, junk bonds, Just-in-time delivery, lockdown, Long Term Capital Management, Louis Bachelier, mandelbrot fractal, Mark Spitznagel, Mark Zuckerberg, market fundamentalism, mass immigration, megacity, Mikhail Gorbachev, Mohammed Bouazizi, money market fund, moral hazard, Murray Gell-Mann, Nick Bostrom, off-the-grid, panic early, Pershing Square Capital Management, Peter Singer: altruism, Ponzi scheme, power law, precautionary principle, prediction markets, proprietary trading, public intellectual, QAnon, quantitative easing, quantitative hedge fund, quantitative trading / quantitative finance, Ralph Nader, Ralph Nelson Elliott, random walk, Renaissance Technologies, rewilding, Richard Thaler, risk/return, road to serfdom, Ronald Reagan, Ronald Reagan: Tear down this wall, Rory Sutherland, Rupert Read, Sam Bankman-Fried, Silicon Valley, six sigma, smart contracts, social distancing, sovereign wealth fund, statistical arbitrage, statistical model, stem cell, Stephen Hawking, Steve Jobs, Steven Pinker, Stewart Brand, systematic trading, tail risk, technoutopianism, The Chicago School, The Great Moderation, the scientific method, too big to fail, transaction costs, University of East Anglia, value at risk, Vanguard fund, We are as Gods, Whole Earth Catalog

He’d made a killing on Black Monday in October 1987, when the Dow fell 22.6 percent in a single day. Like Spitznagel, he’d witnessed all the blowups of the nineties—the 1994 bankruptcy of Orange County, California; the Asian Contagion of 1997 triggered by currency devaluations; the 1998 collapse of the giant hedge fund Long-Term Capital Management after it made wildly misguided bets on Russian debt (among other things). Taleb had begun calling such crises Black Swans—extreme events no one could have predicted (like a sudden market crash). Once upon a time Europeans thought all swans were white… until they discovered black swans in Australia.

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It wasn’t enough to save the firm—Eastbridge shut down a year later—but it was enough to satisfy Spitznagel that his strategy had worked. His “trial and error” experiments, as he liked to call them, were proving themselves with the certainty provided by cold hard cash. His next experiment, the following year, made even more money when the giant quant-packed hedge fund Long-Term Capital Management blew up, triggering more panic. That gave him the financial cushion to quit trading for a while and—hoping to add some scientific rigor to his pit-trader experiments—take what he called a “learning sabbatical.” He enrolled in New York University’s elite Courant Institute of Mathematical Sciences, one of the world’s top applied mathematics schools and home to some of the brightest quantitative minds on Wall Street—including a freshly minted professor of finance, Nassim Nicholas Taleb.

…

The more you expand your model by adding parameters, the more you become trapped in an inextricable apparatus of relationships. It is called overfitting.” Taleb earned a Ph.D. in mathematics in 1998 from the University of Paris–Dauphine. Then he hit the jackpot again when Russia defaulted on its debt (a move that devastated Long-Term Capital Management). Prior to the default, Taleb had purchased a bunch of put options on Russian banks, positions that would pay off if the banks plunged. They did, handsomely. * * * In a small classroom in Greenwich Village ripe with the scent of car exhaust and Chinese takeout, Taleb stood before a whiteboard scribbling equations.

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

Affordable Care Act / Obamacare, Alan Greenspan, asset-backed security, bank run, banking crisis, Basel III, Bear Stearns, behavioural economics, Bernie Madoff, Big bang: deregulation of the City of London, bitcoin, Black Monday: stock market crash in 1987, Black Swan, Bonfire of the Vanities, bonus culture, book value, Bretton Woods, buy and hold, call centre, capital asset pricing model, Capital in the Twenty-First Century by Thomas Piketty, cognitive dissonance, Cornelius Vanderbilt, corporate governance, Credit Default Swap, cross-subsidies, currency risk, dematerialisation, disinformation, disruptive innovation, diversification, diversified portfolio, Edward Lloyd's coffeehouse, Elon Musk, Eugene Fama: efficient market hypothesis, eurozone crisis, financial engineering, financial innovation, financial intermediation, financial thriller, fixed income, Flash crash, forward guidance, Fractional reserve banking, full employment, George Akerlof, German hyperinflation, Glass-Steagall Act, Goldman Sachs: Vampire Squid, Greenspan put, Growth in a Time of Debt, Ida Tarbell, 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, it is difficult to get a man to understand something, when his salary depends on his not understanding it, James Carville said: "I would like to be reincarnated as the bond market. You can intimidate everybody.", Jim Simons, John Meriwether, junk bonds, light touch regulation, London Whale, Long Term Capital Management, loose coupling, low cost airline, M-Pesa, market design, Mary Meeker, megaproject, Michael Milken, millennium bug, mittelstand, Money creation, 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, Paul Volcker talking about ATMs, peer-to-peer lending, performance metric, Peter Thiel, Piper Alpha, Ponzi scheme, price mechanism, proprietary trading, purchasing power parity, quantitative easing, quantitative trading / quantitative finance, railway mania, Ralph Waldo Emerson, random walk, reality distortion field, regulatory arbitrage, Renaissance Technologies, rent control, risk free rate, risk tolerance, road to serfdom, Robert Shiller, Ronald Reagan, Schrödinger's Cat, seminal paper, 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, vertical integration, Washington Consensus, We are the 99%, Yom Kippur War

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.

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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.

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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.

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

Asian financial crisis, asset-backed security, bank run, Basel III, Bear Stearns, 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 engineering, financial innovation, Glass-Steagall Act, housing crisis, Hyman Minsky, income inequality, invisible hand, Kenneth Rogoff, labor-force participation, light touch regulation, London Interbank Offered Rate, Long Term Capital Management, low interest rates, margin call, money market fund, moral hazard, mortgage debt, negative equity, Northern Rock, opioid epidemic / opioid crisis, pets.com, price stability, quantitative easing, regulatory arbitrage, Robert Shiller, Savings and loan crisis, savings glut, short selling, sovereign wealth fund, special drawing rights, tail risk, 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.

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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.

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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.

Investment: A History by Norton Reamer, Jesse Downing

activist fund / activist shareholder / activist investor, Alan Greenspan, Albert Einstein, algorithmic trading, asset allocation, backtesting, banking crisis, Bear Stearns, behavioural economics, Berlin Wall, Bernie Madoff, book value, 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, Cornelius Vanderbilt, 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, flying shuttle, Glass-Steagall Act, Gordon Gekko, Henri Poincaré, Henry Singleton, high net worth, impact investing, index fund, information asymmetry, interest rate swap, invention of the telegraph, James Hargreaves, James Watt: steam engine, John Bogle, joint-stock company, Kenneth Rogoff, labor-force participation, land tenure, London Interbank Offered Rate, Long Term Capital Management, loss aversion, Louis Bachelier, low interest rates, managed futures, margin call, means of production, Menlo Park, merger arbitrage, Michael Milken, 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, Performance of Mutual Funds in the Period, Ponzi scheme, Post-Keynesian economics, price mechanism, principal–agent problem, profit maximization, proprietary trading, quantitative easing, RAND corporation, random walk, Renaissance Technologies, Richard Thaler, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Sand Hill Road, Savings and loan crisis, seminal paper, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, sovereign wealth fund, spinning jenny, statistical arbitrage, survivorship bias, tail risk, technology bubble, Teledyne, The Wealth of Nations by Adam Smith, time value of money, tontine, too big to fail, transaction costs, two and twenty, underbanked, Vanguard fund, working poor, yield curve

As industry developed from the fifteenth century onward, credit also facilitated the financing of activities and assets for industrial development, growth, and achievement of a return.4 Financial leverage has long been an important contributor to the achievement of outstanding investment outcomes, as well as to disastrous ones. When an investment is a success, however, people do not generally talk about the role leverage has played. 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.

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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.

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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.

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

Affordable Care Act / Obamacare, Alan Greenspan, asset-backed security, bank run, banking crisis, banks create money, Bear Stearns, book value, 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, currency risk, Detroit bankruptcy, diversification, double entry bookkeeping, eurozone crisis, facts on the ground, financial engineering, financial innovation, fixed income, friendly fire, full employment, Glass-Steagall Act, hiring and firing, housing crisis, Hyman Minsky, illegal immigration, inflation targeting, interest rate swap, Isaac Newton, junk bonds, Kenneth Rogoff, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, low interest rates, market bubble, market clearing, market fundamentalism, McMansion, Minsky moment, money market fund, moral hazard, naked short selling, new economy, Nick Leeson, Northern Rock, Occupy movement, offshore financial centre, Paul Volcker talking about ATMs, price mechanism, proprietary trading, quantitative easing, Ralph Waldo Emerson, Robert Shiller, Robert Solow, Ronald Reagan, Savings and loan crisis, shareholder value, short selling, South Sea Bubble, statistical model, the payments system, time value of money, too big to fail, vertical integration, 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.

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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.

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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.

In Pursuit of the Perfect Portfolio: The Stories, Voices, and Key Insights of the Pioneers Who Shaped the Way We Invest by Andrew W. Lo, Stephen R. Foerster

Alan Greenspan, Albert Einstein, AOL-Time Warner, asset allocation, backtesting, behavioural economics, Benoit Mandelbrot, Black Monday: stock market crash in 1987, Black-Scholes formula, Bretton Woods, Brownian motion, business cycle, buy and hold, capital asset pricing model, Charles Babbage, Charles Lindbergh, compound rate of return, corporate governance, COVID-19, credit crunch, currency risk, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, Donald Trump, Edward Glaeser, equity premium, equity risk premium, estate planning, Eugene Fama: efficient market hypothesis, fake news, family office, fear index, fiat currency, financial engineering, financial innovation, financial intermediation, fixed income, hiring and firing, Hyman Minsky, implied volatility, index fund, interest rate swap, Internet Archive, invention of the wheel, Isaac Newton, Jim Simons, John Bogle, John Meriwether, John von Neumann, joint-stock company, junk bonds, Kenneth Arrow, linear programming, Long Term Capital Management, loss aversion, Louis Bachelier, low interest rates, managed futures, mandelbrot fractal, margin call, market bubble, market clearing, mental accounting, money market fund, money: store of value / unit of account / medium of exchange, Myron Scholes, new economy, New Journalism, Own Your Own Home, passive investing, Paul Samuelson, Performance of Mutual Funds in the Period, prediction markets, price stability, profit maximization, quantitative trading / quantitative finance, RAND corporation, random walk, Richard Thaler, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Robert Shiller, Robert Solow, Ronald Reagan, Savings and loan crisis, selection bias, seminal paper, shareholder value, Sharpe ratio, short selling, South Sea Bubble, stochastic process, stocks for the long run, survivorship bias, tail risk, Thales and the olive presses, Thales of Miletus, The Myth of the Rational Market, The Wisdom of Crowds, Thomas Bayes, time value of money, transaction costs, transfer pricing, tulip mania, Vanguard fund, yield curve, zero-coupon bond, zero-sum game

Scholes served as a consultant to the investment bank Salomon Brothers and became its managing director and cohead of the fixed-income derivatives sales and trading group while still at Stanford (where he has remained as professor emeritus since 1996). In 1994, Scholes joined several former Salomon Brothers colleagues to cofound Long-Term Capital Management, a hedge fund focused on applying financial technology to practice. The fund was extremely successful for several years before requiring a historically major recapitalization in 1998 (an event that will be considered in more detail in chapter 7).58 In 1997, for his accomplishments, Scholes was awarded the Nobel Prize in Economics, along with Robert C.

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In 1988, Merton joined Salomon Brothers, the global investment bank then led by John Gutfreund, as a special consultant to the Office of the Chairman. John Meriwether was the head of the domestic fixed-income arbitrage group and had attracted many of Merton’s former students, most of whom had PhDs.56 Meriwether left Salomon Brothers in 1991, and in 1993 he had the idea to start a new firm. This would be a hedge fund named Long-Term Capital Management (LTCM), founded to undertake global fixed-income arbitrage on, for example, price discrepancies between similar bonds trading in different markets. Merton and Scholes were among its eleven founders, seven of whom had strong connections to MIT, Harvard Business School, or both. Over $1 billion was raised from its investors, a very large investment for its time.

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See Scholes and Williams (1977). 55. See Scholes, Wolfson, Erikson, Hanlon, Maydew, and Shevlin (2014). Scholes and Wolfson were coauthors through the fifth edition. The most recent edition was published in 2020. 56. Interview with authors. 57. Interview with authors. 58. For a history of Long-Term Capital Management, see Lowenstein (2000). 59. See “Award Ceremony Speech Presentation, Speech by Professor Bertil Näslund of the Royal Swedish Academy of Sciences,” The Nobel Prize, December 10, 1997, http://www.nobelprize.org/nobel_prizes/economic-sciences/laureates/1997/presentation-speech.html. 60.

Layered Money: From Gold and Dollars to Bitcoin and Central Bank Digital Currencies by Nik Bhatia

Alan Greenspan, bank run, basic income, Bear Stearns, bitcoin, blockchain, Bretton Woods, British Empire, central bank independence, Cornelius Vanderbilt, Credit Default Swap, cryptocurrency, distributed ledger, fiat currency, fixed income, Fractional reserve banking, interest rate derivative, interest rate swap, Isaac Newton, joint-stock company, Kickstarter, Long Term Capital Management, margin call, Money creation, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, offshore financial centre, quantitative easing, reserve currency, risk free rate, Satoshi Nakamoto, slashdot, smart contracts, time value of money, tulip mania, universal basic income

Figure 13 shows what the dollar pyramid looked like as we headed for the twenty-first century and how MMF shares became the dominant form of retail money. There are two pyramids, one to represent the U.S. dollar system and another to represent the offshore U.S. dollar system.14 15 Figure 13 When Interbank Trust Failed Long Term Capital Management (LTCM) was a hedge fund launched in 1994 with tremendous fanfare. Its partners painted a picture of perfection with their track record. They hailed from the mighty Salomon Brothers investment bank, the Federal Reserve, and included a pair of Nobel Prize winning economists. Their art was arbitrage, much like the first bill discounters of sixteenth century Antwerp upon which the money markets were built.

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“History of the Chicago Mercantile Exchange.” 1970. https://legacy.farmdoc.illinois.edu/irwin/archive/books/ Futrs_Tradng_in_Livestck/ Futures_Trading_in_%20Livestock_Part%20I_2.pdf Hearing before the Committee on Banking and Financial Services U.S. House of Representatives, One Hundred Fifth, Second Session, October 1, 1998. https://fraser.stlouisfed.org/title/policy-discussion-papers-federal-reserve-bank-cleveland-4514/lessons-rescue-long-term-capital-management-495652/fulltext Hearings before the Joint Economic Committee Congress of the United States, Eighty-Sixth Congress, First Session, October 26-30, 1959. https://www.jec.senate.gov/reports/86th%20Congress/Hearings/ Constructive%20Suggestions%20for%20Reconciling%20and%20 Simultaneously%20 Obtaining%20the%20Three%20 Objectives%20%28130%29.pdf Jefferson, Thomas.

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“Innovations, Debts, and Bubbles: International Integration of Financial Markets in Western Europe, 1688-1720,” The Journal of Economic History, vol. 48, no. 2, 1988, The Tasks of Economic History June 1988: 299-306. Cambridge University Press on behalf of the Economic History Association. http://www.jstor.com/stable/2121172 Slivinski, Stephen. “Too Interconnected to Fail?” The Rescue of Long-Term Capital Management, Region Focus, Federal Reserve Bank of Richmond, Summer 2009. https://www.richmondfed.org/-/media/richmondfedorg/publications/research/econ_focus/2009/ summer/pdf /economic_history.pdf Steil, Benn. The Battle of Bretton Woods: John Maynard Keynes, Harry Dexter White, and the Making of a New World Order.

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

Alan Greenspan, Asian financial crisis, banking crisis, Bear Stearns, 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, Glass-Steagall Act, green new deal, guns versus butter model, housing crisis, Howard Zinn, Hyman Minsky, income inequality, information asymmetry, It's morning again in America, John Meriwether, junk bonds, kremlinology, Long Term Capital Management, low interest rates, margin call, market bubble, market fundamentalism, McMansion, Michael Milken, Minsky moment, money market fund, mortgage debt, Naomi Klein, new economy, Nixon triggered the end of the Bretton Woods system, offshore financial centre, payday loans, pets.com, plutocrats, Ponzi scheme, price stability, pushing on a string, race to the bottom, Ralph Nader, rent control, Robert Shiller, Ronald Reagan, Savings and loan crisis, savings glut, sovereign wealth fund, structural adjustment programs, subprime mortgage crisis, 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

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.

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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.”

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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.

Heads I Win, Tails I Win by Spencer Jakab

Alan Greenspan, Asian financial crisis, asset allocation, backtesting, Bear Stearns, behavioural economics, Black Monday: stock market crash in 1987, book value, business cycle, buy and hold, collapse of Lehman Brothers, correlation coefficient, crowdsourcing, Daniel Kahneman / Amos Tversky, diversification, dividend-yielding stocks, dogs of the Dow, Elliott wave, equity risk premium, estate planning, Eugene Fama: efficient market hypothesis, eurozone crisis, Everybody Ought to Be Rich, fear index, fixed income, geopolitical risk, government statistician, index fund, Isaac Newton, John Bogle, John Meriwether, Long Term Capital Management, low interest rates, Market Wizards by Jack D. Schwager, Mexican peso crisis / tequila crisis, money market fund, Myron Scholes, PalmPilot, passive investing, Paul Samuelson, pets.com, price anchoring, proprietary trading, Ralph Nelson Elliott, random walk, Reminiscences of a Stock Operator, risk tolerance, risk-adjusted returns, Robert Shiller, robo advisor, Savings and loan crisis, Sharpe ratio, short selling, Silicon Valley, South Sea Bubble, statistical model, Steve Jobs, subprime mortgage crisis, survivorship bias, technology bubble, transaction costs, two and twenty, VA Linux, Vanguard fund, zero-coupon bond, zero-sum game

The stock market was still down by nearly 17 percent for the month, but Dalbar calculates that individual mutual fund investors probably lost over 24 percent—the sort of deficit that would normally take a couple of years’ worth of errors to rack up. The third-worst month came following the crash of October 1987 and the fifth-worst in August 1998 when Russia defaulted on its debts and hedge fund Long Term Capital Management threatened to blow up the world financial system. The second-worst month for investor timing, on the other hand, was a good one overall: March 2000. Stocks rose by nearly 10 percent, but investors lagged that by six percentage points, probably for two reasons. It was a very volatile month that saw technology stocks peak, but also an era during which many investors had abandoned so-called old-economy stocks that still made up a big chunk of the benchmark S&P 500 stock index.

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If you’ve been paying attention, for example, then you should be asking why at least three events that shouldn’t have happened even once since the Big Bang have occurred in the past three decades alone. It’s because even the most sophisticated traders make poor predictions. When people with pointy heads and absolute conviction in models that claim to do so are united with billions of dollars of borrowed money, trouble often ensues. See Long Term Capital Management, Bear Stearns, and Lehman Brothers. You won’t blow up the global financial system, but you could blow a big hole in your nest egg by dipping in and out of the market. If you have done so successfully in the past (I plead guilty to a few naïve attempts), then it involved at least some luck.

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Many were the equivalent of Hall of Famers, including two Nobel Prize winners, a man mooted as a possible Federal Reserve chairman, and some of the most profitable bond traders on Wall Street. John Meriwether, among the top brass at Salomon Brothers during its heyday, described so colorfully in Michael Lewis’s Liar’s Poker, gathered this dream team in 1993. He decided to name his firm Long Term Capital Management. Having denizens of financial Cooperstown managing your money didn’t come cheap even by hedge fund standards. Investors had to part with 2 percent of assets and 25 percent of profits yearly—more than the typical “two and twenty” fee structure then typical for competitors. But customers gladly agreed, and even seemed to be getting their money’s worth for the first few years.

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

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

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.

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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.

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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.

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, financial engineering, fixed income, frictionless, frictionless market, George Santayana, global macro, implied volatility, interest rate swap, invisible hand, Isaac Newton, John Meriwether, Long Term Capital Management, managed futures, market design, Myron Scholes, performance metric, price mechanism, price stability, proprietary trading, risk free rate, 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, uptick rule, 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.

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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.

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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.

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, Alan Greenspan, Bear Stearns, Bernie Sanders, Bretton Woods, buy and hold, carried interest, classic study, 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, Glass-Steagall Act, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, Greenspan put, illegal immigration, interest rate swap, laissez-faire capitalism, London Interbank Offered Rate, Long Term Capital Management, margin call, market bubble, medical malpractice, military-industrial complex, money market fund, moral hazard, mortgage debt, Nixon triggered the end of the Bretton Woods system, obamacare, passive investing, Ponzi scheme, prediction markets, proprietary trading, prudent man rule, quantitative easing, reserve currency, Ronald Reagan, Savings and loan crisis, Sergey Aleynikov, short selling, sovereign wealth fund, too big to fail, trickle-down economics, Y2K, Yom Kippur War

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.

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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.

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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.

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

accounting loophole / creative accounting, Alan Greenspan, 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, cotton gin, 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, gentrification, Glass-Steagall Act, global reserve currency, Google Earth, Great Leap Forward, Guggenheim Bilbao, Gunnar Myrdal, guns versus butter model, Herbert Marcuse, 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, military-industrial complex, Money creation, 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, Savings and loan crisis, sharing economy, Shenzhen special economic zone , Silicon Valley, special drawing rights, special economic zone, statistical arbitrage, structural adjustment programs, subprime mortgage crisis, technological determinism, the built environment, the market place, The Theory of the Leisure Class by Thorstein Veblen, The Wealth of Nations by Adam Smith, Thomas L Friedman, Thomas Malthus, Thorstein Veblen, Timothy McVeigh, too big to fail, trickle-down economics, urban renewal, urban sprawl, vertical integration, 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.

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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.

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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.

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

Alan Greenspan, asset allocation, backtesting, Benchmark Capital, Bernie Madoff, book value, buy and hold, capital asset pricing model, cognitive dissonance, correlation coefficient, currency risk, Daniel Kahneman / Amos Tversky, diversification, diversified portfolio, endowment effect, estate planning, Eugene Fama: efficient market hypothesis, fixed income, implied volatility, index fund, intangible asset, John Bogle, junk bonds, Long Term Capital Management, money market fund, passive investing, Paul Samuelson, Performance of Mutual Funds in the Period, Ponzi scheme, prediction markets, proprietary trading, prudent man rule, random walk, Richard Thaler, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, survivorship bias, Tax Reform Act of 1986, too big to fail, transaction costs, Vanguard fund, yield curve, zero-sum game

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.

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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.

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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.

Statistical Arbitrage: Algorithmic Trading Insights and Techniques by Andrew Pole

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

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.

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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.

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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.

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

Alan Greenspan, 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, Bear Stearns, behavioural economics, Berlin Wall, Bernie Madoff, bitcoin, Bob Litterman, Bonfire of the Vanities, bonus culture, break the buck, Brexit referendum, Brownian motion, business cycle, business process, butterfly effect, buy and hold, capital asset pricing model, Captain Sullenberger Hudson, carbon tax, Carmen Reinhart, collapse of Lehman Brothers, collateralized debt obligation, commoditize, computerized trading, confounding variable, corporate governance, creative destruction, Credit Default Swap, credit default swaps / collateralized debt obligations, cryptocurrency, Daniel Kahneman / Amos Tversky, delayed gratification, democratizing finance, Diane Coyle, diversification, diversified portfolio, do well by doing good, double helix, easy for humans, difficult for computers, equity risk premium, Ernest Rutherford, Eugene Fama: efficient market hypothesis, experimental economics, experimental subject, Fall of the Berlin Wall, financial deregulation, financial engineering, financial innovation, financial intermediation, fixed income, Flash crash, Fractional reserve banking, framing effect, Glass-Steagall Act, global macro, Gordon Gekko, greed is good, Hans Rosling, Henri Poincaré, high net worth, housing crisis, incomplete markets, index fund, information security, interest rate derivative, invention of the telegraph, Isaac Newton, it's over 9,000, James Watt: steam engine, Jeff Hawkins, Jim Simons, job satisfaction, John Bogle, John Maynard Keynes: Economic Possibilities for our Grandchildren, John Meriwether, Joseph Schumpeter, Kenneth Rogoff, language acquisition, London Interbank Offered Rate, Long Term Capital Management, longitudinal study, loss aversion, Louis Pasteur, mandelbrot fractal, margin call, Mark Zuckerberg, market fundamentalism, martingale, megaproject, merger arbitrage, meta-analysis, Milgram experiment, mirror neurons, money market fund, moral hazard, Myron Scholes, Neil Armstrong, Nick Leeson, old-boy network, One Laptop per Child (OLPC), out of africa, p-value, PalmPilot, paper trading, passive investing, Paul Lévy, Paul Samuelson, Paul Volcker talking about ATMs, Phillips curve, Ponzi scheme, predatory finance, prediction markets, price discovery process, profit maximization, profit motive, proprietary trading, public intellectual, 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 Solow, Sam Peltzman, Savings and loan crisis, seminal paper, Shai Danziger, short selling, sovereign wealth fund, Stanford marshmallow experiment, Stanford prison experiment, statistical arbitrage, Steven Pinker, stochastic process, stocks for the long run, subprime mortgage crisis, survivorship bias, systematic 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, uptick rule, Upton Sinclair, US Airways Flight 1549, Walter Mischel, Watson beat the top human players on Jeopardy!, WikiLeaks, Yogi Berra, zero-sum game

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.

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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.

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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 fixed-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.

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, fear index, fixed income, global macro, implied volatility, index fund, interest rate swap, Long Term Capital Management, low interest rates, margin call, Market Wizards by Jack D. Schwager, merger arbitrage, Nick Leeson, paper trading, performance metric, proprietary trading, risk free rate, risk tolerance, risk-adjusted returns, risk/return, Sharpe ratio, short selling, survivorship bias, systematic trading, technology bubble, transaction costs, Two Sigma, 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

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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.

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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.

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

Alan Greenspan, Albert Einstein, asset allocation, Augustin-Louis Cauchy, behavioural economics, Benoit Mandelbrot, Big bang: deregulation of the City of London, Black Monday: stock market crash in 1987, 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, electricity market, Elliott wave, equity premium, equity risk premium, Eugene Fama: efficient market hypothesis, Fellow of the Royal Society, financial engineering, 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, power law, price mechanism, quantitative trading / quantitative finance, Ralph Nelson Elliott, RAND corporation, random walk, risk free rate, risk tolerance, 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.

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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.

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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.

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

"World Economic Forum" Davos, accounting loophole / creative accounting, Alan Greenspan, asset-backed security, bank run, banking crisis, Bear Stearns, Black-Scholes formula, Blythe Masters, book value, 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 engineering, financial innovation, fixed income, Glass-Steagall Act, housing crisis, interest rate derivative, interest rate swap, inverted yield curve, junk bonds, Kickstarter, locking in a profit, Long Term Capital Management, low interest rates, McMansion, Michael Milken, money market fund, mortgage debt, North Sea oil, Northern Rock, Plato's cave, proprietary trading, Renaissance Technologies, risk free rate, risk tolerance, Robert Shiller, Satyajit Das, Savings and loan crisis, short selling, sovereign wealth fund, statistical model, tail risk, 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.

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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.

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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.

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, Alan Greenspan, Asian financial crisis, asset-backed security, backtesting, bank run, Bear Stearns, 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, currency risk, debt deflation, disinformation, distributed ledger, diversification, financial engineering, financial intermediation, Flash crash, global reserve currency, implied volatility, income inequality, inflation targeting, junk bonds, labor-force participation, Long Term Capital Management, low interest rates, Lyft, margin call, market bubble, Money creation, money market fund, money: store of value / unit of account / medium of exchange, moral hazard, negative equity, Network effects, Ponzi scheme, proprietary trading, public intellectual, purchasing power parity, quantitative easing, random walk, rent-seeking, reserve currency, rising living standards, risk free rate, risk/return, sharing economy, short selling, short squeeze, sovereign wealth fund, stock buybacks, tail risk, TikTok, 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.

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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.

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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.

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

"Friedman doctrine" OR "shareholder theory", "World Economic Forum" Davos, accounting loophole / creative accounting, activist fund / activist shareholder / activist investor, additive manufacturing, Airbnb, Alan Greenspan, algorithmic trading, Alvin Roth, Asian financial crisis, asset allocation, bank run, Basel III, Bear Stearns, behavioural economics, Big Tech, bonus culture, Bretton Woods, British Empire, business cycle, buy and hold, call centre, Capital in the Twenty-First Century by Thomas Piketty, Carl Icahn, 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, data science, David Graeber, deskilling, Detroit bankruptcy, diversification, Double Irish / Dutch Sandwich, electricity market, Emanuel Derman, Eugene Fama: efficient market hypothesis, financial deregulation, financial engineering, financial intermediation, Ford Model T, Frederick Winslow Taylor, George Akerlof, gig economy, Glass-Steagall Act, Goldman Sachs: Vampire Squid, Gordon Gekko, greed is good, Greenspan put, guns versus butter model, 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, James Carville said: "I would like to be reincarnated as the bond market. You can intimidate everybody.", John Bogle, John Markoff, joint-stock company, joint-stock limited liability company, Kenneth Rogoff, Kickstarter, knowledge economy, labor-force participation, London Whale, Long Term Capital Management, low interest rates, 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, proprietary trading, quantitative easing, quantitative trading / quantitative finance, race to the bottom, Ralph Nader, Rana Plaza, RAND corporation, random walk, rent control, Robert Shiller, Ronald Reagan, Satyajit Das, Savings and loan crisis, scientific management, 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, stock buybacks, subprime mortgage crisis, technology bubble, TED Talk, 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, Tragedy of the Commons, trickle-down economics, Tyler Cowen: Great Stagnation, Vanguard fund, vertical integration, zero-sum game

(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.

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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.

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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.

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

Alan Greenspan, AOL-Time Warner, Asian financial crisis, asset allocation, backtesting, banking crisis, Bear Stearns, behavioural economics, Black Monday: stock market crash in 1987, Black-Scholes formula, book value, 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, currency risk, Daniel Kahneman / Amos Tversky, Deng Xiaoping, discounted cash flows, diversification, diversified portfolio, dividend-yielding stocks, dogs of the Dow, equity premium, equity risk 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, Glass-Steagall Act, housing crisis, Hyman Minsky, implied volatility, income inequality, index arbitrage, index fund, indoor plumbing, inflation targeting, invention of the printing press, Isaac Newton, it's over 9,000, John Bogle, joint-stock company, London Interbank Offered Rate, Long Term Capital Management, loss aversion, machine readable, market bubble, mental accounting, Minsky moment, Money creation, 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, proprietary trading, purchasing power parity, quantitative easing, random walk, Richard Thaler, risk free rate, risk tolerance, risk/return, Robert Gordon, 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, Tyler Cowen: Great Stagnation, uptick rule, Vanguard fund

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.

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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.

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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.

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

"RICO laws" OR "Racketeer Influenced and Corrupt Organizations", Albert Einstein, anti-communist, asset allocation, Bear Stearns, beat the dealer, Benoit Mandelbrot, Black Monday: stock market crash in 1987, Black-Scholes formula, Bletchley Park, 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, financial engineering, Henry Singleton, high net worth, index fund, interest rate swap, Isaac Newton, Johann Wolfgang von Goethe, John Meriwether, John von Neumann, junk bonds, Kenneth Arrow, Long Term Capital Management, Louis Bachelier, margin call, market bubble, market fundamentalism, Marshall McLuhan, Michael Milken, Myron Scholes, New Journalism, Norbert Wiener, offshore financial centre, Paul Samuelson, publish or perish, quantitative trading / quantitative finance, random walk, risk free rate, risk tolerance, risk-adjusted returns, Robert Shiller, Ronald Reagan, Rubik’s Cube, short selling, speech recognition, statistical arbitrage, Teledyne, The Predators' Ball, The Wealth of Nations by Adam Smith, transaction costs, traveling salesman, value at risk, zero-coupon bond, zero-sum game

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.

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“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.

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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.

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

affirmative action, Affordable Care Act / Obamacare, Alan Greenspan, Albert Einstein, Andrew Wiles, automated trading system, backtesting, Bayesian statistics, Bear Stearns, beat the dealer, behavioural economics, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Black Monday: stock market crash in 1987, blockchain, book value, Brownian motion, butter production in bangladesh, buy and hold, buy low sell high, Cambridge Analytica, Carl Icahn, Claude Shannon: information theory, computer age, computerized trading, Credit Default Swap, Daniel Kahneman / Amos Tversky, data science, diversified portfolio, Donald Trump, Edward Thorp, Elon Musk, Emanuel Derman, endowment effect, financial engineering, Flash crash, George Gilder, Gordon Gekko, illegal immigration, index card, index fund, Isaac Newton, Jim Simons, John Meriwether, John Nash: game theory, John von Neumann, junk bonds, Loma Prieta earthquake, Long Term Capital Management, loss aversion, Louis Bachelier, mandelbrot fractal, margin call, Mark Zuckerberg, Michael Milken, Monty Hall problem, More Guns, Less Crime, Myron Scholes, Naomi Klein, natural language processing, Neil Armstrong, obamacare, off-the-grid, p-value, pattern recognition, Peter Thiel, Ponzi scheme, prediction markets, proprietary trading, 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 Bannon, Steve Jobs, stochastic process, the scientific method, Thomas Bayes, transaction costs, Turing machine, Two Sigma

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.

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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.

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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.

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, financial engineering, Long Term Capital Management, Rubik’s Cube, Skype, the scientific method

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.

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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.”

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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.

The Global Minotaur by Yanis Varoufakis, Paul Mason

active measures, Alan Greenspan, AOL-Time Warner, banking crisis, Bear Stearns, 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, Easter island, endogenous growth, eurozone crisis, financial engineering, financial innovation, first-past-the-post, full employment, Glass-Steagall Act, Great Leap Forward, guns versus butter model, 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, low interest rates, market fundamentalism, Mexican peso crisis / tequila crisis, military-industrial complex, Money creation, money market fund, mortgage debt, Myron Scholes, negative equity, new economy, Nixon triggered the end of the Bretton Woods system, 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, Suez crisis 1956, 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

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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.

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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.

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

Alan Greenspan, Asian financial crisis, asset-backed security, bank run, barriers to entry, Bear Stearns, Bernie Madoff, break the buck, call centre, collateralized debt obligation, corporate governance, Credit Default Swap, credit default swaps / collateralized debt obligations, financial engineering, financial innovation, fixed income, Glass-Steagall Act, information asymmetry, invisible hand, Isaac Newton, iterative process, junk bonds, Long Term Capital Management, margin call, money market fund, moral hazard, mortgage debt, place-making, Ponzi scheme, prediction markets, proprietary trading, risk tolerance, Savings and loan crisis, 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.

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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.

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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.

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, algorithmic management, 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, Eddington experiment, en.wikipedia.org, epigenetics, From Mathematics to the Technologies of Life and Death, Garrett Hardin, Geoffrey West, Santa Fe Institute, Gregor Mendel, Gödel, Escher, Bach, Hacker News, Hans Moravec, 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, power law, Ray Kurzweil, reversible computing, scientific worldview, stem cell, Stuart Kauffman, synthetic biology, The Wealth of Nations by Adam Smith, Thomas Malthus, Tragedy of the Commons, Turing machine

“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.

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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.

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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.

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

Affordable Care Act / Obamacare, Alan Greenspan, asset-backed security, bank run, barriers to entry, Basel III, Bear Stearns, Bernie Sanders, Black Monday: stock market crash in 1987, 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 engineering, financial innovation, fixed income, Flash crash, forward guidance, full employment, George Akerlof, Glass-Steagall Act, greed is good, Greenspan put, high net worth, housing crisis, income inequality, index fund, inflation targeting, interest rate swap, invisible hand, John Meriwether, Joseph Schumpeter, junk bonds, liquidity trap, London Whale, Long Term Capital Management, low interest rates, margin call, market bubble, Mexican peso crisis / tequila crisis, money market fund, moral hazard, Myron Scholes, natural language processing, Navinder Sarao, negative equity, new economy, Northern Rock, obamacare, Phillips curve, price stability, proprietary trading, pushing on a string, quantitative easing, regulatory arbitrage, Robert Shiller, Ronald Reagan, selection bias, short selling, side project, Silicon Valley, stock buybacks, tail risk, The Great Moderation, The Wealth of Nations by Adam Smith, too big to fail, trickle-down economics, yield curve

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.

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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.

…

., 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.

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

Alan Greenspan, asset-backed security, bank run, Basel III, Bear Stearns, beat the dealer, Big bang: deregulation of the City of London, Bletchley Park, 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 engineering, financial innovation, G4S, Glass-Steagall Act, high net worth, interest rate swap, invisible hand, joint-stock company, Kickstarter, light touch regulation, London Whale, Long Term Capital Management, long term incentive plan, low interest rates, moral hazard, negative equity, Neil Kinnock, Nick Leeson, North Sea oil, Northern Rock, old-boy network, pets.com, proprietary trading, Red Clydeside, shareholder value, The Wealth of Nations by Adam Smith, too big to fail, upwardly mobile, value at risk, warehouse robotics

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.

…

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?

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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.

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

Alan Greenspan, asset-backed security, bank run, banking crisis, Bear Stearns, 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 engineering, financial innovation, fixed income, housing crisis, income inequality, junk bonds, London Interbank Offered Rate, Long Term Capital Management, low interest rates, margin call, money market fund, moral hazard, Northern Rock, price discovery process, price mechanism, regulatory arbitrage, Ronald Reagan, Saturday Night Live, Savings and loan crisis, 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.

…

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.

…

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.

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

"RICO laws" OR "Racketeer Influenced and Corrupt Organizations", "there is no alternative" (TINA), "World Economic Forum" Davos, affirmative action, Alan Greenspan, Albert Einstein, algorithmic trading, Andy Kessler, AOL-Time Warner, Asian financial crisis, asset allocation, asset-backed security, bank run, banking crisis, banks create money, Basel III, Bear Stearns, behavioural economics, Benoit Mandelbrot, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, Bonfire of the Vanities, bonus culture, book value, Bretton Woods, BRICs, British Empire, business cycle, buy the rumour, sell the news, capital asset pricing model, carbon credits, Carl Icahn, 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, currency risk, Daniel Kahneman / Amos Tversky, deal flow, debt deflation, Deng Xiaoping, deskilling, discrete time, diversification, diversified portfolio, Doomsday Clock, Dr. Strangelove, Dutch auction, 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 engineering, financial independence, financial innovation, financial thriller, fixed income, foreign exchange controls, full employment, Glass-Steagall Act, global reserve currency, Goldman Sachs: Vampire Squid, Goodhart's law, Gordon Gekko, greed is good, Greenspan put, happiness index / gross national happiness, haute cuisine, Herman Kahn, high net worth, Hyman Minsky, index fund, information asymmetry, interest rate swap, invention of the wheel, invisible hand, Isaac Newton, James Carville said: "I would like to be reincarnated as the bond market. You can intimidate everybody.", job automation, Johann Wolfgang von Goethe, John Bogle, John Meriwether, joint-stock company, Jones Act, Joseph Schumpeter, junk bonds, Kenneth Arrow, Kenneth Rogoff, Kevin Kelly, laissez-faire capitalism, load shedding, locking in a profit, Long Term Capital Management, Louis Bachelier, low interest rates, margin call, market bubble, market fundamentalism, Market Wizards by Jack D. Schwager, Marshall McLuhan, Martin Wolf, mega-rich, merger arbitrage, Michael Milken, Mikhail Gorbachev, Milgram experiment, military-industrial complex, Minsky moment, money market fund, Mont Pelerin Society, moral hazard, mortgage debt, mortgage tax deduction, mutually assured destruction, Myron Scholes, Naomi Klein, National Debt Clock, 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, Phillips curve, planned obsolescence, plutocrats, Ponzi scheme, price anchoring, price stability, profit maximization, proprietary trading, public intellectual, quantitative easing, quantitative trading / quantitative finance, Ralph Nader, RAND corporation, random walk, Ray Kurzweil, regulatory arbitrage, Reminiscences of a Stock Operator, rent control, rent-seeking, reserve currency, Richard Feynman, Richard Thaler, Right to Buy, risk free rate, risk-adjusted returns, risk/return, road to serfdom, 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, short squeeze, Silicon Valley, six sigma, Slavoj Žižek, South Sea Bubble, special economic zone, statistical model, Stephen Hawking, Steve Jobs, stock buybacks, survivorship bias, tail risk, Teledyne, 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 Theory of the Leisure Class by Thorstein Veblen, The Wealth of Nations by Adam Smith, Thorstein Veblen, too big to fail, trickle-down economics, Turing test, two and twenty, Upton Sinclair, value at risk, Yogi Berra, zero-coupon bond, zero-sum game

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.

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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.

…

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.

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

asset allocation, bank run, Bear Stearns, behavioural economics, 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, data science, disintermediation, Edward Lorenz: Chaos theory, epigenetics, feminist movement, financial engineering, financial innovation, fixed income, Flash crash, geopolitical risk, Henri Poincaré, impact investing, 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, Robert Solow, Saturday Night Live, self-driving car, seminal paper, 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.

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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.

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

airline deregulation, airport security, Alan Greenspan, Alvin Toffler, Andrei Shleifer, anti-communist, Asian financial crisis, balance sheet recession, bank run, barriers to entry, Bear Stearns, behavioural economics, Benoit Mandelbrot, Black Monday: stock market crash in 1987, bond market vigilante , book value, Bretton Woods, business cycle, central bank independence, centralized clearinghouse, classic study, 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, Dr. Strangelove, energy security, equity premium, fiat currency, financial deregulation, financial engineering, financial innovation, fixed income, Flash crash, forward guidance, full employment, Future Shock, Glass-Steagall Act, Greenspan put, Hyman Minsky, inflation targeting, information asymmetry, interest rate swap, inventory management, invisible hand, James Carville said: "I would like to be reincarnated as the bond market. You can intimidate everybody.", junk bonds, Kenneth Rogoff, Kickstarter, Kitchen Debate, laissez-faire capitalism, Lewis Mumford, Long Term Capital Management, low interest rates, low skilled workers, market bubble, market clearing, Martin Wolf, Money creation, money market fund, moral hazard, mortgage debt, Myron Scholes, Neil Armstrong, new economy, Nixon shock, Nixon triggered the end of the Bretton Woods system, Northern Rock, paper trading, paradox of thrift, Paul Samuelson, Phillips curve, plutocrats, popular capitalism, price stability, RAND corporation, Reminiscences of a Stock Operator, rent-seeking, Robert Shiller, Robert Solow, rolodex, Ronald Reagan, Saturday Night Live, Savings and loan crisis, savings glut, secular stagnation, short selling, stock buybacks, subprime mortgage crisis, The Great Moderation, the payments system, The Wealth of Nations by Adam Smith, Tipper Gore, too big to fail, trade liberalization, unorthodox policies, upwardly mobile, We are all Keynesians now, WikiLeaks, women in the workforce, Y2K, yield curve, zero-sum game

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.

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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.

…

Rather, he was expounding on the advent of the new megabanks, and explaining why they were not actually threatening. With the benefit of hindsight, the Fed’s refusal to be emotionally exercised by the disruptive proliferation of unregulated swaps was a failure of the Greenspan era. • • • If there was one institution that embodied Greenspan’s optimism about the new finance, it was Long-Term Capital Management. Founded four years earlier by quantitative wizards from Salomon Brothers, Long-Term’s partners included the financial economists Myron Scholes and Robert Merton, who had received the Nobel Prize for their “new method to determine the value of derivatives.” David Mullins, the former Fed vice chairman who had lectured Mike Prell about the efficiency of markets, was another principal at LTCM; and for its first two and a half years, the firm performed spectacularly.

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

algorithmic trading, asset allocation, automated trading system, backtesting, Bear Stearns, Black Monday: stock market crash in 1987, Black Swan, book value, Brownian motion, business continuity plan, buy and hold, classic study, compound rate of return, Edward Thorp, Elliott wave, endowment effect, financial engineering, fixed income, general-purpose programming language, index fund, Jim Simons, John Markoff, Long Term Capital Management, loss aversion, p-value, paper trading, price discovery process, proprietary trading, quantitative hedge fund, quantitative trading / quantitative finance, random walk, Ray Kurzweil, Renaissance Technologies, risk free rate, 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.

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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.

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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.

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

Bear Stearns, Bernie Sanders, Black Monday: stock market crash in 1987, call centre, centralized clearinghouse, computerized trading, Credit Default Swap, Downton Abbey, eat what you kill, electricity market, Flash crash, Glass-Steagall Act, Goldman Sachs: Vampire Squid, information asymmetry, interest rate derivative, interest rate swap, London Interbank Offered Rate, London Whale, Long Term Capital Management, Michael Milken, Navinder Sarao, Nick Leeson, Northern Rock, Occupy movement, performance metric, profit maximization, proprietary trading, Savings and loan crisis, tulip mania, work culture , 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

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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.)

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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.

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

"World Economic Forum" Davos, Affordable Care Act / Obamacare, Alan Greenspan, Asian financial crisis, asset allocation, Ayatollah Khomeini, bank run, banking crisis, Bear Stearns, Ben Bernanke: helicopter money, bitcoin, Black Monday: stock market crash in 1987, Black Swan, Boeing 747, 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, Dr. Strangelove, Edward Snowden, eurozone crisis, fiat currency, financial engineering, financial innovation, financial intermediation, financial repression, fixed income, Flash crash, floating exchange rates, forward guidance, G4S, George Akerlof, global macro, global reserve currency, global supply chain, Goodhart's law, Growth in a Time of Debt, guns versus butter model, Herman Kahn, high-speed rail, income inequality, inflation targeting, information asymmetry, invisible hand, jitney, John Meriwether, junk bonds, Kenneth Rogoff, labor-force participation, Lao Tzu, liquidationism / Banker’s doctrine / the Treasury view, liquidity trap, Long Term Capital Management, low interest rates, mandelbrot fractal, margin call, market bubble, market clearing, market design, megaproject, Modern Monetary Theory, Money creation, money market fund, money: store of value / unit of account / medium of exchange, mutually assured destruction, Nixon triggered the end of the Bretton Woods system, obamacare, offshore financial centre, oil shale / tar sands, open economy, operational security, plutocrats, Ponzi scheme, power law, price stability, public intellectual, 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, Solyndra, 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

. : 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.

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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.

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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.

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

Alan Greenspan, 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 engineering, financial thriller, fixed income, forensic accounting, high net worth, index card, Long Term Capital Management, Louis Bachelier, low interest rates, Market Wizards by Jack D. Schwager, offshore financial centre, payment for order flow, Ponzi scheme, price mechanism, proprietary trading, quantitative trading / quantitative finance, regulatory arbitrage, Renaissance Technologies, risk-adjusted returns, risk/return, rolodex, Sharpe ratio, statistical arbitrage, too big to fail, transaction costs, two and twenty, your tax dollars at work

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.

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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.

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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.

Crisis Economics: A Crash Course in the Future of Finance by Nouriel Roubini, Stephen Mihm

Alan Greenspan, Asian financial crisis, asset-backed security, balance sheet recession, bank run, banking crisis, barriers to entry, Bear Stearns, behavioural economics, Berlin Wall, Bernie Madoff, Big bang: deregulation of the City of London, Black Swan, bond market vigilante , bonus culture, Bretton Woods, BRICs, British Empire, business cycle, call centre, capital controls, Carmen Reinhart, central bank independence, centralized clearinghouse, collapse of Lehman Brothers, collateralized debt obligation, corporate governance, creative destruction, credit crunch, Credit Default Swap, credit default swaps / collateralized debt obligations, currency risk, dark matter, David Ricardo: comparative advantage, debt deflation, Eugene Fama: efficient market hypothesis, Fall of the Berlin Wall, fiat currency, financial deregulation, financial engineering, financial innovation, Financial Instability Hypothesis, financial intermediation, full employment, George Akerlof, Glass-Steagall Act, global pandemic, global reserve currency, Gordon Gekko, Greenspan put, Growth in a Time of Debt, housing crisis, Hyman Minsky, information asymmetry, interest rate swap, invisible hand, Joseph Schumpeter, junk bonds, Kenneth Rogoff, laissez-faire capitalism, liquidity trap, London Interbank Offered Rate, Long Term Capital Management, Louis Bachelier, low interest rates, margin call, market bubble, market fundamentalism, Martin Wolf, means of production, Minsky moment, money market fund, moral hazard, mortgage debt, mortgage tax deduction, new economy, Northern Rock, offshore financial centre, oil shock, Paradox of Choice, paradox of thrift, Paul Samuelson, Ponzi scheme, price stability, principal–agent problem, private sector deleveraging, proprietary trading, pushing on a string, quantitative easing, quantitative trading / quantitative finance, race to the bottom, random walk, regulatory arbitrage, reserve currency, risk tolerance, Robert Shiller, Satyajit Das, Savings and loan crisis, savings glut, short selling, South Sea Bubble, sovereign wealth fund, special drawing rights, subprime mortgage crisis, Suez crisis 1956, The Great Moderation, The Myth of the Rational Market, The Wealth of Nations by Adam Smith, The Wisdom of Crowds, too big to fail, tulip mania, Tyler Cowen, unorthodox policies, value at risk, We are all Keynesians now, Works Progress Administration, yield curve, Yom Kippur War

Llewellyn, “Fragile Banking in Norway, Sweden and Finland: An Empirical Analysis,” Journal of International Financial Markets, Institutions and Money 4 (1994): 5-19. 28 savings and loan associations: Timothy Curry and Lynn Shibut, “The Cost of the Savings and Loan Crisis: Truth and Consequences,” FDIC Banking Review 13 (2000): 26-35. 28 countries in Latin America and Asia: Nouriel Roubini and Brad Setser, Bailouts or Bail-Ins? Responding to Financial Crises in Emerging Economies (Washington, D.C.: Institute for International Economics, 2004). 29 Long-Term Capital Management: Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management (New York: Random House, 2000). 29 Crises continued to materialize: Roubini and Setser, Bailouts or Bail-Ins, 61-70. 31 “There is no national housing bubble”: Daniela Deane, “In Real Estate Fever, More Signs of Sickness,” Washington Post, April 17, 2005. 31 “the charm of history . . .”: Aldous Huxley, The Devils of Loudun (London: Chatto and Windus, 1952), 259. 31 greed: See, for example, Ruth Gledhill, “Rowan Williams Says ‘Human Greed’ to Blame for Financial Crisis,” Times (London), October 15, 2008. 33 “we should be quite cautious . . .”: Alan Greenspan, “Consumer Credit and Financial Modernization,” remarks to Economic Development Conference of the Greenlining Institute, San Francisco, Calif., October 11, 1997, online at http://www.federalreserve.gov/boarddocs/speeches/1997/19971011.htm. 33 “lenders are now able . . .”: Alan Greenspan, remarks to the Federal Reserve System’s Fourth Annual Community Affairs Research Conference, Washington, D.C., April 8, 2005, online at http://www.federalreserve.gov/boarddocs/speeches/2005/20050408/default.htm. 33 slashing the rate: Jean Claude Trichet, “Activism and Alertness in Monetary Policy,” lecture to “Central Banks in the 21st Century” conference, Madrid, June 8, 2006, online at http://www.ecb.int/press/key/date/2006/html/sp060608_1.en.html.

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Doubts grew about its ability to maintain the value of the ruble and its commitment to honor its debts. In the summer of 1998 investors fled the country, and the value of the ruble collapsed. The Russian government defaulted on debt owed to its citizens and stopped payments on most of the debt owed to foreign creditors. The effects of these actions reverberated around the world. Long-Term Capital Management (LTCM), a hedge fund based in the United States, had placed extremely complicated bets on the prices of other countries’ government bonds that failed to factor in the possibility of a financial crisis. As panic over Russia’s default spread, the usual relationships among different kinds of bond prices went haywire, and LTCM was forced to liquidate its assets in order to survive.

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But the ranks of too-big-to-fail institutions—the TBTF club—contain few such traditional banks. Instead, most TBTF institutions belong to another species: big broker dealers like Morgan Stanley and Goldman Sachs; AIG and other sprawling insurance companies; government-sponsored enterprises like Fannie Mae and Freddie Mac; and hedge funds like Long-Term Capital Management. While the crisis left fewer such firms intact, those that remain are often larger, thanks to the waves of consolidation that followed the panic. JPMorgan Chase took over Bear Stearns and then Washington Mutual; Bank of America absorbed Countrywide and then Merrill Lynch. Finally, Wells Fargo and Citigroup fought over who would gobble up Wachovia, an enormous but otherwise insolvent bank.

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

"World Economic Forum" Davos, activist fund / activist shareholder / activist investor, Alan Greenspan, Anthropocene, assortative mating, bank run, barriers to entry, Bear Stearns, 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, digital divide, diversification, Dunbar number, East Village, eat what you kill, Elon Musk, eurozone crisis, fake it until you make it, family office, financial engineering, financial repression, Gini coefficient, glass ceiling, Glass-Steagall Act, Goldman Sachs: Vampire Squid, Google bus, Gordon Gekko, haute cuisine, high net worth, hindsight bias, income inequality, index fund, intangible asset, Jaron Lanier, Jim Simons, John Meriwether, junk bonds, Kenneth Arrow, Kenneth Rogoff, Kevin Roose, knowledge economy, London Whale, Long Term Capital Management, longitudinal study, Mark Zuckerberg, mass immigration, McMansion, mittelstand, Money creation, money market fund, Myron Scholes, NetJets, Network effects, no-fly zone, offshore financial centre, old-boy network, Parag Khanna, Paul Samuelson, peer-to-peer, performance metric, Peter Thiel, plutocrats, Ponzi scheme, power law, public intellectual, quantitative easing, Renaissance Technologies, rent-seeking, reserve currency, risk tolerance, Robert Gordon, Robert Shiller, rolodex, Satyajit Das, search costs, shareholder value, Sheryl Sandberg, Silicon Valley, social intelligence, sovereign wealth fund, Stephen Hawking, Steve Jobs, subprime mortgage crisis, systems thinking, tech billionaire, The Future of Employment, The Predators' Ball, The Rise and Fall of American Growth, too big to fail, Tyler Cowen, 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.

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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.

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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.

Safe Haven: Investing for Financial Storms by Mark Spitznagel

Albert Einstein, Antoine Gombaud: Chevalier de Méré, asset allocation, behavioural economics, bitcoin, Black Swan, blockchain, book value, Brownian motion, Buckminster Fuller, cognitive dissonance, commodity trading advisor, cryptocurrency, Daniel Kahneman / Amos Tversky, data science, delayed gratification, diversification, diversified portfolio, Edward Thorp, fiat currency, financial engineering, Fractional reserve banking, global macro, Henri Poincaré, hindsight bias, Long Term Capital Management, Mark Spitznagel, Paul Samuelson, phenotype, probability theory / Blaise Pascal / Pierre de Fermat, quantitative trading / quantitative finance, random walk, rent-seeking, Richard Feynman, risk free rate, risk-adjusted returns, Schrödinger's Cat, Sharpe ratio, spice trade, Steve Jobs, tail risk, the scientific method, transaction costs, value at risk, yield curve, zero-sum game

These citation rings or circular support groups were called mutua muli by the ancients: the association of mutually respecting mules. COST‐EFFECTIVE RISK MITIGATION Most financial and business returns come from rare events—what happens in ordinary times is hardly relevant for the total. Financial models have done just the opposite. A fund miscalled Long Term Capital Management that blew up in 1998 was representative of such decorated mutua muli misunderstanding. The Nobel‐decorated academics proved in a single month the fakeness of their models. Practically everyone in the 1980s, particularly after the crash of 1987, must have known it was quackery. However, most if not all financial analysts exhibit the clarity of mind of a New York sewer after a long weekend, which explains how the mutua muli can take hold of an entire industry.

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(A plot of the Sharpe ratios overlaid on the previous chart would simply be a horizontal line—more free money for all as leverage increases, meanwhile ending wealth plunges.) And less risk would always only mean less return. What a disaster those superficial, pseudoscientific tools are! Leverage can indeed kill the golden goose. (Just ask the investors of the hedge fund Long Term Capital Management.) Now think about this for a second. If setting aside 60% of your stack of cash raises your end‐point wealth from 0 to 7 times your starting wealth over 300 rolls, then in a vacuum you could reason that the rate of return on that cash must have compounded at a fixed 0.8% on each toss—like a fixed annuity.

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See also Holism value, 104 Investment risk, 8 J “Jack of the Baltic,” 43–45, 197 Jevons, William Stanley, 36 Jobs, Steve, 8 “Joyful wisdom,” 60 Julius Caesar, 23 Jung, Carl, 17 K Kahneman, Daniel, 53 Kamikaze criterion, 86 Kelly, John, 79–81 Kelly criterion, 78–87 Kelly optimal bet size, 81–87, 89–90, 93–94, 134 Klipp, Everett, 6, 195 Knew‐it‐all‐along phenomenon, 113, 114, 194 Kundera, Milan, 200 L Latané, Henry, 80, 81 Law of large numbers, 30 Leverage, 11, 83–84, 116–117 Le Verrier, Urbain, 167 Localized thinking, specialized thinking vs., 157–160 Logarithmic cost, 46–48 Logarithmic Rhine Falls, 54–56 Logarithm of wealth, 38–39 The Logic of Scientific Discovery (Popper), 19 Log utility maximization criterion, 54 Long Term Capital Management, 84 Long volatility strategy, 108, 177–178 Losses. See also Returns and buying into crashes, 149–150 diminishing marginal utility with, 53 in fair value of wagers, 34–35 focusing on, 6 horizontal vs. vertical, 48 insuring against, 44–52 Klipp on, 34–35 potential for, 8 reducing costliness of, 11 scaled by total wealth, 37–38 Loving your fate, 199–201 Ludic fallacy, 25 Lynch, Peter, 109, 115 M Mantle, Mickey, 63 Marcus Aurelius, 199 Marginal Revolution, 36–37 Markowitz, Harry, 80 Mean, 41 Mechanical payoffs, 168, 170 Median ending wealth: expected, 74–76 with insurance, 92 and Kelly‐optimal best size, 81, 86 raising, by lowering risk, 163 with real‐world safe havens, 163 Meditations (Marcus Aurelius), 199 Menger, Carl, 36 Merchant marine insurance, 202 Mises, Ludwig von, 37, 165, 180 Modern portfolio theory, 80, 99, 115 Modus tollens, 18–22 and groundhog problem, 18, 21–22 Monetary interventions, 11 Moonraker (Fleming), 36 Morgenstern, Oskar, 37 Multiverse thought experiment, 64–69, 74–76, 79, 89, 90 Murphy, Robert, 182 N Naïve empiricism, 127 Naïve falsificationism, 167–170 Napier (Scottish mathematician), 40 Narrow framing, 152–158 Neptune, 167, 169, 175, 187 Net portfolio effect: with combined payoff strategy, 79 in cost‐effectiveness analysis, 136–142 for gold, 178 and Kelly optimal bet size, 84–86 in no‐crash bootstrap, 146 in Petersburg merchant trade, 47 for real‐world safe havens, 184 and safe haven frontier, 186 for US Treasuries, 172, 174 value known by, 151 when reshuffling, 142–143 Neumann–Morgenstern utility function, 37 Newton, Isaac, 167 Niederhoffer, Victor, 114 Nietzsche, Friedrich: admonition and imperative of, 195 background of, 57–58 Dionysian ideal of, 69 eternal return (demon) thought experiment of, 58–63, 69–73, 75, 76, 79, 89, 90, 193, 199 on fighting monsters, 109 on forgetting one's purpose, 157 on forgetting umbrella, 203 on formula for greatness, 201 “joyful wisdom” idea of, 60 on loving your fate, 199 on merchant and pirate, 197 on what doesn't kill you, 199 on what is written with blood, 3 Non‐crash payoff: for safe haven imposters, 112 for safe haven phenotypes, 105, 106, 145–148 Non‐ergodicity, 72–77, 80 O Offensive defense, 148–151 120‐sided die (d120), 118–122, 127–129, 166 On the Origin of Species (Darwin), 102 Operating Manual for Spaceship Earth (Fuller), 158 Opportunity cost, 152–155 Opportunity cost neglect, 153 Overspecialization, 158–159 P Pascal, Blaise, 23 Paths.

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, book value, corporate governance, discounted cash flows, disinformation, diversification, fixed income, index fund, John Bogle, junk bonds, Long Term Capital Management, Michael Milken, 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.

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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.

Unfinished Business by Tamim Bayoumi

Alan Greenspan, algorithmic trading, Asian financial crisis, bank run, banking crisis, Basel III, battle of ideas, Bear Stearns, behavioural economics, Ben Bernanke: helicopter money, Berlin Wall, Big bang: deregulation of the City of London, book value, 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, Glass-Steagall Act, Greenspan put, hiring and firing, housing crisis, inflation targeting, junk bonds, 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, Rubik’s Cube, Savings and loan crisis, 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