Tag Archive: greed

When Genius Failed: the rise and fall of long-term capital management (2000)

Roger Lowenstein

Rating: 7/10

This book was quite technical (though the author did a good job of explaining terms overall), and a bit tough to wade through.  But the subject is crucial, hence the high rating.  Lowenstein takes a look at an elite firm (Long-Term Capital Management) and shows how their hubris, greed, and detachment led not only to their own downfall, but threatened to exasperate an economic crisis in 1998.  What’s really revealed, however, is that LTCM is merely a microcosm of how Wall Street and the financiers of the world seek only short-term profits at the expense of everyone else, even if that means some truly damaging consequences.

Then I came across the Fed’s speech about the 2008 crisis and its causes, and it basically reads like the Cliff’s Notes of Lowenstein’s book.  Thus, Wall Street, the Fed, and the financiers of the world learn no lessons from history, and carry on with business as usual, trampling 95% of the global population underfoot.  The system needs significant changes.

Below is a more detailed synopsis of the book for those with the inclination but not the the time to wade through the whole thing.

I.  Overview

  • John Meriwether worked for Salomon Brothers in the 1980s, and got a group of PhDs together to create mathematical models to play the finance game; he eventually had to leave over a minor scandal (1991).
  • JM created his own company (LTCM), pitching to a very elite clientele ($100 million investors)
  • LTCM was incredibly profitable for 4 years (1994-1998), playing the markets of derivatives, spreads, bonds, arbitrage, etc.
    • They remained secretive (to Wall Street banks), and leveraged themselves to 30-1
    • Their models worked on the assumption that market was rational and efficient, and they would always bounce back from any losses
    • Running out of ways to make money, they ventured into areas where they had no expertise and greater risk was present
    • In 1998, a default in Russia set off a domino effect on the global markets.  LTCM began hemorrhaging money, and lost some 90% of its value inside 5 weeks.
    • The FED summoned the big Wall Street banks to orchestrate a bailout in fear of what the loss of LTCM’s $100 billion balance sheet would do to the global market.  They barely got it done.

II. Specifics

  • LTCM’s models were based on odds premised with no uncertainty—which is not how the market works.  (Using the newish computers and Internet to look over global trends, they had an aura of invincibility and infallibility; some of these similar models leaked to other firms from academia—the Merton and Scholes model).
  • LTCM became illiquid which is fine—unless you have to sell in a hurry (they wound up not being able to when the crisis hit because doing so would have exasperated the crash and their losses).
  • Unregulated derivatives (a side bet on the direction of stocks as opposed to actually purchasing stocks—which is regulated) (and unregulated derivatives were advocated by Alan Greenspan) started in 1981.  In 10 years, one type of derivative swaps soared to $2 trillion and then ballooned to $22 trillion by 1997.
    • Significantly, derivatives aren’t disclosed in any useful way to outsiders (and thus impossible to pinpoint risks)
    • Thus: Wall Street “bought into a massive faith game, in which each bank had become knitted to its neighbor through a web of contractual obligations requiring little or no down payment.”  By the late 1990s, most of WS was leveraged 25-1
    • Fears abounded about what a shock could now do to the entire system, but the banks didn’t care b/c they were focused on short-term profits
    • Since Mexico was bailed out, investors shoveled speculative money into Asia, underwriting the corruption there.  When Asia had its crisis, foreign investors pulled their money out, exasperating the problem further.
      • The IMF stepped in to bailout S.Korea, stabilizing the markets.  Investors then assumed Asia was isolated and that the IMF would bailout similar situations in the future.
      • John Succo (ran equity derivatives desk at Lehman Brothers) declared that senior management on WS didn’t know what their 26-year-old traders were doing.  He was forced to resign for such heresy.
      • More warnings came in from the Fed warning that banks put too much faith in the past as a gauge for the future (forgetting the shocks).
      • When Russia defaulted and the IMF refused a bailout, global markets began plummeting.  This sent investors running from any risk (since nuclear powers weren’t supposed to default).
        • Main Street economy was sound, but financial markets were overleveraged and overextended, and were panicking.
        • LTCM began hemorrhaging money but had trouble getting new capital to shore up their finances (being so highly leveraged, every percentage point loss resulted in tens of millions).  Their secrecy and aloofness came back to bite them; other banks began sniping at their deals, causing further losses as LTCM’s portfolio became known.
          • If LTCM’s assets dipped below $500 million, Bear Stearns would refuse to clear them, effectively sinking the firm.
          • Desperately, LTCM looked anywhere for money (banks, William Buffet, foreign or domestic); Goldman Sachs offered a potential saving merger, and when their analysts began pouring over LTCM’s books, they began playing their weakened positions (taking total advantage of inside info).
            • Goldman Sachs used to be known as a gentleman’s banker, but their tactics changed and became much more aggressive (‘bare-knuckled traders’).
            • They admitted they needed to protect their own positions which may have hurt LTCM, but didn’t apologize for it.
            • Eventually, the WS banks saw that by savaging the bloated firm, they risked bringing themselves down
            • After all the losses, LTCM became leveraged greater than 100 to 1.
              • Greenspan didn’t seem to understand that the lenders (banks) avoided regulations in order to cash in on the hedge fund.
              • Buffet, a potential savior, was able to dictate his offer ($250 million for a fund that had been worth $4.7 billion at the start of the year and was now worth $555 million) and gave them a 50 minute deadline.  The deal didn’t go through.
              • A deal with 14 banks (and over 100 lawyers) drafted a deal for the consortium to take over the fund (it needed all the partners’ signatures). One thought about holding out and letting the fund fail so he would not have to work for the banks for a “mere” $250k salary.  Eventually it went through.
                • The public got wind that the Fed initiated the deal, and a backlash against them for bailing out private investors and funds came on.  If investors knew they’d always get bailed out, they’d go after riskier deals and make more mistakes, causing further shocks.

III. Conclusions

  • (Lowenstein) The government or the IMF keeps coming to the rescue of private speculators (S&L, big commercial banks that had overlent to real estate, Mexico, Thailand, South Korea and Russia (attempted but failed)).
    • Losses would deter imprudent risks; not allowing them to fail leads to more greed and thus risk
    • Greenspan constantly wanted less regulation (thrall to Ayn Rand), even calling for less sixth months after the crisis!
    • Prophetic words from the author:
      • “Will the investors in the next problem-child-to-be, having been lulled by the soft landing engineered for LT, be counting on the Fed [i.e. a bailout], too?”
      •  “As the use of derivatives grows, this deficiency will return to haunt us”
      • “Banks have repeatedly shown that they will exceed the limits of prudence if they can.  Greenspan endorses a system can rack up any amount of exposure they choose—as long as it’s from derivatives”
      • “The Fed’s two-headed policy—head in the sand before a crisis, intervention after the fact—is more misguided when viewed as a single policy.  The government’s emphasis should always be on prevention, not on active intervention.”
      • “the fathers of the crisis were the big WS banks, which let their standards grow lax as their pocketbooks grew flush.”
      • (Me) Egos and greed facilitated the crisis; financiers play with virtual money and our out-of-touch with the common man (the real economy) and the effects their actions can have on the global and domestic markets
        • No lessons were learned as we steamed ahead into the 2008 crisis, this time on the back of derivatives (swaps) on the housing market.  Lehman Brothers collapsed during the subprime mortgage crisis b/c of its policies—a special session of derivatives trading was held to account for their bankruptcy.  In some ways, it was AIG in the place of LTCM because they could not pay out when the house of cards came tumbling down which shook the whole market.  And Bear Stearns was failing, so the Fed gave a loan to JP Morgan who then bought BS.
        • The Fed’s speech about the 2008 crisis: “The scale of long-term risky and relatively illiquid assets financed by very short-term liabilities made many of the vehicles and institutions in this parallel financial system vulnerable to a classic type of run, but without the protections such as deposit insurance that the banking system has in place to reduce such risks.” (http://www.newyorkfed.org/newsevents/speeches/2008/tfg080609.html)

So there’s some important legislation being considered in Washington: interchange fees.  That’s the small cost whenever we use a debit card to pay for something.  Right now, the retailers pay these fees, but the legislation is seeking to change that (putting the cost on the banks and credit card companies and in the process wind up “costing” them some $12 billion dollars a year in lost revenue).

That’s a lot of dough.

Both sides are lobbying their case with Congress right now, to the tune of hundreds of thousands of dollars.  And both sides claim they’re on the side of us, whom they call the “little guy.”

Yet if the banks/credit card companies lose, they claim they might have to forgo giving out debit cards or slash their rewards programs.  If the retailers lose, they might have to pass the costs (which they’ve been eating thus far) along to us, the consumers.  Neither of these options sound like either of the opponents are, in fact, on “our” side.

This is another perfect example of those in power (i.e. those with the money) are battling for control over our material lives and view us merely as collateral damage.  They pay lip service to wanting to protect us, but all they want is more money.

Let’s take a closer look at what’s actually going on.  The section of the Dodd-Frank Wall Street Reform and Consumer Protection Act in question deals with determining if these interchange fees are “reasonable and proportional” to the costs of each transaction.   It provided 9 months for the Board of Governors of the Federal Reserve System to investigate the matter and produce its findings, which it did.  In a short and abbreviated nutshell, it found that the average transaction cost was about 12 cents.  The Board also found that the average charge for these same transactions was 44 cents.  That’s a 366% mark up for profit.  That seems far from “reasonable and proportional” to me.  The Board then offered a couple of alternatives to adjust the current system involving caps on how much the issuers (banks/credit card companies) can charge for these interchange fees.

The real kicker? “Small issuers” are exempt from any caps proposed by the Board.  Who qualifies as being “small?” Issuers with less than $10 billion in assets.  Yeah, with a “B.”

With markups and shenanigans like these, is it any wonder why the top 5 banks alone posted over $60 billion in profit in 2010?  Nor is it clear from these documents how or why the changes would wind up costing us (the consumers) more money, which is what both sides are claiming.  Either we remain in the status quo (and the retailers continue to eat the costs as they’ve done for years) or the banks/credit card companies will simply have their costs covered and make no or little profit from these fees.  Neither of these outcomes justify the lobbyists’ fear campaigns about how we’ll suffer if the “other side” wins.

Isn’t it amazing what one can learn when we read the actual documents instead of letting lobbyists try and bullshit us?

Update 5/11:

My favorite quote from the retailers’ campaign is when the clerk at a Starbucks tells the guy who wants to pay with his debit card to take the coffee because the bank will make more money off the transaction than the barista will.  Yeah, that 44 cents on a $4 cup of coffee really sinks your profit.

On the flip side, the banks/credit card companies claim that Congress gave retailers a $12 billion payday.  It’s not a payday because they’re not charging that fee to the customer!