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Essay on Investment Theory

Uncontrollable Risk

Turning and turning in the widening gyre
The falcon cannot hear the falconer;
Things fall apart; the center cannot hold;
Mere anarchy is loosed upon the world,
The blood-dimmed tide is loosed, and everywhere
The ceremony of innocence is drowned;
The best lack all convictions, while the worst
Are full of passionate intensity.
W. B. Yeats, The Second Coming


In September 1998, eighteen months before the first leg in the collapse of the Great Bubble, the U.S. Federal Reserve Bank engineered a bailout of the mammoth hedge fund, Long Term Capital Management (LTCM).

The story of the debacle is well told by Roger Lowenstein in his book, 'When Genius Failed (1)'.

The saga of LTCM throws light on the motivation and attitudes of some leading market personalities and institutions during the Great Bubble.

The event exposed rifts and weaknesses in the banking system and presents insights as to ethics on Wall Street.

Traders, Academics, and a Former Fed Official

John Meriwether, a bond trader, who in 1991 had been forced to resign from a top position in Solomon Brothers for not having taken action when a subordinate submitted fraudulent bids to the U.S. Treasury Department, formed a hedge fund in partnership with the famed academics Myron Scholes and Robert Merton.

The senior partners included David W. Mullins, the former Vice Chairman of the U.S. Federal Reserve Bank, and a number of aggressive derivative traders from the Arbitrage Division of Solomon Brothers.

LTCM was a blind pool for extremely wealthy speculators.

The investment was essentially a blind pool, in which John Meriwether provided little information to investors as to the operations of the fund, although all understood that the purpose was to speculate in the derivatives markets, using models for option pricing inspired by Black, Scholes, and Merton.

Whereas economists used to define 'capital' as 'produced goods for further production', the 'capital' in LTCM was little more than a wager or stake in a gigantic betting pool.

The 'long-term' in Long Term Capital Management was but three years – perhaps an eternity to short-term bookmakers, but hardly the time-frame used when measuring serious projects like steel mills, shopping malls, or forest reserves.

It was implicit that the scheme would involve a high degree of risk and that the investor's money would be locked up for at least thirty-six months.

Nevertheless, institutions were anxious to entrust their money to this group and agreed to pay twenty-five percent of the profits and two percent of fund assets to the managers, with no down-side penalties.

This was the equivalent of giving the promoters a claim on profits equal to that of investors who had put up over three hundred million dollars in hard cash.

Banks as Big Time Gamblers

This fund's assets were to comprise hundreds of highly leveraged side-bets – unhedged speculative positions, based on the promoters' expectations regarding the direction of interest rates, foreign currencies, and stock prices.

World famous institutions were not ashamed to be speculating with money of depositors, pensioners, and taxpayers.

In 1994, the promoters raised an unprecedented $1.25 billion in equity from private and institutional investors throughout the world, including Hong Kong Land & Development Corporation, the Bank of Taiwan, the Bank of Bangkok, the Kuwaiti state-run pension fund, the foreign exchange office of Italy's central bank, Sumitomo Bank, Dresdner Bank, Liechtenstein Global Trust, Bank Julius Baer, Republic New York Corporation, Banco Garantia (Brazil), partners of McKinsey & Company, St John's University, Yeshiva University, the University of Pittsburgh, Paine Webber, Black & Decker Corporation pension fund, Continental Insurance of New York, Presidential Life Corporation, and others.

The directors and trustees of well-known institutions had made this massive and reckless bet with little apparent concern that one day they might be called to account for speculating with money of depositors, pensioners, shareholders, or the people of countries that they represented.

They seem to have been assured by the fame of the future Nobel laureates and the hint that nothing could be amiss in a venture sponsored by a recent Vice Chairman of the U.S. Federal Reserve Bank.

Growing Concerns, Multiple Warnings

To put the LTCM fiasco in perspective, we must go back to 1994, the year in which John Meriwether approached Merrill Lynch for assistance in bringing together the investors that made up the fund.

The reliance of the global financial system on derivatives was already causing concern among the more prudent in financial circles and government.

Derivatives were already causing concern among the more prudent in finance and government.

Studies by the Bank of International Settlements, the Bank of England, the Group of Thirty, the U.S. Office of the Comptroller of the Currency, the Commodity Future Trading Commission, and the U.S. Government Accounting Office (GAO) all focused on the explosive growth of the OTC market for derivatives, the lack of strong regulation, and the complexity and general dearth of understanding regarding systemic risk in this market.

Causing particular anxiety was the degree to which large U.S. banks had become engaged in trading and maintaining positions in derivatives.

The GAO report pointed out that in 1991 eight U.S. banks held fifty-six percent of the contractual value of the global OTC market in currency and interest rate derivatives.

For seven large U.S. banks, credit exposure on derivatives exceeded capital and reserves.

For the seven largest banks acting as derivative dealers, the credit exposure on OTC derivative contracts exceeded their capital and reserves and amounted to almost one-quarter the outstanding risk on their loan portfolios.

In other words, major U.S. banks were investing depositor money in speculative positions in derivative markets without much governmental oversight.

Furthermore, it was determined that the accounting profession had no way to accurately and clearly report derivative risks to investors and creditors.

The GAO report recommended measures to shore up the regulatory framework of the derivatives market.

Several members of the U.S. Congress proposed legislation that would tighten the system.

The 'Free Derivatives' Lobby

Lobbyists for banks and derivative traders were successful in warding off what they considered to be unnecessary government intervention.

This should not be surprising: bankers have argued against government restraints as long as there have been banks:

Although many depositors lost life savings in failed banks during the 1920s, bankers relentlessly lobbied against banking reform that would protect the public.

For years before the founding of the Federal Deposit Insurance Corporation (FDIC), the president of the American Bankers Association had promised his members to fight federal deposit insurance 'to the last ditch', even as 5,600 banks collapsed during the 1920s.

In the four years before the FDIC was finally established in 1933, 9,460 banks had closed their doors (2).

Among the most influential of those averse to establishing prudent supervision of derivatives trading was the Financial Economists Roundtable – a group of about fifty famous working economists that included a number of Nobel laureates specializing in financial markets.

The Wizards Say, 'Don't Worry'

On September 26, 2020, the Financial Economists Roundtable issued a 'Statement on Derivative Markets and Financial Risk' that essentially pooh-poohed the concerns of the GAO and advised against increasing government oversight of the market or placing controls on bank derivative trading.

These experts proclaimed with that the banks and the other intermediaries involved in derivatives trading had sound risk management systems and that although lesser mortals might not understand these instruments, the people that counted did.

Experts said that banks trading derivatives had sound risk management systems.

They argued with passionate intensity that self-preservation and free markets would keep unfettered capitalists out of trouble.

This statement was signed by thirty-three well-known academic experts in derivatives.

All but one of these economists indicated connections with a leading university, such as Harvard, Stanford, Columbia, North Carolina, Pennsylvania, Chicago, MIT, Yale, Cornell, California, or NYU.

The signatories included Nobel laureates Myron Scholes, William F. Sharpe, Robert C. Merton, Merton Miller, and Franco Modigliani.

Myron Scholes identified himself on the signing statement as associated with Long Term Capital Management, rather than a university.

The Risk Management Elite

The Financial Economists Roundtable represented an entrenched intellectual establishment of risk-management elite.

These people had significant connections and wielded power by guiding government capital market policy in the U.S. and abroad.

The signers of the 1994 statement included editors, members of editorial boards, and associate editors of a list of two dozen influential academic financial journals that dictated the latest wisdom on financial risk, capital valuation, and derivatives, including:

China Accounting and Finance Review, European Finance Research, Financier, Management Science, Review of Derivatives Research, Review of Futures Markets, The Accounting Review, The Case Research Journal, The International Journal of Accounting, The International Journal of Theoretical and Applied Finance, The International Review of Financial Analysis,

Roundtable economists dominate influential academic financial journals.

The Journal of Applied Corporate Finance, The Journal of Banking and Finance, The Journal of Derivatives, The Journal of Finance, The Journal of Financial and Quantitative Analysis, The Journal of Financial Economics, The Journal of Financial Intermediation, The Journal of Financial Research, The Journal of Financial Services Research, The Journal of Fixed Income, The Journal of Futures Markets, The Journal of Money Credit and Banking, or The Journal of Pension Fund Management and Investment.

The members of the Financial Economists Roundtable were connected to many other prominent people by membership, committee and advisory roles, and leadership positions in organizations such as:

The Western Economics Association, the American Finance Association, the Shadow Finance Regulatory Committee, the American Bar Association, the American Stock Exchange,

Roundtable economists also serve on boards of banks, securities exchanges, and investment funds.

the New York Stock Exchange, the National Association of Securities Dealers, the Federal Reserve Bank, the Futures Industry Association, the New York Mercantile Exchange, the Society for the Promotion of Financial Studies, the International Financial Risk Institute, the Financial Management Association, the Institute for the Study of Securities Markets, the Pacific Exchange, the Securities and Exchange Commission, the Accounting Standards Board, and the Financial Standards Advisory Council.

In addition to using their connections to influence government policy, members of the Financial Economists Roundtable exerted a dominant role in deciding what was taught to young MBAs at American universities.

Their intellectual output, taken together, numbered in thousands of published articles, reviews, text books, and lectures.

They served as expert witnesses before the courts and testified at Congressional hearings. Their message to Congress and the people was that risk is good and that, with the right know-how, risk can be managed, yielding above-average profits to those with access to the tools which they were selling.

Aggressive Academics

These professors were not the impartial, scientific observers of the market that they would have the world believe.

They had more than one dog in the fight.

They profited from a consulting industry that thrived on the complexity of financial markets – the more mysterious, the better.

Roundtable economists thrive and become rich on the complexity of the financial markets.

Many had become wealthy, even millionaires, in non-academic roles as consultants to governments and business.

Some were directors of banks, mutual funds, and pension funds.

It was not to their economic advantage to reduce risk or simplify financial markets, nor would they profit by speaking out against excesses on Wall Street, since this would be casting aspersions on the primary source of their non-academic cash flow.

These financial scholars were not the mousy, professorial stereotypes of the classic, Goodbye Mr. Chips.

These were in-your-face, modern, aggressive, macho capitalists.

In the same year that Myron Scholes signed the 'Statement on Derivative Markets and Financial Risk', he was hard-selling investments in Long Term Capital Management.

The Rest of Us Are Fools

Roger Lowenstein recounts an incident that occurred when Myron Scholes, together with promoters from Merrill Lynch, solicited funds from Conseco, a big insurance company in Indianapolis:

Scholes started to talk about how Long-Term could make bundles even in relatively efficient markets. Suddenly, Andrew Chow, a cheeky thirty-year-old derivatives trader, blurted out,

'There aren't that many opportunities; there is no way you can make that kind of money in Treasury markets.'

Chow, whose academic credentials consisted of merely a master's in finance, seemed not at all awed by the famed Black-Scholes inventor.

Furious, Scholes angled forward in his leather-backed chair and said,

'You're the reason – because of fools like you we can.' (3)

It would be four years before Long Term Capital Management collapsed and Myron Scholes had to face the fact that his theories did not work as expected, but increasing signs of stress in the OTC derivatives markets could already be seen within months of the 'Don't Worry, Be Happy' proclamation of the Financial Economists Roundtable.

How Derivatives Got So Big

Financial derivatives were developed as a way to insure against interest rate and currency volatility and to transfer risk among market players.

Some players hedge against fluctuations in prices, interest rates, or currencies, but many more are speculators, trading in risk, and this includes banks that are at the foundations of the financial system.

Derivatives markets got big after the U.S. went off the gold standard.

Inflation and floating exchange rates were a consequence of the U.S. having gone off the gold standard in 1971.

The derivative product line expanded rapidly to satisfy the desire for stability following the abandonment of fixed interest and currency rates in the 1970s.

Competition from money market funds drove U.S. commercial banks to demand freedom to set interest rates on deposits, eliminating controls that had been in place since the 1930s.

This caused failure in U.S. savings and loan banks that could not balance interest rate income with expense.

As developing countries discarded exchange and capital controls, emerging economies began to have periodic currency devaluations that triggered defaults on public and private debt.

In the year that LTCM failed, the worldwide over-the-counter derivative market had a total notional value of more than seventy trillion dollars (4), of which about seventy percent were non-diversifiable interest rate derivatives, with the rest concentrated in equally risky foreign exchange contracts.

There was an additional fourteen trillion dollars in contracts of exchange-traded derivatives (5), mainly interest rate products.

Financial Engineering Run Amuck

The notional value of a contract does not represent the likely risk to the parties, which is usually from two or three percent of the value of the underlying loans or exchange contracts.

However, the effective risk is difficult to evaluate for several reasons:

Leverage. Almost all participants in the derivatives markets are leveraged to some degree. This means that the effective risk to the liquidity or profits of banks and corporations probably ranges from two to twenty times the nominal risk.

On a global scale, in 1998, this represented an effective risk to profits and liquidity on the order of from four to forty trillion dollars.

Effective risk is difficult to evaluate because of leverage, non-diversification, adverse selection, illiquidity, and lack of centralized credit control.

Non-Diversification and Adverse Selection of Risk . Although derivatives are often compared to insurance, most bets are related to changes in interest and exchange rates that are not susceptible to diversification.

When the Russian Ruble falls, all contracts in this currency are affected. If insurers are concentrated in financial institutions, hedge funds, and a relatively few large traders, rather than being diversified over hundreds of thousands of corporations, the effect is similar to that of a war, earthquake, or hurricane on the finances of the insurance industry.

Whereas traditional insurers exclude war and flood risk from their policies, derivative insurers have no similar escape clauses. Not only are derivative insurers subject to natural limitations on diversification, but concentration of risk is intensified as 'insurers' take one-sided views of the market in speculative trading positions.

Illiquidity. Over seventy percent of the global derivatives market takes place over-the-counter, which means that there is no organized exchange to provide liquidity.

A rapid shift in foreign exchange or interest rates of a country dries up the OTC derivatives market – making is difficult or impossible for those on the wrong side of the bet to limit losses.

Sudden illiquidity was seen in the fall of Latin America and Asian economies during the 1980s and 1990s.

Lack of Centralized Credit Controls. The clearinghouses of the organized derivative exchanges stand on the other side of each trade and this extreme concentration of risk gives rise to strict credit controls and risk management procedures.

Barings Bank failed when a rogue trader took extreme positions in the derivative market for Japanese stock indices, while SIMEX, the Singaporean clearinghouse, had demanded and received essentially the entire capital of the bank as cash collateral without the top management of Barings taking notice.

In the OTC derivative market there is no centralized disciplined approach to credit and risk management. In the case of LTCM, most banks had waived strict credit and collateral rules and were exposed when the giant hedge fund got into difficulty.

No one knows for sure the degree to which the OTC derivative market is adequately collateralized, or how well credit risk is being managed.

Essay: continued >

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