History repeats. It just looks different

September 1998 is when the star-studded hedge fund Long Term Capital Management (LTCM) was wound up. Large institutional investors bailed it out. One bank – Bear Stearns,  refused to participate.

A decade later, Bear Stearns was bought over by J P Morgan Chase. Trouble at the bank had started after two of its hedge funds got into trouble.

Reason for failure of LTCM – derivative trades using leverage

Reason for failure of Bear Stearns’ hedge funds – derivative trades using leverage

History repeats. It just looks different.

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Black swan

September 11, 2001 – the world witnessed an event that nobody had anticipated. The twin towers of the World Trade Centre at Manhattan, New York were blown away using aeroplanes of a US airline.

This was a “black swan” event – an event that one could not envisage. However, the probability of such an event is near zero and not exactly zero.

Be aware. A black swan phenomenon is one that even experts could not foresee.

in the financial markets, the collapse of LTCM was one such event. Read more about it in the book …

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Can the Governments and regulators prevent the next crisis?

Recently I came across an article from Knowledge@Wharton. The article quotes two  professors: Wharton’s Peter Conti-Brown and Carnegie Mellon’s Allan Meltzer. I would like to highlight one point in particular that Prof. Meltzer talked about..

Meltzer noted that regulators failed to anticipate the 1929-1932 financial crisis and others that followed over the decades. “The whole idea that the government, the Federal Reserve or any other agency — clever, intelligent [and] smart people that they are — will anticipate the next crisis is very small,” he said. “It will come from a direction in which they are not looking. That is why crises blow up, because they aren’t looking in the direction where the crisis is coming from.”

Meltzer argued that regulation alone will not solve financial crises, and called for banks to have higher equity as a proportion of their total capital. “We can regulate the mistakes of the past; we can’t foresee the mistakes of the future …”

At the same time, they discussed that the only way is to increase the bank’s own capital. The skin was not in the game for the banks. Many banks were hugely leveraged. Though the banks are required to maintain a capital adequacy ratio, many banks took off-shore routes to register their SPVs (Special Purpose Vehicles) and heavily used derivatives. Lehman Brothers, the famous failure of the 2008-09 crisis had more than 50 times leverage.

There are so many instances referred in the book:

  • Benjamin Graham later said that the mistake was that he owed money.
  • The leverage at LTCM was way too high. At some point, it was more than 50 times the capital. Leverage can enhance returns when the cost of borrowing is lower than the return on investment. However, when the returns are poor, the cost and the liability of repayment can be detrimental.
  • Easy availability of cash (foreign capital, easy credit, leverage – in whatever form) is one of the common factors among all the market frenzies.
  • Leverage used to invest in illiquid assets also poses a risk. Once again, if you do not have an alternative cash flow and the asset is illiquid, repayment of borrowed capital becomes difficult.

I have just highlighted a few from the book.

Two important points here: Every crisis looks very different in the beginning. This happens since we keep looking at the events that happened without understanding the lessons. We keep looking for the old crisis to happen again from the same place. Government and the regulators are no different.

The crisis is not new. It just crops up from somewhere else.

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When genius failed

As per the Institutional Investor magazine, “They (LTCM) are in effect the best finance faculty in the world.”

Probably that is why Roger Lowenstein titled his book giving an account of the rise and fall of LTCM “When Genius Failed”.

Read the chapter on LTCM in the book “Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget”

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Lehman Brothers or Lehman Sisters

I am back tweeting about the book after a long gap. On this day, International Women’s Day, it would be appropriate to pay a tribute to all the wonderful ladies in my life.

In the year 2008, Lehman Brothers collapsed and filed for bankruptcy. Someone said, “It wouldn’t have collapsed had it been Lehman Sisters”.

Yes, women are believed to be wiser than men when it comes to financial decisions. Please read again – the key word is “wise”, and not “intelligent” or “knowledgeable”.

History suggests that eventually wisdom wins over intelligence. The men at Lehman Brothers, and even at many other firms were intelligent and knowledgeable. However, history also tells us that we don’t learn from history.

Lehman Brothers went bust in 2008. It was just a decade ago in 1998 that they had the best view of what went wrong with Long Term Capital Management. Lehman Brothers were custodians for LTCM.

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Murphy’s Law

Someone forwarded a message on social media listing Murphy’s Laws. One of those caught my attention:

“If everything seems to be going well, you have obviously overlooked something”

In the world of investing, if a risk is not visible, it is a reflection of our inability to see the risk not the absence of the risk.

Exactly the same has happened time and again in the history of financial markets.

This is exactly what happened with Long Term Capital Management (LTCM). (See our post of 31st Dec 2015 on the same).

The problem with LTCM was, the risk was very much there, except that it was not obvious.

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Low risk – high returns: is it a problem?

In the words of Prof. Myron Scholes, “Well, our (LTCM’s) goal is to get the risk level of S&P 500. We are having trouble having it that big.”

The problem Long Term Capital Management (LTCM) was not about getting enough returns, but about having enough risk.

Something was missing here. The fund was generating extraordinary returns, without commensurate risks, as is evident from Prof. Scholes’ statement above.

Read more about the lessons from the LTCM episode in “Riding The Roller Coaster – Lessons from financial market cycles we repeatedly forget”

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