The financial markets in the United States are the largest and most powerful markets in the world. The loosening of regulation in the last twenty years and the availability of inexpensive computing power has created markets that effect the lives of almost every US citizen. Mortgages are packaged bonds and traded in a huge mortgage backed securities market. This tends to assure that the interest rate a home buyer pays will be at a competitive rate. Many people have taken advantage of stock market gains via mutual funds. Venture capital funds the new companies, creating new jobs and wealth.
Markets have their dark side as well. During the Reagan years Michael Milken and Drexel Burnham used junk ("high-yield") bonds to fund a vast corporate takeover boom that resulted in massive job losses, while enriching those who manipulated this game of greater fools. The 1980s are sometimes referred to as "the greed decade". A time when some people got rich or richer while others lost their jobs and houses. Even when the markets are not in the grips of excess, the rich benefit more than anyone else.
One of the benefits of being a "high net worth individual" is that you can invest in hedge funds, which are not regulated as mutual funds are. Compared to mutual funds, hedge funds offer a higher rate of return. For example, in October 2000 Jeffrey Vinik, who at one time managed the Fidelity's Magellan mutual fund, retired from his hedge fund, which during the previous four years produced a return of over 100% per year after fees.
There is a reason that only "high net worth" individuals can invest in hedge funds. In many cases the returns produced by these funds are matched by the risk of financial loss. The US regulators and congress assume that high net worth individuals are experienced investors or at least that they can afford the potential losses associated with higher risk.
Inventing Money: The story of Long-Term Capital Management and the legends behind it by Nicholas Dunbar tells the story of the immolation of a hedge fund named Long-Term Capital Management. During a period of about four years this hedge fund had returns of about 40% per year. Then it lost over 90% of the investor's capital: almost five billion dollars. To avoid a potential market crash, Long-Term Capital Management's positions in various financial instruments was taken over by a US Federal Reserve organized consortium of investment banks.
The story of the demise of Long-Term Capital Management (LTCM) is interesting on a number of levels. On one level it is a story of hubris and arrogance. Although this part of the story is told in Dunbar's book, an even better telling of this side of the tale is given in Roger Lowenstein's book When Genius Fails.
For anyone who works in a trading firm or who has even tangentially studied quantitative finance, the failure of LTCM is a cautionary tale about the limits of modern financial theory. Nicholas Dunbar tells this facet of the story far better than Lowenstein. Dunbar's background is in physics and he understands the theories of modern finance much more completely than Lowenstein. For the last four years Dunbar has been working as a journalist for financial publications. He clearly explains the interest rate swaps, options and interest rate yield curve spreads which were the basis of LTCM's investments.
The description of the last days of LTCM and the Federal Reserve organized bail-out is finally told in the final forty pages of Inventing Money. The rest of the book details the events that lead up to the failure. This is a powerful story telling technique. By the time we get to the end of the story, we understand many of the reasons for LTCM's failure. The story takes on a certain inevitability. Instead of the Greek Gods pulling the threads of the tale, modern finance lurks behind the scenes. In the opening act John Meriwether, the founding partner of LTCM and one of the pioneers in bringing those trained in physics, mathematics and quantitative finance to Wall Street, is forced out of Salomon Brothers in a US Treasury Bill bidding scandal. Rather than retire to an exclusive golf course, he founds LTCM. Meriwether recruits many of the top traders he worked with at Solomon Brother, along with some of the top people in academic quantitative finance. They are joined by an ex-Federal Reserve vice chairman. In the second act LTCM applies financial models that assume that markets are logical and will always tend toward equilibrium. LTCM makes huge financial bets, in thousands of market positions. For four years LTCM shows excellent returns. In the third and final act, LTCM crashes and burns, endangering the US financial system. As Dunbar describes it, LTCM ignored two underlying assumptions behind the market models they used:
The models assumed that markets are always liquid (e.g., you can always sell an asset at a reasonable price).
Markets tend toward equilibrium, where "mispricings" are corrected.
During a market panic, liquidity dries up as investors move their money to safer investments. While market equilibrium may be true in the long run, there can be "mispricings" that can persist for periods of time long enough to lose five billion dollars. In the end much of the personal wealth of the LTCM founders is destroyed.
Nothing that is written here should be interpreted as reflecting the views of my employer. This review was written on my own time, using my own computing and Internet resources. The bearcave.com domain is mine and these opinions are not necessarily shared by anyone else. Obviously this is a book review, and so, a critical work. As a result, all quotes used in this review fall under the doctrine of fair use. In writing this review, I am not engaged in rendering professional services. If professional advice or other expert assistance is required, the services of a competent professional person should be sought. To borrow from Dr. Leonard McCoy, Chief Medical Officer of the starship Enterprise: "Damn it Jim, I'm a software engineer, not a licensed investment advisor."
Ian Kaplan - November, 2000
Revised: