When Genius Failed

Maxrum – Again, thanks for the comments and yes I have read ‘When Genius Failed’ by Roger Lowenstein.
Roger Lowenstein is mostly recognized for his work – writing about big-dick-swinging people in the world of Finance as well as a bunch of very interesting articles on the NY Times Magazine. ‘When Genius Failed’ is more of a description of the people involved – John Meriwether, Robert Merton, Myron Scholes than a description of the actual trading strategies which caused LTCM to collapse. But it is still a very good read. Roger also wrote “Buffet:The Making of an American Capitalist” which is also a great read.

However, if you are really interested in the strategies LTCM was involved in you should pick up the book titled “Inventing Money” by Nicholas Dunbar.

As for me, I work in Structured Finance, in the big-bad world of ‘subprime’.

Having said that, let me reiterate that all the views and opinions expressed in this blog are my own and have nothing to do with my employer.

Moving on, I had an interesting albeit insane experience last night and for once I will try and put it across as it was. As Thomas Aquinas puts it in his work – Summa Theologica – “God is perfect. HE is different from all other beings in being perfect”. Of course that is but a translation of sorts and those might not be the exact words he used. But, my point is that I think we all are. We all are perfect.

So in the next couple of days I will post a new thought inspired by last night’s incidents and Aquinas and a little bit of insanity.

Cheers! and have a great weekend.

Answers to comments

I am so impressed with the responses that I thought it best to reply to comments in the space of a new post.

Indeed – maxrum – Scholes’ first name is not Martin – it is Myron. Thanks for pointing that out to me. Hopefully, I will get more hits now. (37 and counting within the first 24 hours)

Now onto the first remark you made – Yes, LTCM did collapse in 1998 but the wheels had started turning in 1997. After the Asian financial crisis. The fact that the whole world essentially assumed that there was no risk at all eventually led to the Russian default and hence the LTCM collapse.

In 1997 when problems from thailand started hitting the shores of South Korea, the leaders of the US markets decided to get together on a cold wintry night on the eve of christmas to bail out South Korea – their comrades with a geopolitical advantage. World Bank, IMf and The US Treasury formed a so-called global consortium to reschedule South Korea’s debt in the face of an impending downslide of the complete Korean economy.

Of course it was not all capitalism, it was the fear of a spillover effect. Not surprising, because although Thailand, Malaysia, Indonesia and the sorts don’t have much of an macroeconomic influence over each other’s economy they did have quite a bit of an influence with more links to developed countries than amongst themselves. In the same space – a spillover was not foreseen when the problem started with the Thai economy, but the disease spread fast and I mean real fast. Eventually when Korea was hit, the US came out guns blazing and rescheduled Korea’s debt.

The world sat-back and watched and rightly assumed that the super-developed countries will bail them out in the face of an economical disaster. We entered a no-risk safe haven. LTCM buried their claws in deep. Russia – the superpower of yesterday was not going to go down – with all their missile reserves and some of the best vodka and caviar in the world! No way sir!

It did! Russia defaulted on their debt. Capitalism won and took the blow. IMF had tried to help Russia, but it did not work. The Russian currency devalued massively and all those no-risk angels with degrees from MIT and Harvard and PHDs from the moon – panicked. There was suddenly a huge risk in everything. Let’s buy US Treasuries because USA is still a superpower! The on-the-run rates for 30 year US Treasuries fell because of this hurried buying by every economy that had become very very risk-averse. Money was pulled out from Russia, Brazil, Japan, etc. LTCM could not even unwind their trades effectively because there was no participant in that market – no buyer. This eventually led to the collapse of LTCM and which is why I had mentioned 1997 in my earlier blog, although, technically LTCM did collapse in 1998.

So thanks for reading my blog – maxrum and all the others – and hopefully we will have much much more interesting conversations. I look forward to more comments from you.

In the current Credit Crunch that the US and global markets are experiencing the situation is a little different albeit noteworthy might be the fact that this time the US is saying – Mea Culpa! Mea Maximus Culpa!

The answer is 2.

Lehman is uncertain. Merrill is uncertain. Morgan is uncertain. Goldman is uncertain. And of course how could I miss out Bear Stearns!

Where is Wall St. headed?

The financial markets, they say, move in circles. The rally and frenzied selling are intrinsic parts of it. Have we seen this type of a movement in the market?
The answer is – Yes, at least 2 of them.
The most recent one being in 1997 when LTCM lost their foothold even with the behemoths of Quantitative finance backing the structural construct of complex fixed-income arbitrage trades. Convergence trades as they are known were the most common.

Let’s start with the basic concept of Convergence. The word by itself means – The act, condition, quality, or fact of converging. In Mathematics it means – The property or manner of approaching a limit, such as a point, line, function, or value.

A convergence trade with respect to the fixed-income market was based on the idea that long-term bonds issued around the same time would eventually ‘converge’ to the same price/value. The rate at which they converged would be different depending on their liquidity. An on-the-run bond is always more liquid than a off-the-run bond. The convergence would take place as new bonds would come on the run. (That’s funny ‘come on the run’ – but let’s not digress).

Thats a unique bond-arbitrage position. Buy off-the-run bonds at a cheaper price and short-sell on-the-run bonds. So where is the catch? The trick (or should we call it the downfall of LTCM) was highly leveraged positions. Since the differences in the values of these bonds were really small, the positions had to be highly leveraged in order to make a decent buck.

Did the leveraged positions define the downturn? -no, but they were a major factor in defining the effect it had on LTCM. Causality is but a post-action study. What did define the downturn was the loss of liquidity and a spike in the volatility in the market. After the Asian Market crisis (1997)and the Russian financial crisis (1998) the Global markets lost a ton of liquidity, prompting the investors and banks alike to run for cover under the umbrella of US Treasuries. The so called zero-default-risk bonds. As the demand went up so did the prices and instead of converging they ‘diverged’. To unwind these positions meant huge losses for LTCM and eventually their assets were wiped out.

LTCM’s impact was felt all across the US as almost all of the big banks and investment firms pooled in to contribute money to LTCM to cover their asses!(sic) Without significant contributions, LTCM would have had to liquidate a lot of it’s securities to cover it’s debt which would lower prices and in turn other companies would offload their debt creating a complete downward slide in the debt/credit market. That of course did not happen since LTCM was bailed out.

So how is this related to the markets now and where is Wall St. headed?

We see the same trend – Low liquidity – High volatility and more risk-averse investors. Let’s talk about that in the next post. I also want to talk about:
1. Black-Scholes (since Martin Scholes was part and parcel of the quantitative trading strategy development team at LTCM)
2. Martingale (probability and betting theory)
3. Game theory.

The last one being my favorite (cos it teaches you how to get to the blonde without being rejected!)

LTCM stands for Long Term Capital Management.

The reflection and the rules.

So that last blog was funny. Last night I decided to blog and used my real name as my blog address – and what do I write? A bunch of probably very unrealistic and much-maligned questions. If anyone has read it so far (before i deleted it) – I feel sorry for you and apologize for wasting your time.

Moving on – I used google to search for ‘nilanjan mishra’ and the first link is this blog. Surprising, because personally I do not feel like it should be so. No, but I will not question it. Who doesn’t like an audience? So if someone is going to read my blogs – I will lay down a few rules:
1. I do not believe in punctuation.
2. This is my blog and the opinions are strictly my own.
3. Based on 2. above I will be writing about whatever the hell I feel like.
4. Based on 2. and 3. above I would really appreciate if someone left their comments/opinions out here. You can also issue ‘fatwas’ against me.
5. I will read your opinions and most assuredly will try my best to answer you.

Reflect on the title for a bit. This is what my posts are going to be about. I do not claim to be a philosopher or writer with uncanny skills over words or mastery of the english language. But I do tend to think a lot about nothing in general and that is what I am going to jot down here.