All posts by Dr. Douglas Rice

The derivatives market and LTCM

For those not familiar with the situation, Long Term Capital Management (LTCM) was a hedge fund run by John Meriwether, a legendary trader who, after a spectacular career, had left Salomon Brothers following a scandal over the purchase of US Treasury bonds. This had not tarnished his reputation or dented his confidence. Asked whether he believed in efficient markets, he replied: “I MAKE them efficient”. Moreover, the fund’s principal shareholders included two eminent experts in the “science” of risk, Myron Scholes and Robert Merton, who had been awarded the Nobel prize for economics in 1997 for their work on derivatives, and a dazzling array of professors of finance, young doctors of mathematics and physics and other “rocket scientists” capable of inventing extremely complex, daring and profitable financial schemes. The fund had investors that were the crème de la crème of society. (A hedge fund is a private investment partnership that is NOT subject to strict governmental oversight)

The fund’s operations were conducted in absolute secrecy. Investors who asked questions were told to take their money somewhere else. Nevertheless, despite the minimum initial payment of $10 million frozen for three years, there was a rush to invest and the results appeared to be well up to expectations. After taking 2% for “administrative expenses” and 25% of the profits, the fund was able to offer its shareholders returns of 42.8% in 1995, 40.8% in 1996, and “only” 17.1% in 1997 (the year of the Asian crisis).

But because of the reputation of the managers, big banks continued to lend massive amounts of money to the fund in terms of margin. The banks’ staggering lack of curiosity about the fund’s activities is particularly disturbing in view of the astronomical sums involved. At the beginning of the year, LTCM had capital of $4.8 billion, a portfolio of $200 billion (borrowing capacity in terms of leverage) and derivatives with a notional value of $1,250 billion. But in September, after mistakenly gambling on a convergence in interest rates, it found itself on the verge of bankruptcy.

William J. McDonough, president of the Federal Reserve Bank of New York, (who just announced retirement) called on the cream of the international financial establishment to refloat the fund which was virtually bankrupt. And, in only a few hours, 15 or so American and European institutions (including three French banks) came up with $3.5 billion in return for a 90% share in the fund and a promise that a supervisory board would be established

The CATO institute argues that the intervention also is having more serious long-term consequences: it encourages more calls for the regulation of hedge-fund activity, which may drive such activity further offshore; it implies a major open-ended extension of Federal Reserve responsibilities, without any congressional authorization; it implies a return to the discredited doctrine that the Fed should prevent the failure of large financial firms, which encourages irresponsible risk taking; and it undermines the moral authority of Fed policymakers in their efforts to encourage their counterparts in other countries to persevere with the difficult process of economic liberalization.

Shouldn’t we be able to believe in someone?

In Senate hearings testimony was given by David Tice of David Tice and Associates. He testified that, “an analyst is just a banker who writes reports. No one makes a pretense that it’s independent.” He quotes Sean Ryan, a former banking analyst at Bear Stearns Co. when he explained his reasons for recommending NetBank like this: “I put a buy on it because they paid for it.” Ryan said he told clients that “we just launched coverage on NetBank because they bought it fair and square with two offerings.”

Further, Greg Hymowitz of Entrust Capital, a financial house for wealth investors and a former Goldman Sachs employee. He testified in defending current practice, “Investing is as humbling as golf. Every day is riddled with mistakes. Unfortunately, often the only way to learn in this business is from mistakes and that costs money. Investors have learned a hard lesson: with huge rewards come equally huge risks. The bubble has burst. Investors should not believe everything they read, hear or see.”

Shouldn’t we be able to believe someone? And who would that someone be?

Interesting point on commissions

Investment banking business if far more profitable than managing accounts for investors. Accounting firms make more from consulting than from auditing. Advisors make more from moving money from here to there than just holding it. No one is making more money for getting it right and often they make far more for getting it wrong.

Agency theory says that there is a cost to a principal for having an agent work for them because the goals of the principal and the agent are not totally aligned. In other words, the agent acts in their own best interest and that isn’t 100% in the best interest of the principal.

Is there anyway to align the goals of investors and those agents that they use during the investing process?