Another Fine Mess

I was thinking a bit more about the current economic crisis – let’s face it, it is all over the news, even if I didn’t want to, I’d be thinking about it – and what people were saying about hedge funds a couple of weeks ago.

One of the things that was discussed but I hadn’t mentioned was Long Term Capital Management. LTCM was a large hedge fund in the mid-1990s. It featured two Nobel prize winners amongst its founders – Myron Scholes and Robert Merton, who devised methods of valuing options and financial derivatives – as well as some of the biggest names on Wall Street. They had super-whizzy mathematical models to manage their investments, and they made spectacularly large amounts of money.

These were the financial superstars of the 1990s. They were the heroes of the time; and they had excessive hubris: they thought they couldn’t go wrong. They invented the ways hedge funds work.

They also invented the way hedge funds go bust – involving similarly spectacular large amounts of money.

Their basic strategy involved fixed interest arbitrage – which I think means they traded in government bonds of the major economies, using their models to spot small but profitable differences in different markets: they needed leverage to amplify those small returns. As more people invested, increasing the fund’s capital, they took on more and more risk to maintain their profits – they were leveraged about 25 times, with liabilities of $125bn and equity of $5bn.

In May and June 1998, LTCM made losses as a result of market turmoil stemming from the Asian financial crisis which reduced their capital; in August and September, the Russian financial crisis hit, and LTCM had to sell assets into falling markets. Clients wanted to free their capital, and LTCM faced a liquidity crisis – a run on the bank, if you will.

They went bust, and had to be rescued by a bailout organised by the Federal Reserve Bank of New York of $3.6bn spread across fourteen US and European banks.

Fundamentally, LTCM’s models, and the positions they took as a result of them, should have made the fund a lot of money, but the Asian and Russian crises created adverse trading conditions, and capital fled to safety, leaving LTCM high and dry. As Keynes said, “The market can stay irrational longer than you can stay solvent”.

What is interesting is the similarities between LTCM and hedge funds today – and, more pertinently, the broader financial crisis we find ourselves in:

• high leverage

• large off balance sheet positions
• resulting lack of transparency
• external stimuli (bursting bubbles)
• capital flight
• thereby increasing liquidity
• asset sales into falling markets

with the fund – or bank – going bust as a result.

The thing is, despite all the rocket-science mathematical models and financial engineering, this isn’t rocket science. This is what has happened time and time again. John McFall MPwas on 5Live this morning explaining why the Treasury Committee was competent to grill UK banking chiefs about their role in the crisis: and he replied with a list of previous crises his committee has reported on.

So why were shareholders, markets, governments and regulators so taken aback when the same thing has happened, yet again? Why have they not learned from past financial crises – their own past experience?

(The story of LTCM is told in When Genius Failed: The Rise and Fall of Long-Term Capital Management, by Roger Lowenstein.)

Wikinomics

Wikinomics has the subtitle “how mass collaboration changes everything”. I’m not sure that it proved its point, but it made interesting reading.

(In true Web2.0 fashion, the authors have a Wikinomics blog, too; I’m just writing about their book now.)

It is all about collaboration and openness, and how the authors believe that these two principles will changes the way organisations and people will work. They provide lots of interesting stories and examples of how organisations have embraced openness and collaboration in many forms, how users forced collaboration on organisations (and how it would have been better if those organisations had been open in the first place), and how the world is changing forever, however hard some organisations struggle against it.

It is a fascinating, compelling vision.

But I am not sure I really buy it. It all sounds a bit like the arguments given by those prophets of the dotcom boom in the late 1990s – the internet was changing the way the economy works, the future of organisations is being changed forever, yadayada. I don’t doubt the power of user-created content, collaborative working and open-source developments leading to new, exciting business models which change the way people chose to live and work.

But I am doubtful that these models will really wreak the havoc described, or will prove as solid as they may need to be to survive.

The authors are also consultants, and the book suffered from consultants’ myopia: they picked examples which supported their arguments. I couldn’t help thinking of the examples that have failed; and the Economist attributes the open, collaborative supply chain as a cause of worker unrest and a strike – an example praised in Wikinomics.

“Six Degrees”

This is a post I wrote elsewhere in February 2008.

I recently read a book called Six Degrees: The New Science of Networks, by Duncan Watts. Whilst he might be describing his educational successes, the book is actually about networks: the name comes from the idea that everyone can be linked to anyone else in the world in just six steps – “six degrees of freedom”. (Watts actually demonstrates how this theory is actually very poor indeed – the idea stems from an experiment by controversial psychologist Stanley Milgram, and a very poor experiment it appears to have been.)

I found it a fascinating book, particularly since we are now all part of an online, connected world. It was full of lots of interesting stuff – true, not a great deal of it seems to have stuck in my brain, but it was interesting whilst I was reading it…

“The Corporation”

This is a post I wrote elsewhere, in June 2007. I am trying to work out whether the turmoil in the economic and financial markets over the last year make me want to revise my views…

“The Corporation” was a film which was turned into a book, by Joel Bakan; or maybe it was the other way around. A film described as “the thinking man’s Fahrenheit 9/11”. I’ve not seen the film; but I have read the book.

It describes how large companies – the multinationals, the global firms that are so economically active and powerful – are by their nature dysfunctional, set up to solely to meet the short term needs of shareholders by means fair and foul – the book focuses on the foul – and how, based on medical definitions, if they were people they would be defined as sociopathic.