Monthly Archives: February 2009

“Interpreting Extreme Events in Financial Markets”

John Hibbert of Barrie & Hibbert gave a talk on interpreting extreme events in the financial sector. Once more, a topic rather pertinent for these turbulent times.

His area of expertise is building models to stress-test the effect of external events on life insurers’ asset portfolios – although what he said probably works just as well for banks. Essentially, this is meant to help organisations’ managers effectively manage risk within their portfolio. The models are used to answer two different questions –

  • what is the fair value of an asset (which is a risk-neutral approach for pricing policies)
  • projecting what capital is required to maintain the asset (which is risk-based, using historical risk premia and observed probabilities of real events)

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Surviving the Downturn

I went to a talk a couple of weeks ago by Mike Clauser about surviving the downturn. Essentially he was discussing different strategies for small businesses and entrepreneurs to survive and – better – profit from the recession.

If you run a business which doesn’t need debt to survive – either because it is a low capital business or because it has lots of free cashflow – a recession can be pretty profitable, especially one in which deflation takes hold: your inputs become cheaper (commercial rent, advisers, commodities…), staff become cheaper and more available, and staff turnover (a big cost for businesses) can be greatly reduced.
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All A Twitter

For months, people I know have been talking about Twitter; indeed, once can’t move around the internet without seeing people’s tweets, the one-line updates that have captivated the internet.

The term microblogging has been used to explain Twitter, and I’ll admit I didn’t get it.

A lot of the people talking about it said that you won’t get it until you try it – sounding like the dark pushers of the internet (and twitter certainly does sound addictive). This I found very unsatisfying – the inability to explain how it would enrich my life, already busy with online-chatter and a variety of social networking opportunities.

Yesterday I was at Tuttle Club – a real-life social networking informal group, whose interests include online networking, and of course lots of people were talking about Twitter. Many of them provided some very sound reaons for trying Twitter out – extending one’s network of contacts, providing quick access to a wide-range of knowledge and resources, and – potentially important for a freelance – a way of making new business connections, too.

So I finally decided to set up a Twitter account. You can find me here, should you want to. And if I find it works for me, I’ll come back and let you all know!

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.)

“Why Japan Can’t Reform”

Susan Carpenter called “Why Japan Can’t Reform” – same title as her new book. She has worked extensively in Japan, and seemed well placed to desribe the situation there.

I was curious – I know little about Japan, but given the sclerotic nature of the Japanese economy over the past couple of decades and the potential for Japan to be seen as a model for the global economy in recession, I thought it sounded interesting.
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“Hedge Funds: future trends and challenges.”

I went to a crowded talk about hedge funds and their future role in the financial system. There were four speakers, industry insiders – this meeting was conducted under the Chatham House rule – although I didn’t feel anything said was particularly sensitive. I was there out of curiosity and a desire to understand more about hedge funds and what they actually do.

One of the problems the speakers identified was one of definition: just about any fund can label itself as a hedge fund. Wikipedia defines a hedge fund as “a private investment fund open to a limited range of investors that is permitted by regulators to undertake a wider range of activities than other investment funds and also pays a performance fee to its investment manager”. Hedge funds use a variety of alternative investing strategies, including borrowing money to invest, to increase returns for investors, and charge on that basis. The strategies using a variety of investment tools, including short selling (selling assets they don’t own in the expectation the price will fall and they can then buy the assets back more cheaply – pocketing the difference in price), as well as a wide range of markets. Continue reading