Tag Archives: long term capital management

Janet Yellin for FED chair

Personally, I think that if you have proven that you have fumbled the ball in critical situations, you probably shouldn’t get the ball in critical situations. This concept works in football and it should work in government. Larry Summers was a big cheerleader for deregulation. He squashed the regulation of derivatives, which would’ve prevented the meltdown of Long-Term Capital Management in the ’90s and would’ve prevented the great recession. All we needed to do was regulate derivatives. (Let us not forget that this month marks the 10th anniversary of the meltdown of Lehman Brothers.)

Economist Joseph Stiglitz has more:

The controversy over the choice of the next head of the Federal Reserve has become unusually heated. The country is fortunate to have an enormously qualified candidate: the Fed’s current vice chairwoman, Janet L. Yellen. There is concern that the president might turn to another candidate, Lawrence H. Summers. Since I have worked closely with both of these individuals for more than three decades, both inside and outside of government, I have perhaps a distinct perspective.

But why, one might ask, is this a matter for a column usually devoted to understanding the growing divide between rich and poor in the United States and around the world? The reason is simple: What the Fed does has as much to do with the growth of inequality as virtually anything else. The good news is that both of the leading candidates talk as if they care about inequality. The bad news is that the policies that have been pushed by one of the candidates, Mr. Summers, have much to do with the woes faced by the middle and the bottom.

The Fed has responsibilities both in regulation and macroeconomic management. Regulatory failures were at the core of America’s crisis. As a Treasury Department official during the Clinton administration, Mr. Summers supported banking deregulation, including the repeal of the Glass-Steagall Act, which was pivotal in America’s financial crisis. His great “achievement” as secretary of the Treasury, from 1999 to 2001, was passage of the law that ensured that derivatives would not be regulated — a decision that helped blow up the financial markets. (Warren E. Buffett was right to call these derivatives “financial weapons of mass financial destruction.” Some of those who were responsible for these key policy mistakes have admitted the fundamental “flaws” in their analyses. Mr. Summers, to my knowledge, has not.) (more…)

Labor Arbitrage

Several months ago I talked about the rapid rise and fall of a small hedge fund called Long-Term Capital Management (here, here and here). This fund did nothing but arbitrage trading. Arbitrage trading was just a small part of my financial education right after the fall of the stock market in 2007/2008. I learned about derivatives, mortgage-backed derivatives, credit default swaps, collateralized debt obligations and arbitrage trading. I never knew these types of vehicles existed. The simplest definition of arbitrage trading is taking advantage of price difference in different markets. As an example, suppose in New York one American dollar can be exchanged for 10 pesos (Mexican). In London, one American dollar can be exchanged for eight pesos. Therefore, the dollar would be stronger in New York, or worth more than it would be worth in London. So, if you had a large sum of money and a computer you could take advantage of this relatively small difference in price. Selling in one market and buying in the other. Sweet, ain’t it?

Labor arbitrage is no different. With the advances in shipping that occurred during the 1970s and 1980s, it became relatively cheap to move merchandise across oceans. Shipping containers can easily be loaded onto trucks or trains directly from the shipyard. The backbreaking labor of moving every single box on and off a ship is suddenly gone. This time-consuming task has disappeared. Plus, building factories in Mexico, China and Indonesia is probably far less expensive an endeavor.

For decades, the United States boasted the most well-educated labor force in the world. We had the most skilled workers. Computer technology has made many of these skills obsolete. Now, for some manufacturing jobs, you just need a couple of guys/gals sitting in front of a computer pushing buttons. These computers have replaced hundreds of workers. Therefore, this makes moving a factory overseas even easier. You don’t have to worry about training hundreds of thousands of of workers who don’t have the experience or the education. Instead, you need to train just a couple of people to push computer buttons.

Since the 1980s, free trade has been all the rage. Breaking down barriers. Decreasing or eliminating tariffs. The government has been more than happy to oblige. The government has created a regulatory atmosphere, in which shipping jobs overseas is not only made easy but you are actually penalized, with decreased profits, if you don’t do this. Off-shoring has now become a manufacturer’s paradise. Overseas, you have no labor laws, you have no EPA, no environmental regulations, no OSHA regulations It becomes a no-brainer. You can pay some dude in China a dollar a day versus paying an American factory worker $20-$45/hour. This is labor arbitrage.

Your thoughts? How do we fix this?

Long-Term Capital Management – The Carnage

This is the last in my series (here, here, here) on Long-Term Capital Management. For those who haven’t been following, long-term capital management is a hedge fund that was started by John Meriwether. John Meriwether was one of the founders of arbitrage trading. He started this over at Salomon Brothers. Meriwether gathered an All-Star team and opened the fund in 1994. The first three years can only be described as an amazing success. Almost everything they touched turned to gold. There were using the sophisticated computer models which wowed Wall Street. (Much of the following information comes from the book When Genius Failed – The Rise and Fall of Long-Term Capital Management.)

If one person is making money on Wall Street, you can bet that everyone, is looking to see how that person is making money. Everyone will try to duplicate what ever it is you’re doing. All of the major brokerage houses open up their own arbitrage unit. By the end of 1997 investment opportunities were closing. LTCM returned $2.7 billion to its investors. (LTCM increase their leverage in the markets and did not reduce their exposure.) The exact reason for the return is unclear. It is clear that LTCM was making money hand over fist. It is also clear that LTCM was a huge player in many markets, if you’re too big, you are the market. None of the complex formulas that LTCM used assumed that they would become the market and therefore change market conditions.

The above graph, reveals the life and times of LTCM. It’s crash was spectacular. The exact reason for the clash, or like all crashes, multifactorial. The “geniuses” at LTCM did not really manage their risk. Instead, they may multiple variations of the same that throughout the world. Secondly, they leveraged their leverage. It is pretty amazing that you can raise $1 billion just by showing up and shaking some hands. Then, you buy securities with ease funds and leverage the securities. Through derivatives and other financial means you leverage your securities, again. In 1998, LTCM had approximate $4 billion under management but had leverage this $4 billion to over $1 trillion in transactions.

A large consortium of banks was called together at the New York Fed. Long-term capital management was going under. They were in deep trouble. They lost a spectacular amount of money in a short period of time. There was a fear, because LTCM was entwined with so many different financial institutions that they could destabilize the whole system. I hope this sounds familiar. It should. Mortgage-backed securities blew up and we were told that they would destabilize the whole system and therefore we had to “rescue” Wall Street. So, 10 years earlier, in 1999, more than a dozen of the nation’s largest financial institutions were brought together in order to rescue LTCM. In the end, billions were lost.

Yes, Wall Street was saved and LTCM was lost but, the bottom line is – what was learned? LTCM was a black box. They held their information incredibly close to the vest. We need greater disclosure. LTCM, like most hedge funds, would send out a quarterly report but it would say nothing. It would not mention any the specific trades or even how they were trading. We need more disclosure. There has to be some limits on leverage. 100 to one seems to be somewhat excessive. There has to be some risk management. The risk management has to be more than just a formula that is hidden in some closet somewhere. There was no one at LTCM that was responsible for risk. None of the companies that lent LTCM money actually poured through its books to figure out risk exposure. (One of the cries from conservatives would be that these are private companies doing whatever they want with private money, what’s the big deal? Whenever a deal/company can get so big that it can bring down all of Wall Street, it needs to be regulated.) The bottom line, as I see it, was that there was no supervision. There is no outside government regulators. There’s nobody within the company that supervised training and risk. None of the companies that handed over truckloads of money actually did any supervising. So, 10 years later, when the housing market began to melt down, we see some of the same problems. Lax regulations. Little or no supervision. Risky derivatives. Unfortunately, I still think that we learned our lesson.

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