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January 25 - February 2, 2020
The riskier the bond, the wider the spread—that is, the greater the difference between the yield on it and the yield on (virtually risk free) Treasurys.
By law, funds can sign up no more than ninety-nine investors, people, or institutions each worth at least $1 million, or up to five hundred investors, assuming that each has a portfolio of at least $5 million. The implicit logic is that if a fund is open to only a small group of millionaires and institutions, agencies such as the SEC need not trouble to monitor it. Presumably, millionaires know what they are doing; if not, their losses are nobody’s business but their own.
The term “hedge fund” is a colloquialism derived from the expression “to hedge one’s bets,” meaning to limit the possibility of loss on a speculation by betting on the other side.
Fearing that his stocks would fall during general market slumps, Jones decided to neutralize the market factor by hedging—that is, by going both long and short.
By the 1990s there were perhaps 3,000 (no one knows the exact number), spread among many investing styles and asset types. Most were small; all told, they held perhaps $300 billion in capital, compared with $3.2 trillion in equity mutual funds.
J.M. and his partners would rake in 25 percent of the profits, in addition to a yearly 2 percent charge on assets.
Merrill moved the fund-raising forward by devising an ingenious system of “feeders” that enabled Long-Term to solicit funds from investors in every imaginable tax and legal domain. One feeder was for ordinary U.S. investors; another for tax-free pensions; another for Japanese
Long-Term’s fund-raising blitz had netted $1.25 billion—well short of J.M.’s goal but still the largest start-up ever.20
The real culprit in 1994 was leverage. If you aren’t in debt, you can’t go broke and can’t be made to sell, in which case “liquidity” is irrelevant. But a leveraged firm may be forced to sell, lest fast-accumulating losses put it out of business. Leverage always gives rise to this same brutal dynamic, and its dangers cannot be stressed too often.
On Wall Street, the older bond, which has about 29½ years left to mature, is known as off the run; the shiny new model is on the run.
normally, when you borrow a bond from, say, Merrill Lynch, you have to post a little bit of extra collateral—maybe a total of $1,010 on a $1,000 Treasury and more on a riskier bond. That $10 initial margin, equivalent to 1 percent of the bond’s value, is called a haircut.
Long-Term dubbed its safest bets convergence trades, because the instruments matured at a specific date, meaning that convergence appeared to be a sure thing. Others were known as relative value trades, in which convergence was expected but not guaranteed.
you know (for certain) the chances of getting a 7 and every other result. Investing confronts us with both risk and uncertainty. There is a risk that the price of a share of IBM will fall, and there is uncertainty about how likely it is to do so.
A senior executive at J. P. Morgan, when asked how he defined risk, breezily replied, “As volatility around the mean.”
Statisticians had long been aware of the “law of large numbers.” Roughly speaking, if you have enough samples of a random event, they will tend to distribute in the familiar bell curve, with the most occurrences around the average and a sharp drop-off at either extreme.
In 1987, so-called portfolio insurance was marketed (with absurd ballyhoo) to institutional investors as a technique of limiting losses via continuous selling when markets fall. These portfolio insurers helped to exacerbate a market crash that was later dubbed Black Monday.
Samuelson, the first financial economist to win a Nobel Prize, recognized that “continuous time” was merely an ideal state; in real time, traders took seconds, minutes, or even hours to analyze events and react. When events overwhelmed them, the markets gapped.
As Fama put it, “Life always has a fat tail.”12
Black Monday, when, on no apparent news, the market plunged 23 percent. Economists later figured that, on the basis of the market’s historic volatility, had the market been open every day since the creation of the Universe, the odds would still have been against its falling that much on any single day. In fact, had the life of the Universe been repeated one billion times, such a crash would still have been theoretically “unlikely.”
But markets have memories. Sometimes a trend will continue just because traders expect (or fear) that it will.
Not random
After three bad “flips” in the market, the fourth flip may no longer be completely random. Some traders may have taken losses and be forced to sell; other investors, looking over their shoulders, may panic and decide to beat them to it—
they predicted what one would lose on a normal day but not when the peso collapsed.
Risk models, VAR
it was leveraged 28 to 1. Of course, its return on total assets—both those that it owned and those that it had borrowed—was far, far less than the gaudy return cited above. This return on total capital was approximately 2.45 percent.23
partners would pay the bank about $15 million a year, give or take, depending on interest rates. In return, Chase would pay the partners whatever they would have earned on a $200 million slice of the fund.
Fixed / floating arrangement
Although pricing a bond can largely be reduced to math, valuing a stock is far more subjective.
Over the short run, stocks are subject to the whim of often emotional traders.
Contrary to common supposition, there is nothing wrong with being illiquid—unless you are vulnerable to being forced to sell in a hurry.
If, for instance, Long-Term wanted to earn the return on $100 million of CBS stock over a three-year period, it would strike a “swap” contract with, say, Swiss Bank. Long-Term would agree to make a fixed annual payment, calculated as an interest rate on $100 million. And Swiss Bank would agree to pay Long-Term whatever profit would have been earned had Long-Term actually purchased the stock. (If the stock fell, Long-Term would pay Swiss Bank.) Most likely, Swiss Bank would hedge its risk by buying actual shares.
a naked, unhedged bet that this rate would rise—a so-called directional trade in that it was betting on a single rate as distinct from a spread.
Weill and his top lieutenant, Jamie Dimon, were hostile to the star system pioneered by Hilibrand, under which traders at Salomon (now Salomon Smith Barney) took home a percentage of their profits. Since the traders were not penalized for losses, they had a perverse incentive to bet as much of the company’s money as they could.
Thus, this swap spread is a basic barometer of credit market anxiety; it is the premium that investors demand for taking the risk of being exposed to rate fluctuations in the future.
But could a “model” truly anticipate a country—not merely its markets but its politicians, its legislators, its passions, too?
unlikely to lose more than $35 million on any single day, had just dropped $553 million—15 percent of its capital—on that one Friday in August. It had started the year with $4.67 billion. Suddenly, it was down to $2.9 billion. Since the end of April, it had lost more than a third of its equity.
Despite the ballyhooed growth in derivatives, there was no liquidity in credit markets. There never is when everyone wants out at the same time. This is what the models had missed.
“We had no idea they would have trouble—these people were known for risk management. They had taught it; they designed it,”
Gensler had a related thought: During a crisis, the correlations always go to one.
Thus, even omitting derivatives, its leverage was greater than 100 to 1—a fantastic figure in the annals of investment. Now, if Long-Term lost even a mere 1 percent more, it would be wiped out.
Allison said that the fallout could be truly scary, even worse than after Russia. Long-Term had $100 billion of assets and $1 trillion in notional derivative exposure, he reminded the group.
Though it is seldom realized, a creditor is also beholden to his debtor.
A man driving a car at thirty miles an hour may blame the road if he skids on a patch of ice; a man driving at a hundred miles an hour may not.
