Jean & All: Somewhat off topic, but since you were wondering about "what the hell is happening out there in the global market land?" I thought you might find this article interesting. Scary, but interesting:
The Geniuses of Greenwich
This month we would like to comment on what the current global financial turmoil means to us, where we think we are in the investment cycle, and where we think we will end up in 1999. At the same time, we will describe some of the financial "shenanigans" some of our investment brethren rained down upon all of us, and what policymakers are doing to undo the mess.
Greenwich Geniuses replaced by the Magnificent Six
It's amazing and frightening that what started out as a small capital flight problem in Thailand during the summer of 1997 blossomed into a full-blown financial crisis around the world by August of 1998. The problem could have been contained within Asia if Japan had acted quickly to stimulate its economy and fix its banks, or if the IMF (International Monetary Fund) policy "wonks" had growth policies in their bag of tricks instead of austerity measures. But because these things did not happen, capital continued to flee from the more risky and emerging parts of the world into the large, liquid and perceived-to-be safe U.S. Treasury market. As this trend picked up steam in summer 1998, another specter emerged from a totally different direction. The specter we speak of (and the major exacerbating cause of the current financial problem) is the "derivatives" market. Claiming to be around 28 trillion dollars in size, derivatives are financial instruments ranging from simple "forward" contracts to instruments of almost unimaginable complexity. The philosophical reason derivatives are encouraged by academics and Wall Street types is that they allow the offloading of risk to many unrelated parties (the insurance principle) and they allow investors to pick and choose financial instruments that fit their particular time horizon, risk level and tax differences. So far, so good.
But from within the hallowed halls of Wall Street, a new beast emerged - the "risk arbitrageur." Risk arbitrage is a term that applies to buying one financial instrument (say a mortgage-backed security) and selling another "related" financial instrument (say a government security of equivalent maturity). This is exactly what the firm "headlined" in the news, Long -Term Capital Management (LTCM), did. John Meriwether (formerly the head of bond trading at Salomon Bros.) formed the company in Greenwich, Conn. in 1996, joined by two Nobel Prize winners in Economics, Merton Miller and Myron Scholes. LTCM "shorted" the U.S. government Treasury bond while buying higher-yielding corporate securities. Their theory was that the "yield spread" between these two instruments, which had been widening during these times of financial stress, would return to normal yield differences. If it did, they would make a great deal of money. Well it didn't, and it hasn't. As an example, normal yield spreads of 6 percent widened at the peak of the recent crisis to 17 percent, and have only recently come down to 12 percent. LTCC is still losing money. However, the problem with Long-Term Capital is not that it is losing money (it may lose only about $3-4 billion of shareholder money), but that to achieve its returns, company officials were able to borrow hundreds of billions of dollars from banks and brokerages to "place their bets." Small changes in interest-rate differentials could wipe out their collateral - and they did. Now the banks and brokers own the assets of Long-Term Capital and they will continue to place collateral into the company until they can "unwind" the bets at a profit. This may take a year or more. Fourteen institutions ponied up capital to save Long -Term Capital Corp. and now own 90 percent of the company.
The new Magnificent Six.
Six "magnificent" individuals were chosen to oversee the daily operations. They are: the best "block trader" from Goldman Sachs, the co-head of global debt markets at Merrill Lynch, the head of fixed income's risk management unit at Morgan Stanley, the head of risk control at UBS, Morgan Guaranty's head of global fixed income (including derivatives), and the head of global fixed derivatives at Traveler's/Smith Barney. As many of you probably noticed, the Federal Reserve got involved in this case. Its interest was in making sure that Long-Term Capital did not "unwind" its vast assets at distress prices. The very size of the company was the problem. Quick margin-call sales would roil the capital markets above and beyond anything fundamentally related to the general capital markets. To further complicate matters and put the problem into a different perspective, the American Stock Exchange Broker/Dealer Index fell 45 percent from July 17 to Oct. 2, 1998. On Oct. 3, the same index rose 4 percent as investors anticipated the Group of Seven meeting in Washington, D.C. (Seven major industrial nations). The S&P 500 Index for the above dates fell 16.9 percent and then rose 2 percent on Friday, Oct. 3. The reason for the sizable decline in the AMEX Broker/Dealer Index is that Wall Street's proprietary trading desks do much of the same thing as LTCM! As of Sept. 2, Wall Street firms were "short" $60 billion of U.S. Treasuries and "long" $63 billion of other similar, but higher-yielding, securities. The Federal Reserve has its work cut out for it in restoring "normalcy" back to the markets.
Our investment position
As you can see from the foregoing discussion, we live in interesting times. We did not and could not have predicted the emergence and effect of Long-Term Capital Management on the U.S. and European scene.
However, every major financial crisis of the last 40 years has produced an improvement in understanding by financial authorities and a new set of policies and regulations. We expect nothing less in this situation. All the major financial policymakers are meeting in early October. We expect a lot of new discussions and changes in how capital around the world is managed. For example, we expect to see some kind of capital "controls" for emerging countries. We expect to see more pro-growth policies from the IMF's lending. We expect to see more regulation by banks of "hedge" funds. Etc..
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I think you get the drift. The part that scares the hell out of me is the "we could not predict the emergence, or the effect....." Why do I hear echo's of 1929 in that statement? Also, echo'ing an above statement, there's an old Asian curse that goes something like this...."May you live in interesting times...." And these most certainly are that, eh? Bottom Line? FUD(Fear, Uncertainty and Doubt) are ruling the roost....and may for some time to come.
Regards!
John |
