Never Invest in Something You Don’t Understand

Consider this: Lehman Brothers at its peak was worth $47 billion. One year later, it filed for bankruptcy and its stock market value was slashed to $138 million. At the top of its game, Bear Stearns was valued at $200 billion. When the dust finally settled, J.P. Morgan’s initial $2 per share bid valued the company at only $236 million. Similarly, AIG’s stock market value dropped from $188 billion to approximately $10 billion in one year.

With these three firms alone, over $400 billion of shareholder value was wiped out faster than you can say “meltdown.” That does not include the loss of value that was experienced at Merrill Lynch, Wachovia, Washington Mutual, Fannie Mae, Freddie Mac, Goldman Sachs, Morgan Stanley and countless other banks and Wall Street firms as the credit crisis unfolded. The stunning loss of value over these past several weeks totals well into the trillions of dollars. No wonder Wall Street’s reaction to the $700 billion bailout package has been lukewarm. No one believes it’s enough to solve the problem.

How could this happen? How could such large amounts of money be made–and then lost—over such a short period of time? The answer is simple. Wall Street got well ahead of itself and became much too complicated for its own good. Believe it or not, even the heads of the large Wall Street firms did not understand their firms’ exposure to risk. After all, why would Dick Fuld, the head of Lehman Brothers who started as an intern at the company 42 years ago, knowingly put Lehman in a position where it could become worthless overnight? The answer is that he wouldn’t, unless he just didn’t understand the exposure that Lehman had taken on with the securities its bankers had created. Combined with large amounts of debt, the trading of these complicated securities generated huge profits—and bonuses– when the markets went the right way, but huge losses when they didn’t. In dealing with such complicated securities, Wall Street forgot one of the cardinal rules of investing: “Never invest in something you don’t understand.”
The precursor to the meltdown on Wall Street and a warning that was not heeded was the failure of Long Term Capital Management (LTCM) in 1998. If there was ever a hedge fund designed in heaven, it was LTCM. Based in Greenwich, Connecticut, LTCM’s founders included two Nobel Prize-winning economists, Myron Scholes and Robert C. Merton. Among other accomplishments, Scholes and Merton developed, along with the late Fischer Black, the Black-Scholes formula for option pricing. LTCM’s roster also included John Meriwether, a former vice chairman of Salomon Brothers and successful bond trader as its guiding light; David Mullins, a former vice chairman of the Board of Governors of the Federal Reserve System; Harvard University professors Eric Rosenfeld and William Lasker; and a group of smart arbitrage analysts from Salomon Brothers, a leading bond trading firm.

The idea behind LTCM was….. to look for arbitrage opportunities in markets using computers, massive databases and the insights of top-level theorists. These opportunities arose when markets deviated from normal patterns and was likely to re-adjust to the normal patterns. By creating hedged portfolios the risks could be reduced to low levels. According to the model developed by Merton, the risk could be reduced to zero, but in practice some of the crucial assumptions of Merton’s model did not hold so the risk of the hedged portfolios was not really zero, as subsequent events proved.

Myron Scholes stated the objective of LTCM in a striking image. He said LTCM would function like a giant vacuum cleaner sucking up nickels that everyone else had overlooked.

At first, LTCM’s models worked according to plan. Between 1994 and 1998, LTCM produced returns on investment of 40 percent or more per annum. But then, its enormously leveraged gamble with various forms of arbitrage involving more than $1 trillion dollars went bad. In August of 1998, Russia defaulted on its debt and the financial markets came unraveled. Historical trading patterns and relationships failed to hold, and LTCM which had bet on those regular patterns nearly went bankrupt, losing $1.9 billion in one month. Prompted by deep concerns about LTCM’s thousands of derivative contracts, the Federal Reserve Bank of New York got involved to avoid a panic by banks and investors worldwide, and organized a $3.65 billion loan fund from a group of banks and Wall Street firms. LTCM was eventually liquidated in 2000.

Although they seemed large at the time, the amounts of money involved with LTCM pale by comparison to those being bandied about today. But, the principles are the same. In the case of LTCM, a group of very smart people using sophisticated computer models believed they had developed a foolproof system for “vacuuming up nickels” that everyone else had left behind, as Myron Scholes explained. Confident in their assessment of the risks involved, they then leveraged their equity capital 30 times to create total buying power of $100 billion. When used to purchase derivatives and other financial contracts that were also inherently leveraged, $1 trillion was controlled by a mere sliver of equity. When Russia’s default caused the markets to behave in ways not predicted by LTCM’s models, the result was financial collapse.

Lured by the profits made by the LTCMs of the world, and also confident that they knew how to manage risk, Lehman Brothers, Bear Stearns and other investment banking firms became nothing but big hedge funds in recent years, overleveraged and bulging with complicated securities that no one understood. If two Nobel prize-winning economists and several Harvard professors can’t get it right, what chances do lesser mortals have?

China’s capital markets currently consist of two stock exchanges; loans by its commercial banks, most of which are state-owned; and a growing pool of venture capital and private-equity funds. Derivative securities and other exotic financial instruments are not yet part of the landscape, but eventually they will come into play. Despite their potential for harm when used improperly, derivatives and other synthetic securities can be important trading instruments that increase market efficiency. The inherent unpredictability of markets and the volatility of these securities, however, make them potentially dangerous when combined with excessive amounts of leverage.

In the aftermath of the 1929 stock market crash and the Great Depression, the Glass-Steagall Act of 1933 separated the commercial banking function from investment banking. The ability to take deposits was limited to commercial banks, and in order to protect depositors, the commercial banks became subject to regulation and strict oversight with respect to capital adequacy. As an additional measure to protect depositors, the Federal Deposit Insurance Corporation (FDIC) was created. Because investment banks were prohibited from taking deposits, they went unregulated.

When hedge funds came into vogue in the 1990s, they didn’t fit the description of a commercial bank and like investment banks, they too fell outside existing regulations. Quite simply, financial legislation in the United States dates back to the 1930s and has never been updated to deal with the new forms of financial institutions and capital market conditions as they exist today. Left to their own devices, the investment banks used their freedom from regulation to supercharge profitability by leveraging their capital bases 30 times or more, degrees of leverage that would be unthinkable for a commercial bank. At a minimum, the failure of the United States to regulate the new breed of financial firms is one of the root causes of the current credit crisis.

The lessons for China are obvious. As its capital markets develop, it must put in place regulations that do not impede their development, but which prevent financial players from taking on amounts of risk that can potentially destabilize the entire system. Each in their turn, LTCM, Bear Stearns, Freddie Mac, Fannie Mae and AIG became “too big to fail,” forcing the government to become involved in their bailouts. Very telling is the fact that both Goldman Sachs and Morgan Stanley have now become commercial bank holding companies, subjecting themselves to increased regulation and stricter capital ratios. In the aftermath of the current financial crisis, the United States capital markets will revert to simpler times. China’s traditional caution and “step by step” approach to development should serve it well in avoiding the pitfalls of excessive complication and leverage in its capital markets.