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Promises

Financial markets may be complex, but possibly they are less so than made to appear. They certainly have their share of obfuscating jargon that serve to exclude commoners from the lucrative inner sanctum and raise the status of the profession.

One example is the misconception that a stock market creates wealth. Such an idea is often expressed by exasperated investors after a crash or correction and it is said that the NYSE “lost $1 billion in value” overnight. But at any other than a purely mathematical level, such statements are quite obviously false. Put aside for a moment the irrelevant notion that a share of stock somehow equates to ownership in the physical assets of the company, because no share (unless you happen to own 50% of them) entitles anyone to take home any nut or brick of the company. For all practical intent, a share is simply a mechanism for trading. And a trade, in itself, does not create anything.

Suppose that I bought a share for $1 last year that I sell today for $10. Did the stock market thereby increase in value? Not at all. The $9 that I earned by these two trades result from a simple exchange, the $10 that my second trading partner lost, and the $1 that my first trading partner earned. A share really is just a promise, made by the whole world to me, to pay me some amount of money if I sell that promise to them. Of course, the promise may be withdrawn tomorrow, which is how fortunes are lost (and gained simultaneously).

Another way to look at this is to imagine the total amount of cash (all the world's dollar bills and coins) in circulation at any given moment. Suppose that overnight, the Dow Jones index shoots up from ten thousand to twenty thousand: there is still precisely the same amount of money in circulation, and no matter how much we all trade cash and shares the next day, we all of us put together can still buy precisely the same quantity of bread, salt, and vodka.

All this is not to say that the markets do not serve any purpose at all. First of all, the market is a way for companies to obtain money to fund their growth. Also, the psychological games that it entices investors to play with other investors also induce corporate leaders (those with truly much to gain or lose by them) to play along. Sometimes this may actually create the desired effect of improving corporate direction in the hope that this, in the medium or long term, will be reflected in a better appreciated stock price. Othertimes it might simply effect pressure to ‘cook the books’ and get the same price boost much faster.

When Genius Failed—
The Rise and Fall of
Long-Term Capital Management
Roger Lowenstein
264pp, Random House

Risk

This is a gripping look at the personalities and mechanics of Long-Term Capital Management, a small bond trading firm that managed to create what might have become a world-wide meltdown of the financial markets.

LTCM was founded on a theory in Economics that won Robert Merton and Myron Scholes a Nobel Prize. The theory itself is fascinating, and it is strangely unfathomable how its application equated to the ability to quantitatively ‘trade risk’. Lowenstein has a fine knack of translating the numbers and financial machinery into real-world concepts so that the financial markets actually begin to make sense.

Although he appears to conclude that flaws in the scientific theory were the ultimate cause of its collapse, it is my opinion that this is not strictly speaking true. It is well-known in science (and more so in the empirical ones) that every theory has its domain of applicability outside of which it cannot be simply assumed to be equally accurate.

What I believe caused LTCM to collapse was the failure by those who applied the theory to test carefully to what extent it could be stretched before a more sophisticated refined version was needed to complement it. The sheer greed inspired by the theory's early success caused LTCM's managers to wilfully ignore warnings from underlings and throw all caution to the wind, as they expanded into ever and ever riskier trades.

The unheard-of use of borrowing exacerbated what might otherwise have been a manageable business failure. LTCM was able to obtain astronomical amounts of money by leveraging off the greed of its lenders. Lowenstein also hints that the moral hazard of the Fed acting as an ‘insurer of last resort’ allows traders to take wild risks with our economy.

All in all, a very interesting, exciting, and readable account of hubris.