‘When Genius Failed’ – Part II Friday, Jun 30 2006

The Fall

Finally, they also undertook a directional trade (purely speculative), betting on the Russian currency not getting devalued despite the trouble Russia was having in servicing its external debt. After four years of majestic performance, the chain reaction started by the Russian government finally defaulting on its external debt and the Russian currency getting devalued earned the fund its first loss. Shock waves of this event were felt in all markets and asset classes that the fund had invested in, and the finely tuned risk measures went haywire as all their trades seemed to be perfectly correlated. Losses started spiralling for the fund in each and every trade it held. The traders were increasingly dazed and stupefied by their strategies backfiring so badly. The high leverage to start with, combined with the diminishing equity of the fund on account of the losses, led to the leverage climbing, at its worst, to 100:1. The fund was close to bankruptcy in the span of five weeks. News of LTCM’s difficulties trickled out and traders, being a heartless tribe, started taking opposite positions in LTCM’s trades, hammering the fund further.

Thus, so suddenly, the time had come to save the fund from bankruptcy. Even though its equity was hammered, the assets measured upto $130 billion or so, and the size of the derivatives book was many times larger. It is incredible how, with so much pressure on him, Meriwether remained outwardly calm and set about the task of raising equity for the fund in earnest. The top investment banks’ exposures to the fund were enormous, although not on the same scale. Saving the fund in some way was imperative. However, Wall Street is a ruthlessly competitive place, and any proposal that involved many investment banks coming together to launch a joint rescue effort would be extremely difficult to devise. Goldman Sachs, in particular, played hardball and milked LTCM by invading their offices and downloading their trades in the name of auditing their books. LTCM, the highly secretive outfit, was out in the open now.

In the climax, the US Federal Reserve had to reluctantly intervene and play a facilitating part in bringing the bankers together and asking them to thrash out a rescue plan. While Herb Allison of Merrill Lynch was the chief architect of the plan, his job was made vastly more difficult by the recalcitrant attitude of the 25 top investment bankers invited. The description of these last few days’ activities sets your pulse racing. A joint rescue plan did materialize, and the powers of LTCM’s freewheeling, arrogant traders were cut drastically. Infusion of new equity, however, did not stop the fund from making losses, even as the erstwhile partners were under pressure to pair the earlier trades, an extremely difficult job with 60,000 trades!

It was inevitable that the traders, bound hand and foot, and not used to such an experience, quickly upped and left. But what was a bit more surprising was Meriwether, Hilibrand and Rosenfeld actually started a new hedge fund! So much for this harrowing experience. As for the Nobel laureates, Scholes was employed as a risk consultant to a Wall Street firm and Merton went back to academics.

Conclusion

The book has two clear tracks, the one enjoyable and the other informative and instructive. One track is the pacy narrative, and the thrilling climax. The other track gives valuable insights into money management and trading, including operational details of repo financing, road shows, fund management vis-a-vis investors, aggregated risk measurement across all the fund’s trades, negotiations in a complex rescue plan, etc. Perhaps, the addition of a technical appendix outlining some basic strategies of the fund with complete hypothetical examples, from spotting an opportunity to devising the trade to financing it to executing it and monitoring risk, would make the book more complete and more valuable, especially to the student of finance.

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‘When Genius Failed’ – Part I Friday, Jun 30 2006

Background

While I was at IIM Lucknow, especially during the second year, I always wanted to read this book, but could never lay my hands on it since it was much in demand. By a stroke of luck, I did manage to get the book now and enjoyed reading it immensely. The book, by Roger Lowenstein (Random House Trade Paperbacks, 2001) is about the meteoric rise and precipitous fall of an American hedge fund called Long-Term Capital Management during the 1990’s.

The book is both greatly interesting, being written like a thriller and gaining more and more pace toward the end, and very instructive for those who have some background in finance and economics. Lowenstein manages to capture the magnitude of the events surrounding this hedge fund perfectly.

The Rise

Long-Term Capital Management (LTCM) was a hedge fund management company (the hedge fund itself was called LTCP or Long-Term Capital Portfolio) started by the famous bond trader John Meriwether, ex-employee of Salomon Brothers. Along with some of his best friends and Salomon colleagues Larry Hilibrand, Eric Rosenfeld and Victor Haghani (among others), he pulled off a coup when he roped in Myron Scholes and Robert Merton, two greats of modern finance, known best for the Black-Scholes-Merton differential equation and the Black-Scholes formula for pricing options (Fischer Black had already passed away when the fund began in 1994). During their stint at LTCM, Scholes and Merton were to reach the pinnacle of their profession, receiving the Nobel Prize for Economics. Gathering together a stupendous team of people, Meriwether, in his reticent but firm and confident style, began the fund, which would have no more than one hundred investors at any time during its life.

The primary strategy that the fund set for itself was that of arbitrage, continuing the work that Meriwether’s Arbitrage Unit at Salomon Brothers used to do, but in a more scientific way (thus Meriwether hoped). The mispricing of any asset in an asset class with respect to another asset in the same asset class (say, two bonds of different maturity, two stocks, etc.) was presumably detected using models developed by the core team led by the finance professors. While undertaking any trade, care was also taken to calculate the fund’s overall risk exposure using financial models so as not to have trades which have high positive correlations with existing trades. Thus, arbitrage in various asset classes accompanied by continuous risk measurement and monitoring was the strategy on which the fund was built. A third element completed the strategy, and that was leverage, or using borrowed money to trade, which would increase the magnitude of any profits as well as any losses.

Meriwether and his colleagues, particularly Hilibrand and Haghani, milked their basic competitive advantage – their A-team of financial gurus to the limit. Using the sheer clout that came from having people who had taught many of the Wall Street traders and top bosses their finance, they created an aura of invincibility right at the inception of the fund. Everyone believed the fund would be like the Titanic – unsinkable. Thus, all the big names in investment banking on Wall Street were falling over themselves to provide financing to and work with this hedge fund. Merrill Lynch did the job of running the initial road show that launched the fund. The fund was flush with capital after the exercise. On most trades thereafter, traders leveraged highly, particularly Hilibrand and Haghani again. Moreover, they just refused to have a haircut on the collateral they put up for the financing. The investment banks, eager to increase their hedge fund business, couldn’t get a better client than this, and agreed to their terms. Numerous other such terms were made to be accepted by banks, including a warrant to protect LTCM, the management company, and hence the capital of the partners themselves.

For four years, the traders undertook various arbitrage trades as suggested by their models. For the most part of this time, the trades were in bonds, mortgage-backed securities, interest rate swaps and the like, across US and European countries, as well as some Asian markets. The fund met with stupendous success, as measured by annual returns, for these four years. Awe felt by the investment banking industry led to imitation and many banks set up arbitrage trading desks with strategies similar to those of LTCM, although the exact trades of the latter were kept extremely secret. This increased competition for LTCM traders, and they found it increasingly difficult to act upon the mispricing they found, because the arbitrage opportunity would vanish before they could act. THis led Hilibrand and Haghani, the most aggressive traders, to look to riskier trades in different asset classes. For example, they took major bets on stocks – merger arbitrage (betting on the gap between a target’s stock price and the offer price by the acquirer closing), the difference between prices of two classes of a stock closing, and so on. Everywhere, their outlook was based on a belief that markets can only become more efficient in the future than they were at present, leading to the arbitrage opportunity.
(continued…)

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Concentration in men’s tennis Thursday, Jun 15 2006

Through the ’80s and ’90s, I always preferred watching men’s tennis to womens’. Men’s tennis had much more depth, top men players couldn’t just breeze through opening rounds of a major tournament beating their rivals without losing more than two or three games, at most. There were great rivalries among the top men as well. Even the Sampras hegemony over Wimbledon in the ’90s didn’t mean drab, one-way matches. Those wins did not all come easy, and Sampras did not seem totally invulnerable at all times, a quality which added some magic to his wins.

How times have changed! The women’s game has been quite robust for a few years now. First the Williams sisters and Hingis, then the Belgians, then the Russian horde, have together made women’s tennis way less concentrated and much more competitive.

On the other hand, if there was an antitrust authority governing tennis, it would have ordered the breaking up of Roger Federer’s game into its component parts – the return of serve going to one baby Fed, the volleys going to another, the backhand slice to another, and so on . I had great hope of a counter-balance in Marat Safin, but sadly, he is extremely erratic and injury-prone. Rafael Nadal’s repeated defeats of Federer on clay are heartening, but this cannot become all that great a rivalry if it is the surface that decides who wins. And then again, one rivalry does not relieve the concentration too much. Hewitt and Roddick have been blown away by Federer and we need more players with class and courage to stand up to the man and make him prove his greatness.

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‘Fanaa’ Thursday, Jun 8 2006

Being a non-resident Gujarati, I could watch this film last weekend. The brouhaha in Gujarat, of course, was not over the film but over Aamir Khan. Knowing that, controversy could not attract me to the film, like it may have done for 'The da Vinci Code' (I say 'may have done' because this film has been banned here in Tamil Nadu). Perhaps I went to watch the film only because of its lead pair. Perhaps most people did, because nearly everyone who had already watched the film warned against spending too much money on plush multiplex seats on weekends in order to watch it. And yet, 'Fanaa' is an official hit.

If I went only to watch the performances of the lead pair, I got most of 90 rupees' worth, though not all. The script is not very believable. It is typical Hindi film fantasy. The screenplay is not good at all. The first half is especially irritating as events happen one after the other with no seeming interconnections. This being so, I will only comment on matters other than story, some details that interested me.

Firstly, Aamir's reputation as an actor demanding perfection from his scriptwriter must be untrue. If he rejected films after reading the script, or asked scripts to be re-written, he couldn't have accepted this film in its current form. Nevertheless, he tries to infuse his terrorist-with-continually-soft-heart character with intensity. The excessive number of shaayarii-s in the first half does become annoying. Also, I couldn't understand why his character had to be a womaniser. Its being one does not make any difference at all for Kajol throughout the film. I liked the Delhi sight-seeing sequence though, especially the irony created when he gets Kajol to the India Gate and the Amar Jawan Jyoti, with the armed forces bugles sounding their stern, yet beautiful theme in the background.

Kajol really is a fine actress. She has eased through the whole film. At least I could not find any jarring moment in her scenes. Her suffering is the only really believable thing in the film.

Rishi Kapoor has bloated almost beyond recognition. In his Kashmiri dress, he resembles his uncle Shammi Kapoor a lot, especially in profile. His role of understanding elder is similar to Shammi's brief role in Gulzar's 'Ijaazat'.

Two people who are badly wasted are Tabu and Jaspal Bhatti. Tabu perhaps sensed that her role was not detailed well, because she seemed half-hearted in her performance. Why an anti-female anti-terrorist official with his pointed jibes at Tabu was needed is beyond me. Jaspal Bhatti's brief attempt at comedy is actually tragic. The easy comedy he is capable of is not taken advantage of, and he is given stupid lines to mouth.

Kunal Kohli evidently does not believe that God lies in the details. For he does not give away any details which could make the film believable. For instance, where did Aamir get the money for Kajol's cornea transplant? How did Rishi Kapoor's house located in the middle of nowhere in Kashmir get magnificent running water? Indeed, what did Rishi Kapoor do for a living in a place like this, to be able to afford such a house and heavy expenses on drink? Where did Aamir Khan, landing in heavy snow, find ski paddles and where did the armed forces get those snow scooters? Such problems, unfortunately, haven't interested the director, but make the film less believable.

The music is interesting. Jatin-Lalit, in their last film together, come up with two good, soothing tunes in 'chaa.Nd sifaarish' and 'mere haath me.n teraa haath ho'. The singers have been chosen well, Sonu Nigam for the latter and Shaan for the former. Kailash Kher's unique voice is used pretty well too, in his high-pitched 'subhaan allaah' chants. In 'cha.ndaa chamake…' the increasingly rare genre of childrens' song is brought in. In its use of tongue-twisters, it reminded me of the Rafi-Asha duet by Iqbal Qureshi in 'Love in Simla' – 'al-zabar aa..'. Prasoon Joshi continues to write good lyrics and develop into a sensible lyricist.

My memories of this film will not be coherent, only these varied snippets remain in my mind.

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