Shop talk Tuesday, Jan 27 2009

Sunday, 25th January, 2009. Big Bazaar, the retail store chain. Particular instance of the store at Hebbal in Bangalore. Have no reason to visit. Attracted significantly enough to decide to visit by 16-page booklet announcing great shopping festival and ‘exciting offers’ that came with the Times of India a day earlier . With my wife. On our two-wheeler. 5-km ride, first on Bellary Road and then on Tumkur Road.

Pass the giant store from the opposite side of the road. Notice, with shock and awe, tremendous activity around the store. Long, long line of two-wheelers parked on tiny side road. Expectedly, have trouble finding a parking slot. Park, far away from the store itself.  Forced to un-park by a guard who says this parking slot is for those visiting a bar in a shopping complex. Now park in front of a darshini, the typical south Indian fast food veg restaurant. Nobody objects. Probably safe, but lingering worry on state of two-wheeler when I return.

Approach the store. Notice that entrance is not directly through the sliding doors, but through a maze designed to hold a long, long queue of peoople. Bemused. Wondering if we have come to Tirumala or Sabarimala. People actually slipping under barricades to get in ahead of others. Curiouser and curiouser.

We enter the store on Level 1. Sales promotions galore. Not all of them bargains. Nearly all promotions offering some goods free on purchase of some others. Almost no outright discounts. Maximum glut, we feel, is in the clothes section. Buy 2 get 2 free. Buy 5 get 7 free. Wondering, how many people want to overhaul their wardrobe by buying 12 clothes at once? Thinking, we don’t even have that much space at home.

People swarming all over the place. Imagining what an ant must feel like on an anthill. All ‘ants’ have shopping carts or tug-along bags stuffed with stuff. Shopping carts frequently have a child or two seated in them, as if children are also offered on a discount on Level 5 of the store.  No aisle or passageway is empty. At any given moment, every passageway has at least one frantic shopper checking out bargains. The American dream.

Typical scenes of people buying completely unncessary stuff. Lot of people carrying two foam pillows each, offered for the price of one. Seems lot of people suddenly want to be very, very comfortable at home with extra pillows. A couple has bought 10 buckets. Probably to distribute in their locality.

Consumer behaviour is contagious. I go in search of an empty shopping cart. Find one near the exit. We select an airtight container and a ladies’ purse. Our real need is to buy groceries. So we reach Level 4, the Food Bazaar. Maximum crowd. Serpentine queues for billing, except that no serpent in the world grows to this length. Dumbfounded by this consumer onslaught. The consumerist Singh is king, or so it appears.

Finally decide to beat a hasty retreat. As hasty as the crowds allow. Drop our shopping cart unobtrusively in a corner. Make our way through jostling crowds near the billing counters on Level 1. Successfully pass through and exit. Security guard at exit looking for bills and articles to check, surprised at not finding any. Walk to two-wheeler, which is safe, thank God. Drive away to home and hearth.

Had certain thoughts while inside this insane shopping asylum. How do you define economic slowdown? How big has the great Indian middle class become? Will the retailers profit, even after offering nearly every good at a discount? When will the countless items in the inventory of that giant store finally all move out? Will it ever happen, even after so many people have bought so many of those items, most of which they didn’t need in the first place? What comes over us when we enter a crowded supermarket with stocked shelves and see others with full shopping bags? Competitive spirit? Animal instinct? Supermarkets resemble casinos. You come out with empty pockets when you had not expected to leak money.

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‘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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