May 13, 2008

Liar’s Poker

Filed under: Anecdote — duncan @ 2:04 pm

Let me take a break from trying to get my head round whatever Marx is saying (thank you all who’ve tried to inform me…), and mention a couple of pot boilers I’ve also been reading, both about Wall Street.

First up, ‘Liar’s Poker’, Michael Lewis’s bestselling memoir of his time as a Salomon Brothers bond salesman. Lewis describes the years of the firm’s greatest success and decline – he describes, among other things, the creation of huge speculative markets in junk bonds and mortgages… and the repackaging of those mortgages as bonds… His book begins with a probably apocryphal anecdote about two of the firm’s partners – John Gutfreund, the chairman, and John Meriwether, a bond tradesman. Gutfreund challenges Meriwether to a game of ‘Liar’s Poker’ [something to do with betting on the serial numbers of one dollar bills…], “one hand, one million dollars, no tears”. Meriwether (supposedly) calls Gutfreund’s bluff, upping the stake to ten million dollars. Gutfreund declines to play. Victory for Meriwether – wouldn’t you like to be such a big swinging dick?

Lewis’s book ends with the crash of 1987 (“Time and time again someone stood up and shouted, for no particular reason, ‘Jeeee-sas Christ!” They were helpless as they watched their beloved market die.”) Lewis leaves the firm shortly afterwards, to become, I think, a freelance writer. (According to the author bio, he’s “served as editor and columnist for the British weekly The Spectator”, which doesn’t inspire confidence.) But although he describes the greed, mismanagement and suicidal short-termism that were at the heart of the firm he left, Lewis still has faith. “As it happens, I still own shares in Salomon Brothers, because I believe it will eventually recover. The strength of the firm lies in the raw instincts of people like John Meriwether, the liar’s poker champion of the world. People with those instincts, including Meriwether and his boys, are still trading bonds for Salomon.” With them on board, what could go wrong?

Move on to ‘When Genius Failed’, Roger Lowenstein’s account of “The Rise and Fall of Long Term Capital Management.” In 1991, Lowenstein tells us, scandal engulfed Salomon, when one of Meriwether’s traders was revealed to have lied to the US Treasury, about something or other. Gutfreund and Meriwether resigned; and Meriwether set about establishing another trading company – ‘Long Term Capital Management’, a hedge fund (the largest start-up ever) staffed by his former “boys” at Salomon.

Between March 1994, when it started trading, and April 1998, the height of its success, ‘LTCM’ was the brightest star in the finance firmament. “The firm had racked up returns of more than 40 percent a year, with no losing stretches, no volatility, seemingly no risk at all.” Then in August and September 1998, it imploded. The firm’s strategy, Lowenstein tells us, had been to bet, across all the markets it traded in, on the return of the market’s volatility to its long-run norm. In late 1997 “[w]ith Asia still in turmoil and stocks at nosebleed levels, investors were understandably jittery.” LTCM, believing that protection was therefore overpriced, became (in effect) a massive seller of insurance. But since “Long Term would have to settle up – paying or receiving monies according to how option prices moved every day”, the firm “wasn’t betting only on the extent of ultimate realized volatility, it was betting on the day-to-day inferred volatility, as determined by what other investors would pay for options.”

In mid August 1998, Russia defaulted on its debt. “Investors, at first singly, and then en masse, concluded that no emerging market was safe.” And investors fled “not just from emerging markets, but from investment risk wherever it lurked.” LTCM went into meltdown. “The losses came from every corner. They were so swift, so encyclodpedic in their breadth, so utterly unexpected that the partners felt abandoned.” In late September, with LTCM hours from bankruptcy, the Fed got the leading Wall Street banks together to bail out the firm – for fear of systemic crisis if it collapsed.

That’s the “raw instincts of people like John Meriwether, the liar’s poker champion of the world”. Now in that silly ‘Fooled By Randomness’ book I was reading a few weeks back, Nicholas Naheem Taleb remarks that the strategy that guided LTCM’s trades – like the strategy of a lot of investors guided by the ‘efficient markets hypothesis’ – is sort of a performative contradiction. Investors look for market mispricing, in order to profit from the market’s eventual readjustment. But whatever forces generate the mispricing, are also forces that can continue to generate the mispricing. In ‘The Alchemy of Finance’, which I’ve also been reading, George Soros argues that the whole idea of market equilibrium – and therefore of ‘correct’ market pricing – is flawed. The ‘reflexivity’ that governs market behaviour means, according to Soros, that ‘fundamentals’ are always produced, in large part, by speculation, expectation, belief, fear, panic, hubris, craziness.

“’No, John,’ he [Meriwether] said, ‘if we’re going to play for those kinds of numbers, I’d rather play for real money. Ten million dollars. No tears.’… Gutfreund declined. In fact he smiled his own brand of forced smile and said, ‘You’re crazy.’” Crazy. And these “crazy” gamblers don’t get decide “no tears”… It’s not their tears that are at stake.

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