Equality and Financial Knowledge

Most Americans outside of the financial industry have very little understanding of how banking, investing, trading, and the various other components of finance work. That banks take deposits and give loans most people grasp, but throw in leverage, interbank loans, portfolios, proprietary trading, or many other activities that are deeply threaded in with deposit taking and the layman is lost. The same is true of investment; buy stocks and if the price goes up, you made money. Buying stock in a company that manages a portfolio of government bonds? Once again, I think most people's grasp beyond the cultural fundamentals is thin.

Now, you could easily say I'm patronizing Joe the plumber. I have very little knowledge of organic chemistry, which no doubt contains as much as nuance and probably more than finance; why should Joe bother divining the likes of arbitrage or ABS tranches? My answer is the very thing I sat down to explore: the idea that understanding how money works, or can work, would greatly alter both how people use it and how money works in the first place. I mean first off there's the fact that by not investing even a tiny slice of his income, Joe is passing up life-changing profit - profit that is constantly garnered by the in-the-know, that is, the rich. Now, the trick lies in the reality that there isn't some magical asset that everyone just needs to realize they should buy. Their are tons of such assets - funds, equities, indexes, CDs.

So now that I've gotten that far in writing that, I see two flaws in my reasoning that I'd have to overcome to keep pushing the point.

1. People can't buy most financial assets (as far as I know). If they thought corporate bonds or Brazilian government debt were good buys, they don't have direct access to them. They either don't have the bulk to buy those things in the huge chunks they exist in (hey, I think I just figured out why they say investment banks "make markets"), or the things aren't traded in publicly accessible exchanges.

2. You have to beat inflation. If people aren't going for big returns (which was going to be my next point - people should play it safe, but start playing when they're still young), they risk getting run over by inflation.

So my initial excitement over the power of financial democracy via knowledge is a bit diminished... but I'll have to think on those two problems.

To summarize the original idea: if people know how financial markets worked, they could engage in them and exploit them the same way the wealthy and the financiers themselves do. Supporting that idea: the industry fights tooth-and-nail for tiny, marginal leads over competitors; if you're not concerned with beating the guy next to you, just making a modest return, you can spend much less time and be much less expert - thus managing your portfolio without quitting your day job.

Long Term Capital Management

A response to:

When Genius Failed: The Rise and Fall of Long Term Capital Management by Roger Lowenstein.

Reading the book in the summer of 2009, the book seems as pertinent as ever. It deals extensively with financial theories that had a role in the crises in mortgage and credit markets, and eventually the broader economy. The parallel continues, as the Fed decided to intervene then as it has now. As a case study, LTCM offers a window into the worlds of arbitrage, academia, and financial markets generally.

There seem to be a few key points to LTCM's strategy and composition:

First, it made heady use of software models. Two partners in particular played huge parts in the development of quantitative finance: Myron Scholes and Robert Merton. Scholes was one half of the Black-Scholes formula, Merton developed that formula even further and also contributed to the Efficient Market school of thought.

Second, it relied on massive capital. Their strategy was to make massive bets with very small pay-offs, "sucking up dimes" as the firm put it. That relied on a huge investor base ($1.25 billion at its inception) and even more colossal amounts of borrowing. In 1995 the firm pulled in a 56% return before fees (43% after). By that time, their capital had grown to $3.6 billion. Their assets under management, meaning capital plus borrowed cash? $102 billion, 28:1 leverage. If they had invested at 1:1 leverage, their return would have been approximately 2.45% (in fact, that doesn't take account of derivatives transactions, which were held off balance sheet - if derivatives were included, the return might have been as low as 1%). Sucking up dimes indeed. Relying on that degree of leverage begs the question of whether the LTCM was really all that good at investing, or if they just had a lot of cash to throw around. So long as you can wait out losses, thanks to a huge amount of capital you can draw on and use to avoid forced sales, you can weather out storms that knock out smaller players. Keynes had a poignant insight on that idea: "markets can remain irrational longer than you can remain solvent." Lowenstein points to an early lesson learned by the LTCM's founder, John Meriwhether, when he was a trader at Salomon Brothers. A bond trader had made what he believed to be a good bet that the spread between bond futures and the actual bonds would narrow, so he bought futures and shorted bonds. But the spread only widened further, until eventually the trader had taken on so much loss he was being forced to sell. Salomon, and Meriwhether, looked at the trade and decided it was in fact a good bet. The little guy simply didn't have the capital to wait it out. So they bought him out, and sure enough, a little while later the spread narrowed and Salmon made a killing. The lesson? Have enough capital to wait out the storm. And eventually, in running LTCM, that's exactly what Meriwhether did - took in massive investment and then massively leveraged it, to the point where he was controlling a hundred billion dollars.