More Money Than God

Sebastian Mallaby, “More Money Than God: Hedge Funds & the Making of a New Elite”, The Penguin Press: A Council on Foreign Relations Book, 2010, 397 Pages

The efficient market theory prevailed from 1960 to the 1987 crash when the market lost a fifth of its value in one day. Apparently prices were not in-fact all that efficient. The efficient market academics had predicted that hedge funds would fail and only luck accounted for those that succeeded. Now, in 1987, academics were joining the funds—if the markets could be beaten, they wanted to be the ones to do it. Yet the biggest effect of the new inefficient-market consensus was not that academics flooded to hedge funds. It was that institutional investors began to entrust vast amounts of capital to them. Before 1987 most money in hedge funds had come from rich individuals, who apparently had not heard academia’s message that it was impossible to beat the market. After, most money in hedge funds came from endowments.

This book makes the case that hedge funds may be the best financial structure for the future as they are generally small enough to fail. Regulation could be aimed at keeping them that way as the too-big-to-fail structure is at the heart of our current financial problem(s). A good threshold of too-big would be $120 billion (LTCM’s exposure). The big-enough-to-fail is the structure the investment banks generally had until they went public and the managers had little of their own money invested in the structure.

My Notes:

Pg. 28: In 1952 modern portfolio theory was born; the author is Harry Markowitz. His chief insights were twofold: The art of investment is not merely to maximize return but to maximize risk-adjusted return, and the amount of risk that an investor takes depends not just on the stocks he owns but on the correlations among them.

Pg. 52: Until the 1960s, the stock market was dominated by individual investors. Pension funds, insurance funds, and mutual funds—the institutional managers of savings—were not yet significant. In 1950 about ten million American workers were covered by a company pension, and because most of these plans were in their infancy, they had relatively few assets. By 1970 the number of workers with company pensions had more than triple; pension-fund assets now stood at $130 billion and were growing at a $14 billion annually. By the late 1960s mutual funds managed more than $50 billion, up from $2 billion in 1950. Investing was no longer the province of amateurs. It had become a professional business.

Pg. 103: Portfolio insurance was only partially responsible for the 1987 crash; of the $39 billion worth of stock sold on October 19th via the futures and the cash markets, only about $6 billion worth of sales were triggered by portfolio insurers. Low-tech villains were just as important. Many investors had standing orders with brokers to sell if their positions fell, and these old-fashioned stop-loss policies may have accounted for at least as much selling as portfolio insurance.

Pg. 104: The efficient-market hypothesis had always been based on a precarious assumption: that price changes conformed to a ‘normal’ probability distribution—the one represented by the familiar bell curve, in which numbers at and near the median crop up frequently while numbers in the tails of the distribution are rare to the point of vanishing. Even in the early 1960s, a maverick mathematician named Benoit Mandelbrot argued that the tails of the distribution might be fatter than the normal bell curve assumed when applied to the markets; and Eugene Fama, the father of efficient-market theory, conducted tests on stock-price changes that confirmed Mandelbrot’s assertion. If price changes had been normally distributed, jumps greater than five standard deviations should have shown up in daily price data about once every seven thousand years. Instead they cropped up about once every three to four years.

Pg. 105: Fama and his colleagues buried Mandelbrot’s insight as it was too awkward to live with; it rendered the statistical tools of financial economics useless, since the modeling of abnormal distributions was a problem largely unsolved in mathematics. If Mandelbrot was correct, his findings rendered the statistical tools of financial economics useless, since the modeling of abnormal distributions was a problem largely unsolved in mathematics. If he is right, almost all of our statistical tools are obsolete—least squares, spectral analysis, workable maximum-likelihood solutions, all our established sample theory, closed distribution functions.

Pg. 130: After the 1987 crash hedge funds flourished: by one count in 1990, six hundred hedge funds had sprouted from the desert, and by 1992 the were over a thousand.

Pg. 227: LTCM return on assets was only 2.45 percent but leverage transformed this indifferent return on assets into a spectacular return on capital—2.45 percent became 42.8 percent. Then in August 1998 LTCM lost 44 percent of their capital, or $1.9 billion. They calculated that his loss should have occurred less than once in the lifetime of the universe. LTCM’s failure had provided an object lesson in the dangers of leveraged finance, And yet the world’s response was not only to let leveraged trading continue. It was to tolerate a vase expansion.

Pg. 252: The technology bubble of the late 1990s serves as a test for two views of hedge fnds. On the one hand here is the optimistic view—that sophisticated traders will analyze prices and move them to their efficient level. On the other hand there is a darker view—that sophisticated traders lack the muscle to enforce price efficiency and that, knowing the limits of their power, they will prefer to ride trends rather than fight them. Many investors saw the tech bubble and the later mortgage bubble but they could not determine how long they would persist. Shorting these bubbles can put you out of business. Markets can remain irrational longer than your money will last.

Pg. 273: By 2009 hedge funds became more than just vehicles for the rich to get richer, roughly half the capital in hedge funds came from institutions (e.g. pensions and college endowments).

Pg. 297: In stable times LTCM-style arbitrage could pay off well: You needed a computer program during stable times that bet on price anomalies disappearing. In unstable times, arbitrage was dangerous: You needed a trend-following program. Now you just need to know which stage you are in and a computer program to automatically make this switch.

Pg. 328: Paulson’s remarkable bet against subprime loans: In April 2005, Paulson placed his first bet against mortgage securities. He bought a credit default swap—an insurance policy on a bond’s default—on $100 million worth of BBB-rated subprime debt. There was a huge asymmetry in the risk and the reward: He paid $1.4 million for a years’ worth of insurance, but if the securities were wiped out, he stood to pocket the full $100 million. Paulson turned to Pellegrini to calculate the odds of default. The first results were not encouraging. They had begun by thinking that families with payable mortgages were bound to default. But now Pellegrini saw there was a catch: so long as house prices continued to head up, homeowners would be bailed out by the option of refinancing. But they also discovered that the mortgage-industrial complex argued that house prices would never fall across the country in a synchronized way; it had never happened before, so bonds backed by bundles of mortgages drawn from different states were regarded as relatively riskless. But Pellegrini found id you adjusted house prices for inflation, there had been national slumps in both the 1980s and 1990s, so there was every reason to suppose that the extraordinary run-up of the early 2000s would be followed by another downturn. Moreover, to block the option of refinancing, it was not actually necessary for house prices to fall; if prices merely went flat, home owners would lack the collateral to take out new and larger mortgages. Zero house-price appreciation would eventually lead to a mortgage default rate of at least 7 percent, wiping out the value of all BBB bonds.

Pg. 377: Since 1900, U.S. banks have tripled their leverage from around four to twelve; they have taken more liquidity risk by using short-term borrowing to purchase long-term assets; and they have focused more of their resources on high-risk proprietary trading.

Pg 381: Hedge funds’ 20 percent performance fees seem to invite excessive risk taking, but banks have distributed fully 50 percent of their net revenues as salary and bonuses.

Pg. 391: Today, hedge funds are the new merchant banks-the Goldman’s and Morgan’s of half a century ago. Their focus on risk is equally ferocious and they are equally lightly regulated. But the same logic that tempted the old merchant banks to go public will seduce some hedge funds too; already a handful have sold shares in themselves, and doubtless more will follow. When that happens, hedge funds will pose the threat to the financial system that they have wrongly been accused of posing in the past. The wheel of Wall Street turns. Greed and risk are always with us.