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Table of Contents 02
Models. Behaving. Badly.
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Emanual Derman Extract: Chapter 1 – A Foolish Consistency
11
Red-Blooded Risk
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Aaron Brown Extract: Chapter 1 – What This Book Is and Why You Should Read It
17
The Number That Killed Us
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Pablo Triana Extract: Chapter 1 – The Greatest Story Never Told
24
Paper Money Collapse
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Detlev S. Schlichter Extract: Chapter 1 – The Fundamentals of Money and Money Demand
32
The Little Book of Trading
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Michael W. Covel Extract: Chapter 1 – Stick to Your Knitting
37
Markets Never Forget (But People Do)
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Ken Fisher Extract: Preface – Hope Springs Eternal
43
Endless Appetites
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Alan Bjerga Extract: Chapter – Floors, Fields and Famines
52
The End of Progress
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Graeme Maxton Extract: Chapter 12 – We Need to Diffuse the Threats of Conflict
58
Exile on Wall Street
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Mike Mayo Extract: Chapter 4 – The Professional Gets Personal
1
Models. Behaving. Badly.
Models. Behaving. Badly. Why Confusing Illusion with Reality Can Lead to Disaster, on Wall Street and in Life
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Emanuel Derman 978-1-1199-6716-3 • Hardback • 240 pages October 2011 • £16.99 / €20.40 / $26.00
Chapter 1 A Foolish Consistency Pragmatism always beats principles. . . . Comedy is what you get when principles bump into reality. —J. M. Coetzee, Summertime
MODELS THAT FAILED I: ECONOMICS “All that is solid melts into air, all that is holy is profaned, and man is at last compelled to face, with sober senses, his real conditions of life, and his relations with his kind,” wrote Marx and Engels in The Communist Manifesto in 1848. They were referring to modern capitalism, a way of life in which all the standards of the past are supposedly subservient to the goal of efficient, timely production. With the phrase “melts into air” Marx and Engels were evoking sublimation, the chemists’ name for the process by which a solid transmutes directly into a gas without passing through an intermediate liquid phase. They used sublimation as a metaphor to describe the way capitalism’s endless urge for new sources of profits results in the destruction of traditional values. Solid-to-vapor is an apt summary of the evanescence of value, financial and ethical, that has taken place throughout the great and ongoing financial crisis that commenced in 2007. The United States, the global evangelist for the benefits of creative destruction, has favored its own church. When governments of emerging markets complained that foreign investors were fearfully yanking capital from their markets during the Asian financial crisis of 1997, liberal democrats in the West told them that this was the way free markets worked. Now we prop up our own markets because it suits us to do so. The great financial crisis has been marked by the failure of models both qualitative and quantitative. During the past two decades the United States has suffered the decline of manufacturing; the ballooning of the financial sector; that sector’s capture of the regulatory system; ceaseless stimulus whenever the economy has wavered; taxpayer-funded bailouts of large capitalist corporations; crony capitalism; private profits and public losses; the redemption of the rich and powerful by the poor and weak; companies that shorted stock for a living being legally protected from the shorting of their own stock; compromised yet unpunished ratings agencies;
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Emanuel Derman government policies that tried to cure insolvency by branding it as illiquidity; and, on the quantitative side, the widespread use of obviously poor quantitative security valuation models for the purpose of marketing. People and models and theories have been behaving badly, and there has been a frantic attempt to prevent loss, to restore the status quo ante at all costs.
THEORIES, MODELS, AND INTUITION For better or worse, humans worry about what’s ahead. Deep inside, everyone recognizes that the purpose of building models and creating theories is divination: foretelling the future, and controlling it. When I began to study physics at university and first experienced the joy and power of using my mind to understand matter, I was fatally attracted. I spent the first part of my professional life doing research in elementary particle physics, a field whose theories are capable of making predictions so accurate as to defy belief. I spent the second part as a professional analyst and participant in financial markets, a field in which sophisticated but often ill-founded models abound. And all the while I observed myself and the people around me and the assumptions we made in dealing with our lives. What makes a model or theory good or bad? In physics it’s fairly easy to tell the crackpots from the experts by the content of their writings, without having to know their academic pedigrees. In finance it’s not easy at all. Sometimes it looks as though anything goes. Anyone who intends to rely on theories or models must first understand how they work and what their limits are. Yet few people have the practical experience to understand those limits or whence they originate. In the wake of the financial crisis naïve extremists want to do away with financial models completely, imagining that humans can proceed on purely empirical grounds. Conversely, naïve idealists pin their faith on the belief that somewhere just offstage there is a model that will capture the nuances of markets, a model that will do away with the need for common sense. The truth is somewhere in between. In this book I will argue that there are three distinct ways of understanding the world: theories, models, and intuition. This book is about these modes and the distinctions and overlaps between them. Widespread shock at the failure of quantitative models in the mortgage crisis of 2007 results from a misunderstanding of the difference between models and theories. Though their syntax is often similar, their semantics is very different. Theories are attempts to discover the principles that drive the world; they need confirmation, but no justification for their existence. Theories describe and deal with the world on its own terms and must stand on their own two feet. Models stand on someone else’s feet. They are metaphors that compare the object of their attention to something else that it resembles. Resemblance is always partial, and so models necessarily simplify things and reduce the dimensions of the world. Models try to squeeze the blooming, buzzing confusion into a miniature Joseph Cornell box, and then, if it more or less fits, assume that the box is the world itself. In a nutshell, theories tell you what something is; models tell you merely what something is like.
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Models. Behaving. Badly. Intuition is more comprehensive. It unifies the subject with the object, the understander with the understood, the archer with the bow. Intuition isn’t easy to come by, but is the result of arduous struggle. What can we reasonably expect from theories and models, and why? This book explains why some theories behave astonishingly well, while some models behave very badly, and it suggests methods for coping with this bad behavior.
OF TIME AND DESIRE In “Ducks’ Ditty,” the little song composed by Rat in Kenneth Grahame’s The Wind in the Willows, Rat sings of the ducks’ carefree pond life:
Everyone for what he likes! We like to be Heads down, tails up, Dabbling free!
Doubtless the best way to live is in the present, head down and tail up, looking at what’s right in front of you. Yet our nature is to desire, and then to plan to fulfill those desires. As long as we give in to the planning, we try to understand the world and its evolution by theories and models. If the world were stationary, if time didn’t pass and nothing changed, there would be no desire and no need to plan. Theories and models are attempts to eliminate time and its consequences, to make the world invariant, so that present and future become one. We need models and theories because of time. Like most people, when I was young I couldn’t imagine that life wouldn’t live up to my desires. Once, watching a TV dramatization of Chekhov’s “Lady with a Lapdog,” I was irritated at the obtuse ending. Why, if Dmitri Gurov and Anna Sergeyevna were so in love, didn’t they simply divorce their spouses and go off with each other? Years later I bought a copy of Schopenhauer’s Essays and Aphorisms. There I read an eloquent description of time’s weary way of dealing with human aspirations. In his 1850 essay “On the Suffering of the World” Schopenhauer wrote: If two men who were friends in their youth meet again when they are old, after being separated for a life-time, the chief feeling they will have at the sight of each other will be one of complete disappointment at life as a whole, because their thoughts will be carried back to that earlier time when life seemed so fair as it lay spread out before them in the rosy light of dawn, promised so much—and then performed so little. This feeling will so completely predominate over every other that they will not even consider it necessary to give it words, but on either side it will be silently assumed, and form the ground-work of all they have to talk about. Schopenhauer believed that both mind and matter are manifestations of the Will, his name for the substance of which all things are made, that thing-in-itself whose blind and only desire is to endure. Both the world outside us and we ourselves are made of it. But though we experience other objects from the outside as mere matter, we experience ourselves from both outside and inside, as flesh and soul. In matter external to us, the Will manifests itself in resilience. In our own flesh, the Will subjects us to endless and unquenchable desires that, fulfilled or unfulfilled, inevitably lead to disappointments over time.
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Emanuel Derman You can be disappointed only if you had hoped and desired. To have hoped means to have had preconceptions—models, in short— for how the world should evolve. To have had preconceptions means to have expected a particular future. To be disappointed therefore requires time, desire, and a model. I want to begin by recounting my earliest experiences with models that disappoint.
MODELS THAT FAILED II: POLITICS I grew up in Cape Town, South Africa, in a society where most white people had Coloured servants, sometimes even several of them. Their maids or “boys” lived in miserably small rooms attached to the outside of the “master’s” house. Early in my childhood the Afrikaner Nationalist Party government that had just come to power passed the Prohibition of Mixed Marriages Act of 1949. The name speaks for itself. Next came the Immorality Act of 1950, which prohibited not just marriage but also adultery, attempted adultery, and other “immoral” acts between whites and blacks, thereby trying to deny, annul, or undo 300 years of the miscegenation that was flagrantly visible. In South Africa there were millions of “Cape Coloureds,” people of mixed European and African ancestry, who lived in the southern part of the country, their skin tone ranging from indistinguishable-from-white to indistinguishable-fromblack and including everything in between. In South Africa we all became expert at a social version of chromatography, a technique chemists use to separate the colors within a mixture. I learned how to do it in my freshman chemistry course at the University of Cape Town. You place a drop of black ink on a strip of blotting paper and then dip the end of the strip into water. As the water seeps through the paper, it transports each of the different dyes that compose black through a different distance, and, as if by magic, you can see the colors separate. How convenient it would have been for the government to put each person into a device that could have reported his or her racial composition scientifically. But the authorities came as close to that as they could: the Population Registration Act of 1950 created a catalogue in which every individual’s race was recorded. South Africa didn’t just catego rize people into simple black and white; there were whites, natives (blacks), Coloureds, and Indians. Racial classification was a tortuous attempt to impose a flawed model on unruly reality: A white person is one who in appearance is, or who is generally accepted as, a white person, but does not include a person who, although in appearance obviously a white person, is generally accepted as a Coloured person. A native is a person who is in fact or is generally accepted as a member of any aboriginal race or tribe of Africa. A Coloured person is a person who is not a white person nor a native. Note the pragmatic combination of objectivity and subjectivity: if you are objectively white but accepted as Coloured, then you’re not white.
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Models. Behaving. Badly. In disputed cases a board made decisions that determined not only who you could sleep with but which beaches you could swim at, where you could work and live, which buses you could take, and which cinemas you could attend. Given South Africa’s history of miscegenation, it was not uncommon for members of the same family to end up with different chromatography profiles. Some Coloureds attempted to be reclassified as white, and some blacks applied to be reclassified as Coloured. Evidence involved keen discussions of texture of bodily hair, nose shape, diet, and ways of earning a living, the latter two being taken as racial characteristics rather than matters of socialization or opportunity. Most Chinese, who were difficult for officials to define or even to distinguish from other Asians, were classified as nonwhite, but Chinese from Taiwan and all Japanese, for trade and economic reasons, were declared honorary whites. The Group Areas Act of 1950 institutionalized apartheid by specifying the regions in which each race could live and do business. Nonwhites were forcibly removed from living in the “wrong” areas, thereby superimposing a legal separation over the less formal physical separation of the races that had already existed.1 Those domestics who didn’t “live in” had to commute long distances to work. In Cape Town the government razed District 6, its Coloured Harlem, and moved the entire community of inhabitants to the Cape Flats, a desolate sandy region outside the city, well described by its name. When I was at university I trekked out there several times as a volunteer on behalf of the Cape Flats Development Association to help persuade poor Coloured families to feed their children milk rather than the cheaper mashed-up squash that, though stomach-filling, had virtually no nutritional value. It was a bleak area with sparse vegetation and no running water, a gulag whose inhabitants lived in makeshift shanties constructed of corrugated iron, plywood, and cardboard. Barefoot children were everywhere. Many parts of South Africa are still like that, despite the end of apartheid. By 1951 nonwhites were being stripped of whatever voting rights they had possessed. Though I knew all this was wrong, I grew up with it as normality. The air you breathe, once you grow accustomed to it, has no smell at all. When I was ten years old our neighbor down the block, a Jewish businessman in his forties with two sons a little older than I, was found on the floor of his downtown office in flagrante delicto with a young black girl. His doctor testified that he had prescribed pills for our neighbor’s heart condition that might have had aphrodisiac side effects. The black girl apparently didn’t need pills to provoke her desire, and I don’t recall what sentence, if any, either of them received. Several years later an acquaintance of my sister’s was arrested. The police had seen him driving in his car at night with a Coloured woman seated beside him. They trailed him to his house, watched through the window, and later testified to observing the sexual act. His stained underwear was presented in court as evidence. The initial giveaway was the fact that the woman sat in the front seat, beside him. White men who gave their maids a ride somewhere commonly made them sit in the backseat to avoid suspicion. But even white women (the “madams”) often made their maids sit in the
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Emanuel Derman backseat. The unarticulated aim was the avoidance of even innocuous physical intimacy. (Of course, if it had to be avoided, it wasn’t innocuous.) A native’s lack of whiteness made him or her untouchable. To avoid contamination, white families often had two sets of knives, forks, and plates: one for the family to use and one for their maids and “boys.” When I read Portnoy’s Complaint in 1969, a few years after I arrived in New York, the following passage reminded me of the visceral sense of defilement that many South African whites had been taught to feel: Once Dorothy chanced to come back into the kitchen while my mother was still standing over the faucet marked H, sending torrents down upon the knife and fork that had passed between the schvartze’s thick pink lips. “Oh, you know how hard it is to get mayonnaise off silverware these days, Dorothy,” says my nimble-minded mother— and thus, she tells me later, by her quick thinking has managed to spare the colored woman’s feelings. The Nationalist Party government that came to power in 1948 hated and feared Communism, not because the Nationalists were lovers of the individual freedom threatened by totalitarianism, but because they were totalitarian themselves. They denounced “radicals,” but as a student leader at a University of Cape Town rally once pointed out to great applause, it was the Nationalists who were the true radicals, intent on wiping out age-old conservative democratic principles. Their government periodically declared a state of emergency, which allowed for arbitrary detention. They put opponents and suspects in jail without trial for 180 days, renewable. Eventually they banned the Communist Party. Then they proceeded to ban the more gentlemanly Liberal Party, whose slogan was “One man, one vote.” Fearful people made an effort to say they were “liberal with a small l.” When I was seventeen and spending the summer working and touring in Israel, I bought a copy of Atlas Shrugged and hid it in my luggage on my return, successfully slipping it through Customs like a copy of Playboy or Tropic of Cancer. The South African prism had shifted the political spectrum so far to the dictatorial right that Ayn Rand’s defense of the individual and of libertarian capitalism seemed to me and my friends to be subversive. At the extremes, left could not be distinguished from right. I thought of this later, when I first learned the theory of complex numbers: in the complex plane, the points at plus and minus infinity coincide, and again far left and far right become indistinguishable. South Africa’s models were rife with internal contradictions. The most severe was the government’s policy of race separation that pretended to grant blacks independence in their supposed homelands while still keeping them available to provide the labor that kept the country running. There were smaller hypocrisies too. As young white teenagers in the 1950s, we spent the entire summer in the sun on Fourth Beach at Clifton or in the crowded Snake Pit at Muizenberg, applying fish oil or Skol so as to get as dark as possible.3 A girl I knew who devoted her time to acquiring a magnificent tan grew indignant when the train conductor mistook her for a Coloured and instructed her to go to the train carriage reserved for that race. Coloureds were treated better than natives but much worse than whites. Their facilities weren’t separate but equal; they were vastly inferior or nonexistent. In
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Models. Behaving. Badly. downtown Cape Town, where I worked in a department store one summer in the early 1960s, I don’t think there was a single restaurant a black person could enter to sit down and eat. All the salesladies behind the counter, even in down-market OK Bazaars, were white. From birth I knew no other society, and though I knew apartheid was wrong, individual blacks were pretty much invisible to me. Once, soon after I learned to drive, I took my parents’ car to the garage to get petrol. In those distant days of luxury all garages were full service, and the “boys” bustled around your car when you drove up. They pumped petrol; checked the oil, water, battery, and brake and clutch fluids; cleaned the windows; and measured the tires’ pressure and put in air if necessary. When you left, you tipped the attendant who had served you. That day, my nervous first time dealing with a garage on my own, there were three or four attendants hovering around the several cars at the petrol pumps, and as I drove away I realized with minor horror that I had mistakenly tipped the wrong man. When you weren’t used to seeing blacks as individuals, they truly did all look the same. Enforced racial separation hadn’t always been the norm. I spent my first seven years in Salt River, a poor mixed-race suburb that was home to many immigrant Jews who hadn’t yet made it. (I remember fondly Mr. Jenkins, our Coloured plumber, who lived in the neighborhood. He spoke Yiddish, and once, when he arrived at our front door while I was in bed with a bad cold, I fearfully mistook his voice and intonation for that of our doctor, who also made home visits.) Apartheid as a legal policy reached peak efficiency only in the late 1950s and 1960s, my formative years, when I became accustomed to racism. My sisters, 9 and 12 years older than I, grew up in a less for mally prejudicial world and were less racist than I was. My nephews and nieces, 16 or more years younger, grew up as the apartheid regime was collapsing, and it left a milder indentation on them. It was only when I left to study in New York in the late 1960s that I had the chance to socialize informally with people that South Africa classified as nonwhites. One day, kidding around physically with some Indian friends in the common room of the graduate student dormitory where we all lived, I suddenly realized that I was doing what I’d never done before, and was grateful for it. When I was ten I spent the winter vacation with my parents about 100 miles northeast of Cape Town, in Montagu, a small town reached by steep switchbacks that crossed a deep ravine called DuToit’s Kloof. Founded by British settlers in the mid-1800s, Montagu was a faded winter retreat, a Jewish immigrant’s colonial-style Bath or Évian, but with a local population of Coloureds and Afrikaners. The town’s main attraction was a nearby thermal spring that was reputedly good for arthritis. The refined hotel on the main street was called The Avalon. We stayed in The Baths, set in the countryside a few miles out of town. The Baths was fun but run-down. There was one toilet and bathroom at the end of each wing, and because it was a long, cold walk down the outdoor passage that connected the rooms, there was a heavy white enamel chamber pot beneath your bed in case you needed to urinate during the night. The Coloured maids emptied it in the morning, when they made up the room. Baboons roamed the small kloof that separated The Baths from the business
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Emanuel Derman center of tiny Montagu. Sometimes they came onto the hotel grounds, emptying trash cans and even entering rooms. An older boy I knew climbed the hills above the hotel to shoot the baboons with an air gun, which I coveted. The adults used to take a constitutional every morning, hiking into town through the kloof to The Avalon, to take tea and Scottish scones with local strawberry jam, butter, and thick whipped cream, but we children stuck to the grounds of The Baths, furiously socializing. My father babied me whenever I allowed him to and embar rassed me by forcing apples on me while I was with my friends. I fell in love with a twelve-year-old girl who scorned me, thanks to my father’s constant attention. It was in Montagu that someone, I don’t recall who, explained to me where babies come from. And it was in Montagu a few years later that I briefly met Adrian Leftwich. Each year seasonal crazes swept through our school. One month it was silkworms that we bought and collected, keeping them in shoeboxes with airholes and feeding them mulberry or cabbage leaves until they grew into fabric-wrapped armatures. A season later came marbles. And then, outdoing all previous crazes, came hypnosis. The sovereign of hypnosis in Cape Town was Max Collie, a professional entertainment hypnotist who had emigrated to South Africa from Scotland. His son and I went to the same school. Every year or so Mr. Collie did a couple of shows in Cape Town, some of them on our school’s premises. He began by testing the audience for suggestibility, attempting to talk their outstretched right arms into floating up into the air while their eyes were closed.4 “Your arm wants to rise up into the air. It feels light, like a balloon, so light it wants to float up towards the ceiling. Don’t resist, let it go, let it go.” Occasionally some hypersuggestible soul whose arm had spontaneously risen up would already be in a trance as a result of the test, and would fail to open his eyes at its conclusion, even before he had been officially hypnotized. Those suggestibles who were uninhibited enough to agree to participate in the show then went onstage to be hypnotized in front of the entire audience, including their own children. Soon adult men and women were under Mr. Collie’s command, shyly attending their first day at school, asking the teacher for permission to go to the washroom, scratching as though there were itching powder in their clothes, lying rigidly across two separated chairs. Finally, there was the post-hypnotic suggestion: “When you wake up and are back in the audience, whenever you hear me say ‘It is very warm in here tonight,’ you will feel as though you are sitting on a hot electric plate and jump up screaming.” Then he woke them: “As I count backwards from ten to one, you will slowly start to feel wider and wider awake. Ten, nine, eight . . . you feel light and cheerful, your eyes are begin ning to open . . . seven, six, five, four . . . you are almost ready to wake up, you feel very good and full of energy . . . three, two, one, wake up! Thank you very much, ladies and gentlemen.” It was awe-inspiring to see people under Max Collie’s power, and soon we were all trying to hypnotize each other. I bought books on hypnosis and self-hypnosis written by the aptly named Melvin Powers. The covers had mesmerizing diagrams of vertigo-inducing centripetal spirals, and some of the books included “the amazing hypnodisk,” which you could use to hypnotize yourself and your friends. My cousin and I spent hours trying to put each other under.
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Models. Behaving. Badly. In Montagu that winter of the hypnosis craze I first met the equally aptly named Adrian Leftwich, several years older than the rest of us and not really a part of our more childish circle. I didn’t see him again until a few years later, in the early 1960s, when I went to the University of Cape Town. By then Leftwich was the charismatic head of the National Union of South African Students, or Nusas, a principled anti-apartheid group. He was one in a series of Nusas student leaders who were in outspoken opposition to the government, and I admired his leadership and courage. And it truly did take courage: many student leaders of Nusas, like other foes of apartheid whom the government despised and even feared, were frequently arrested and eventually “banned,” legally forbidden to attend any public meetings or even go to the cinema or theater. A more extreme punishment was house arrest. Most of the banned had had their passports revoked, so if they chose to leave the country they had to do so on a one-time permit into permanent exile. Anti-apartheid rallies were monitored by policemen and plainclothes agents of the Special Branch, who took photographs, and even those who merely signed anti-apartheid petitions worried about getting their names on a blacklist. As the government clamped down on all forms of legal protest, violent opposition emerged. In 1963 there were sabotage attacks on power pylons and FM transmitters in the vicinity of Cape Town. In 1964 the security police carried out nighttime searches of the houses of known anti-apartheid activists, Leftwich among them. They found him in bed with his girlfriend, his flat carelessly filled with detailed plans that incriminated him as the hitherto anonymous leader of the African Resistance Movement, which had taken responsibility for the sabotage. The police arrested Leftwich and kept him in solitary confinement. Perhaps fearful of being sentenced to death, he quickly turned state’s evidence and, in his own words in a later written reminiscence, “named the names” of his collaborators and recruits and gave testimony for the prosecution at their trial. I attended court on the day of the sentencing, where the presiding judge said that to call Leftwich a rat would be an insult to the genus Rattus. I never had much political courage and had admired Leftwich for his bravery as head of Nusas. I don’t judge him now. Like most of us, he wasn’t what he thought he was. But thankfully, for most of us, comprehension of the disparity between who we think we are and who we truly are comes gradually and with age. We are lucky to avoid a sudden tear in our self-image and suffer more easily its slow degradation. For Leftwich the apparent union between personality and character ruptured like the fuselage of the early De Havilland Comet, in an instant, in midair, unable to withstand the mismatch between external and internal pressure. How do you ever forgive yourself for a betrayal like that? But we have all committed acts that surprise us and are hard to forgive. You can count yourself lucky if your model of yourself survives its collision with time. To continue...
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Aaron Brown
Red-Blooded Risk The Secret History of Wall Street
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Aaron Brown 978-1-1180-4386-8 • Hardback • 432 pages October 2011 • £23.99 / €28.00 / $34.95
Chapter 1 What This Book Is and Why You Should Read It Life is full of choices. At a job interview, you can give short, pleasant answers to questions. Or you can burst into an impassioned rant about how you will add value to the enterprise. You can dress sedately and behave discretely at a party, or go for maximum drama in your clothes and demeanor. In a basketball game you can throw up a quick shot, or pass the ball so the team can work into position for a higherpercentage shot. You can walk on by an interesting looking stranger, or throw out a remark or a wink. These choices all concern risk. In the basketball example, you have a coach. When the team is ahead late in the game, the coach will give one kind of advice. On offense, take plenty of time and get a high- percentage shot. On defense, deny the opponents easy shots and do not foul. Why? Because this style of play minimizes the variance of outcome, which is to the advantage of the team in the lead. The trailing team will try to shoot three- point shots quickly and will play aggressively for steals and blocks on defense. They don’t mind fouls because those can change the score without running time off the clock. They are trying to maximize variance of outcome. If you’re not familiar with basketball, the same idea applies in virtually every competitive sport. The player or team that is ahead wants to minimize risk, whereas the opposing player or team wants to maximize it. In baseball, a pitcher with a lead throws strikes; when his team is trailing he will work the corners and throw off–speed pitches. In soccer with a lead you try to control the ball and keep your defense back; when behind you attack aggressively. In hockey, the trailing team will sometimes even pull the goalkeeper. In American football, the team with the lead will run the ball up the middle and play prevent defenses, while the other team blitzes and throws long passes. In the job interview, the short, safe answers are indicated if you think you’re likely to get the job and just don’t want to blow it. But if you’re a long shot to be hired, maybe it’s time to dust off that rant. Going to an obligatory party for your job, one you know will be boring? Navy suit, say as little as possible and only about the weather, don’t drink, and leave early. But if you want to be the life of the party, have a great time,
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Red-Blooded Risk and maybe change your life? Think hot pink. And before you wink at the stranger, ask yourself if you’re a bit bored and looking for new adventures— or is your life exciting and complicated enough already and you need peace and quiet more than a new friend? Risk is something you dial up or down in order to accomplish a goal. It is neither good nor bad in itself. This is the sense in which I always use the word risk in this book. Compare this to the “risk” of a basketball player getting injured. I will use the word danger for this, not risk. Dangers should be minimized, subject to constraints. For example, we don’t want to require so much protective padding that a game is not fun, or the cost is too great. So we don’t try to set danger of injury to zero, but we also don’t “manage” it; we never increase it for its own sake. The counterpart to a danger on the good side is an “opportunity,” such as the opportunity for a pitcher in baseball to get a no- hitter. This is considered so valuable that a manager will almost always leave a pitcher with a chance at a no- hitter in the game, even if he is tiring and a relief pitcher would increase the probability of winning the game.
Risk, Danger, and Opportunity There are three tests to determine if something is a risk rather than a danger or an opportunity: 1. R isks are two- sided; you can win or you can lose. Dangers and opportunities are one- sided. If you have a sudden change of health while playing football, it is highly unlikely to be an improvement. 2. D angers and opportunities are often not measurable, and if they are, they are measured in different units than we use for everyday decisions. We can’t say how many points a broken collarbone is worth, or whether two sprained ankles are better or worse than a broken finger. There is no dollar figure to put on the glory of setting a record or winning a championship. Risks, however, are measurable. In order to manage an uncertainty, we need some way of assigning relative values to gains and losses. 3. D angers and opportunities often come from nature, and we usually have only limited ability to control them. Risks always refer to human interactions, and their level must be under our control— if not, they may be risks to somebody else but they are facts of life to us. The distinction is not inherent in the uncertain ties themselves; it is our choice how to treat them. For example, NASCAR has been accused of manipulat ing its rules to get an optimal number of fatal crashes per year: enough to keep a dangerous, outlaw edge but not so many as to kill all the popular drivers or provoke safety legislation. I have no opinion on whether this charge is true or false. If true, it means NASCAR is treating as a risk something that most people consider a danger.
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Aaron Brown That might be immoral, but it is not illogical or irrational. Some job applicants treat every question as a danger, carefully probing for traps and giving minimal answers to avoid the chance of mistake. They seldom get hired. Others treat every question as an opportunity to posture or boast. They never get hired. Some people go to parties that should be fun, and dress and act more appropriately for a funeral, letting the danger of embarrassing themselves overwhelm rational consideration of risk. Other people treat funerals as parties, grasping for opportunities that do not exist. Another example of mixing up risk and danger is a famous memorandum by Ford Motor Company concluding that the cost to the company of settling lawsuits for Pinto owners burned to death in low- speed rear collisions was less than the $10 per car it would cost to shield the gas tank. This story, although widely believed, is a distortion of the facts, and Ford is innocent of any such decision. I mention it only to emphasize that the distinction between risks and dangers is in the eye of the beholder. There are also things we can choose to treat as risks or opportunities. In On the Waterfront, protagonist Terry Malloy makes the famous lament, “I coulda had class. I coulda been a contender. I coulda been somebody, instead of a bum, which is what I am,” blaming his brother for persuading him to purposely lose a boxing match for the sure thing “short- end money.” He is not complaining that there was not enough shortend money, but that he sold something that was literally priceless. His brother treated his opportunity like a risk, and managed it. A coward treats risks as dangers, whereas a thrill seeker treats them as opportunities. We call them thin- blooded and hot- blooded, respectively. A coldblooded person treats both dangers and opportunities as risks. Red- blooded refers to people who are excited by challenges, but not to the point of being blinded to dangers and opportunities. To keep this straight, think of the classic movie plot in which the red- blooded hero and his hot- blooded sidekick push aside the thin- blooded person in charge, to fight the cold- blooded villain. We admire the first two people in different ways, feel sorry for the third, and hate the fourth.
Red- Blooded Risk Management In emotional terms, thin- blooded people are motivated mainly by fear, hotblooded people by anger and other passions— or even merely thrills— and coldblooded people by greed. Red- blooded people feel anger and fear and greed like anyone else, but understand successful risk taking is a matter of calculation, not instinct. This is not a self- help book. I do not have any advice for how to achieve this psychological state, if that is what you want to do. What I can tell you is how to compute the red- blooded action in risk situations. It’s mathematics, not psychology. Red- blooded risk management consists of three specific mathematical techniques, which have been thoroughly tested in real- world applications. Although quantitative skills are required to implement them, the ideas are simple and will be explained in this book without math. The techniques are used to: •T urn any situation into a system with clearly delineated risks, dangers, and
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Red-Blooded Risk opportunities. •O ptimize the risks for the best possible outcome. •A rrange things so both dangers and opportunities make the maximum positive contributions. This field was invented by a cohort of quantitatively trained risk takers born in the 1950s. In the 1970s, we rebelled against conventional academic and institutional ideas of risk. We sought wisdom from actual risk- takers, which took us to some disreputable places. In the 1980s, we found ourselves taking risks on Wall Street, and developed the ideas described in this book between 1987 and 1992, although of course most of the ideas can be traced to much earlier work. University of Chicago economics professor Frank Knight, for example, made a distinction between risk, with known probabilities and outcomes, and uncertainty, which is something akin to our dangers and opportunities. But he did this to emphasize the limits of mathematics in decision making under uncertainty. He did not appreciate the power of quantitative methods for separating risk from uncertainty, nor the tremendous benefit from applying mathematics to optimize risk taking. Most important, he failed to see that mathematics can be brought to bear just as fruitfully on nonquantifiable uncertainty as on risk. Knight was a deeper thinker than any of the Wall Street risk takers, but we had far more experience in making successful quantitative risk choices. This group of risk- taking rebels became known as “rocket scientists.” That was partly because several of us actually worked on rockets (I myself spent a summer on satellite positioning, which technically uses rockets, but not the big ones that lift payloads into space; anyway, my contribution was entirely mathematical. I never saw an actual rocket firing except on film, so the experience certainly doesn’t make me a real rocket scientist.), but mostly to capture the combination of intense and rigorous mathematical analysis tied firmly to physical reality, exploration, and adventure. Recall that one of our generation’s defining moments was the Apollo moon landing. We weren’t astrophysicists and we weren’t engineers. We didn’t know exactly what we were, but we knew it was something in between. A more general term for people who use quantitative methods in finance is “quant,” but that term also describes less rebellious researchers with quantitative training who came to Wall Street later and called themselves “financial engineers.” I am aware that “rocket scientist” is a stupid name, both boastful and inaccurate. I didn’t make it up, and don’t use it much. I describe myself as a “quant” with a lowercase q, unpretentious as in, “just a simple quant.” I’m not humble, as you’ll figure out if you keep reading, but I’m not given to overstatement. What I do isn’t rocket science, most of it is trivially simple and the rest is more meticulous care than brilliance. But to be historically accurate, we’re stuck with the term, and it does convey some of the spirit of the group. We contrasted ourselves to people we called “Einsteins,” an even stupider name. We had nothing against Albert Einstein, but we disagreed with people who thought risk was deeply complex and could be figured out by pure brainpower, without actually taking any risk or observing any risk takers. “Einstein” was rarely used as a noun. It was more common as an adjective. “He had a good insight, but went Einstein with it,”
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Aaron Brown or “He used to be a rocket scientist but got offered a tenure track position and went Einstein.” Don’t blame me. I don’t defend the usages, I just report them. The rocket scientists rebuilt the financial system from the ground up. I compare these changes to the differences between a modern digital camera and a point- andshoot film camera from 1980. They look similar. They both have lenses and flashes and shutter buttons. They both run on batteries, in some cases the same batteries. They are used to take pictures of vacations and parties and family members. They cost about the same. From the standpoint of sellers and users, the difference seems to be just an improvement in technology for the same basic device. But for someone making cameras, there is no similarity at all. The modern technology is built on entirely different principles from the old one. From 1982 to 1992 rocket scientists hollowed out the inside of Wall Street and rebuilt it. We didn’t set out to do that; it just happened. Most people, including most people working on Wall Street, didn’t notice the fundamental change. They saw some of the minor external design changes, and noticed one day there was no more film to develop, but missed that something unprecedented in history had been created. At the same time, with even less intention, we figured out the 350- year- old riddle at the heart of probability theory. As has always been the case with probability, practitioners ran ahead of theory. No doubt we will someday have a coherent theoretical explanation of how modern financial risk management works. Until then, all I can do is show you how and why it came into being, and what it is doing to the world.
Risk and Life Risk taking is not just a quantitative discipline, it is a philosophy of life. There are basically two sensible attitudes about risk. The first is to avoid it whenever possible, unless there is some potential payoff worth the risk. The second is to embrace risk taking opportunities that appear to offer a positive edge. The advantage of the second course is that you take enough gambles that the outcome of any one, or any ten or hundred, doesn’t matter. In the long run, you will end up near your expected outcome, like someone flipping a coin a million times. In my experience, people incline to one of these two strategies early in life. Perhaps it’s in our genes. In this context, I always think of a highway sign you can see if you drive from Nice to Monte Carlo. There is a fork, and the sign points right to “Nice Gene” and left to “Monte Carlo Gene.” On that choice, I’m a leftist. That doesn’t mean I take huge risks; it means I take lots of risks. I have learned from others and invented myself ways to balance these to ensure a good outcome, insomuch as mathematics and human efforts can ensure anything. There are three iron rules for risk takers. Since your plan is to arrive at an outcome near expectation, you must be sure that expectation is positive. In other words, you must have an edge in all your bets. Expectation is only an abstraction for risk- avoiders. If you buy a single $1 lottery ticket, it makes no practical difference whether your expected payout is $0.90 or $1.10. You’ll either hit a prize or you won’t. But if you buy a million tickets, it makes all the difference in the world. Second, you need to be sure you’re not making the same bets over and over.
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Red-Blooded Risk Your bets must be as independent as possible. That means you cannot rely on systems or superstitions, not even on logic and rationality. These things will lead you to make correlated bets. You must search hard for new things to bet on, unrelated to prior bets, and you must avoid any habits. In many cases you find it advantageous to make random decisions, to flip coins. For risk avoiders taking only a few big chances, correlation is a secondary concern and flipping a coin for a decision makes no sense. Finally, risk takers must size their bets properly. You can never lose so much that you’re taken out of the game; but you have to be willing to bet very big when the right gambles come along. For a risk avoider, being taken out of the game is no tragedy, as risk taking was never a major part of the life plan anyway. And there’s no need to bet larger than necessary, as you are pursuing plans that should work out if nothing bad happens, you’re not counting on risky payoffs to succeed. While moderation is often a good strategy, I don’t think you can choose a middle way between risk avoiding and risk taking. Consider an investment portfolio. You can invest in high- quality bonds with payoffs selected near the times you expect to need the money, and possibly hedge your bets further by buying hard assets. Or you can buy stocks and hope for the best. If you choose the latter route, the risk-taking approach, you should seek out as many sources of investment risk as you think the market compensates— that is, all the securities for which there is a positive edge. Both strategies make sense, but it’s crazy to split the difference by buying only one stock. You either avoid risk as much as practical, or you try to find as many risks as you can. You could, of course, put half your portfolio in bonds and the other half in diversified risky assets, but this still makes you a risk taker, seeking out as many risks as possible. You just run a low risk version of the strategy. There’s nothing that says a risk taker has to have a high-risk life. In practice, however, once investors take all the trouble to create a broadly diversified portfolio, or individuals learn to embrace risk, they tend to exploit the investment. It’s good that people make this choice young, because each route requires skills and life attitudes that would be fatal to acquire playing for adult stakes. Risk takers must enjoy the volatility of the ride, because that’s all there is. There is no destination. You never stop gambling. Risk avoiders must learn to endure volatility in order to get to the planned destination. The world needs both kinds of people. If you are a risk taker, you need the material in this book to survive, assuming you haven’t already figured it out for yourself. We know a lot about the mathematics of risk taking that no one in the world knew a quarter century ago. If you are not a risk taker, you should still understand the mathematics of risk due to its effect on the world. Quantitative risk models from Wall Street are in considerable disrepute at the moment. I hope to convince you that attitude is wrong. Whether or not I do, I can tell you that these models have changed the world completely, and the pace of that change will only accelerate. So even if you think they are worthless or harmful, it’s worth understanding them. To continue...
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Pablo Triana
The Number That Killed Us A Story of Modern Banking, Flawed Mathematics, and a Big Financial Crisis
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Pablo Triana 978-0-470-52973-7 • Hardback • 304 pages December 2011 • £26.99 / €32.00 / $39.95
Chapter 1 The Greatest Story Never Told Amid all the pomposity that surrounded the analysis of the 2007 credit crisis (“Capitalism is over!,” “The American way is doomed!,” “Hang anyone with a pinstriped suit!”) it was easy to forget what had really happened, and what truly triggered the malaise. Simply put, a tiny bunch of guys and gals inside a handful of big financial institutions made hugely leveraged, often-complex, massively sized bets on the health of the (mostly U.S.) subprime housing market. In essence, the most influential financial firms out there bet the house on the likelihood that precariously underearning mortgage borrowers would honor their insurmountable liabilities. As the subprime market inevitably turned sour, those bets (on occasions many times larger than the firm’s entire equity capital base) inevitably sank the punters, making some of them disappear, forcing others into mercy sales, and sending all into the comforting arms of a public bailout. As these global behemoths floundered, so did the financial system and thus the economy at large. Confidence evaporated, lending froze, and markets everywhere became uncontrollable chute-the-chutes. Investors lost their shirts, workers lost their jobs. It wasn’t a failure of capitalism or a reminder that perhaps we had forgone socialism a tad too prematurely (so far, we haven’t yet heard calls for the rebuilding of the Berlin Wall). The crisis did not symbolize how rotten our system was. While certain bad practices were most certainly brought to the fore by the meltdown, and should be thoroughly corrected, the crisis did not symbolize the urgency of a drastic overhaul in the way we interact economically or politically. What the crisis truly stands for is the failure to prevent a tiny group of mortgage and derivatives bankers (I’m talking just a few hundred individuals here) from recklessly exposing their entities to the most toxic, unseemly, irresponsible of punts. The fact that Wall Street and the City of London were allowed to bet, via highly convoluted conduits, their very existence and survival on whether some folks from Alabama with no jobs, no income, and no assets would repay unaffordable, ill-gotten loans is the theme that should really matter, and not whether we should hastily resurrect Lenin. If capitalism was fine (overall) in May 2007, it should be just as fine today.
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The Number That Killed Us Rather than try to fix beyond recognition an arrangement that overall has served humanity quite well, why not focus on understanding what truly happened and on making sure that it can never happen again? If we don’t address the heart of the matter, instead devoting all our time to distracting platitudes, we may be condemning ourselves to a repeat down the road. We surely don’t want to go through this capitalism-doubting song and dance again five years from now, do we? So the key questions throughout should have been: What really allowed those insanely reckless bets to take place? Several factors were and for the most part have continued to be held responsible for allowing this very specific mess to take place. The conventional list of culprits typically has included the following key malfeasants: a less-than-perfect pay structure at banks, the use of deleteriously complex securities, asleep-at-the-wheel regulators, fraudulent mortgage practices, blindly greedy investors, and ridiculously off-target rating agencies. It is clear that each and every one of those factors played a substantial role and deserves a large share of the blame. But the familiar list has tended to leave out what I would categorize as the top miscreant. While the more conventionally acknowledged elements were definitely required, the carnage would not have reached such immense body count had that prominent, typically ignored, factor not been present. I put forth the contention that that one variable (a number, in fact) ultimately allowed the bets to be made and the crisis to happen. That number is, of course, VaR. In its very prominent role as market risk measure around trading floors and, especially, the tool behind the determination of bank regulatory capital requirements for trading positions, VaR decisively aided and abetted the massive buildup of high-stakes positions by investment banks. VaR said that those punts, together with many other trading plays, were negligibly risky thus excusing their accumulation (any skeptical voice inside the banks could be silenced by the very low loss estimates churned out from the glorified model) as well as making them permissibly affordable (as the model concluded that very little capital was needed to support those market plays). Without those unrealistically insignificant risk estimates, the securities that sank the banks and unleashed the crisis would most likely not have been accumulated in such a vicious fashion, as the gambles would not have been internally authorized and, most critically, would have been impossibly expensive capital-wise. Before banks could accumulate all the trading positions that they accumulated in a highly leveraged fashion, they needed permission to do so from financial regulators. Whether such leveraged trading is possible is up to the capital rules imposed by the policymakers. Capital rules for market risk (under which banks placed those nasty CDOs) were dictated by VaR. So by being so low ($50 million VaR out of a trading portfolio of $300 billion was typical), VaR ultimately allowed the destructive leverage. Had trading decisions and regulatory policies been ruled by old-fashioned common sense, the toxic leverage that caused the crisis would not have been
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Pablo Triana permitted, as it insultingly defied all prudent risk management. But with VaR ruling, things that should have never been okayed got the okay. By focusing only on mathematical gymnastics and historical databases, VaR turned common sense on its head and sanctioned much more risk and much more danger than would have been sanctioned absent the model. VaR can lie big time when it comes to assessing market exposures, unseemly categorizing the risky as risk-less and thus giving carte blanche to the no-holds-barred accumulation of the risky. By disregarding the fundamental, intrinsic characteristics of a financial asset, VaR can severely underestimate true risk, providing the false sense of security that gives bankers the alibi to build huge portfolios of risky stuff and regulators the excuse to demand little capital to back those positions. VaR allowed banks to take on positions and leverage that would otherwise not have been allowed. Those positions and that leverage killed the banks in the end. Thus, we didn’t need all that pomposity calling for all-out revolution. What was, and continues to be, needed is to target the true, yet still wildly mysterious to most, decisive force behind the bloodshed and wholeheartedly reform the fields of financial risk management and bank capital regulation. The exile of VaR from financeland, not the nationalization of economic activity or the dusting-off of Das Kapital, would have been the truly on-target, preventive, healing response to the mess. And yet few (if any) commentators or gurus focused on VaR. You haven’t seen the CNBC or Bloomberg TV one-hour special on the role of VaR in the crisis. This is quite puzzling: The model, you see, had already contributed to chaos before and had been amply warned about by several high-profile figures By blatantly ignoring VaR’s role in past nasty system-threatening episodes as well as its inherent capacity for enabling havoc, the media made sure that the populace at large was kept unaware of how their economic and social stability can greatly depend on the dictates of a number that has been endowed with way too much power by the world’s leading financiers and policymakers. VaR, in fact, may have been the greatest story never told. Imagine that someone has just had a terrible accident driving a bright red Ferrari, perhaps while cruising along the South of France’s coastline. Not only is the driver dead, but there were plenty of other casualties as the recklessly conducted vehicle crashed into a local market, at the busiest hour no less. The bloodbath is truly ghastly, prompting everyone to wonder what exactly happened. How could the massacre-inducing event have taken place? Who, or what, should be held primarily responsible? Public outrage demands the unveiling of the true culprit behind the mayhem. After a quick on-site, postcrash check technicians discover that the Ferrari contained some seriously defective parts, which inevitable malfunctioning decisively contributed to the tragic outcome. So there you have it, many would instantly argue: The machine was based on faulty engineering. But wait, would counter some, should we then really put the blame on the car manufacturer? What about the auto inspectors, whose generously positive assessment of the vehicle’s quality (deemed superior by the supposedly wise inspectors) decisively
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The Number That Killed Us encouraged the reckless driver to purchase the four-wheeled beast? In this light, it might make sense to assign more blame onto the inspectors than on the manufacturers. However, this is not the end of the story. Just because automobile inspectors attest to the superior craftsmanship of the Ferrari doesn’t mean that you can just own it. While the (misguidedly, it turned out) enthusiastic backing by the inspectors facilitated the eventual matching of driver and car, it wasn’t in itself enough. Necessary yes, but not sufficient. Unless the driver positively purchased the red beauty, he could never have killed all those people. And in order to own a Ferrari, you absolutely must pay for it first. It turns out that our imaginary reckless conductor had not paid in cash for the car as by far he did not have sufficient funds, but had rather been eagerly financed by a lender. He had bought the Ferrari in a highly leveraged (i.e., indebted) way under very generous borrowing terms, being forced to post just a tiny deposit. Now, this driver had a record of headless driving, having been involved in numerous incidents. It appeared pretty obvious that one day he might cause some real trouble behind the wheel. And yet, his financiers more than happily obliged when it came time to massively enable the purchase of a powerfully charged, potentially very dangerous machine. Without such puzzlingly friendly treatment and support, the future murderer (and past malfeasant) would not have been able to afford the murder weapon. Yes, he was obviously personally responsible for the accident. Yes, the manufacturing mistakes also played a decisive part. Yes, the okay from the inspectors mightily helped, too. All those factors were required for the fatality to occur. But, at the end of the day, none of that would have mattered one iota had the Ferrari not been bought. So if you are looking for a true culprit for the French seaside town massacre, indiscriminately point your finger at the irresponsible financiers that ultimately and improbably made possible the acquisition of the dysfunctional vehicle by the speed demon who, having trusted the misguidedly rosy expert assessment, inevitably took his own life and that of dozens of unsuspecting innocent bystanders. This fictional story serves us to appreciate the perils of affording excessive leverage to purchase daring toys, and so to illustrate why the 2007 meltdown took place. If you substitute the reckless driver with investment banks, the red Ferrari with racy toxic securities, the auto inspectors with the credit rating agencies (Moody’s, Standard & Poor’s), and the eager financiers with financial regulators, then you get a good picture of the process that caused that very real terrible accident. In order for the wreckage to take place you obviously needed the wild-eyed bankers to make the ill-fated punts, the toxic mechanisms through which those punts were effected (you can’t have a subprime CDO crisis without subprime mortgages and CDOs), and the overtly friendly AAA ratings (without such inexcusably generous soup letters the CDO business would not have taken flight as it did). But at the end of the day, the regulators allowed all that to matter explosively by sponsoring methodologies (VaR) that permitted banks to ride the trading roller coaster on the cheap, having to post up just small amounts of
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Pablo Triana expensive capital while financing most of the punting through economical debt. Such generous terms resulted in a furious amalgamation of temptingly exotic assets. And when you gorge on such stuff in a highly indebted manner the final outcome tends to be a bloody financial crash. If VaR had been much higher (thus better reflecting the risks faced by banks), the positions would have been smaller and/or safer. This was a subprime CDO crisis because VaR allowed banks to accumulate subprime CDOs very cheaply. Without the model, the capital cost of those intrinsically very risky securities would have been higher, making the system more robust. Why exactly can sanctioning leveraged punting be so dangerous in the real financial world? What’s so wrong with gearing? Why can an undercapitalized banking industry pose a threat to the world? In short: It is far easier for a bank to blow up fast if it’s highly leveraged. Given how important and influential banks tend to be for a nation’s economy, anything that makes it easier for banks to go under poses a dire threat to everyone. The bad thing about leverage is that it substantially magnifies the potential negative effects of bad news: Just a small reduction in value of the assets held by a bank may be enough to wipe out the institution. Conversely, the less leverage one has the more robust one is to darkish developments. A bank’s leverage can be defined as the ratio of assets over core equity capital (the best, and perhaps only true, kind of capital, essentially retained earnings plus shareholders’ contributed capital). The difference between assets and equity are the bank’s liabilities, which include its long-term and short-term borrowings. For a given volume of assets, the higher the leverage the less those assets are financed (or backed) by equity capital and the more they are financed by debt. That is, financial leverage indicates the use of borrowed funds, rather than invested capital, in acquiring assets. Regulated financial institutions face minimum capital requirements, in essence a cap on the maximum amount of leverage they can enjoy. A bank with $15 billion in capital may want to own $200 billion in assets, but if policy makers have capped leverage at 10 (i.e., a 10 percent capital charge across the board) the bank must either raise an additional $5 billion of capital (so that those $200 billion are backed by a $20 billion capital chest, keeping the leverage ratio at 10) or lower the size of its bet to $150 billion; under such regulatory stance, $15 billion can only buy you $150 billion of stuff. Were regulators to become more permissive, say increasing the maximum leverage ratio to 20 (from a 10 percent to a 5 percent minimum capital requirement), the bank could now own as much as $300 billion in assets without having to raise extra capital. It is clear that minimum capital rules will impact the size of a bank’s balance sheet: If those rules are very accommodating, a lot of stuff will be backed by little capital (we’ll see in a moment how accommodat ing a VaR-based rules system can be). VaR can easily lead to a severely undercapitalized banking industry; few things can create more economic and social problems than a severely undercapitalized banking industry. If an entity has no equity it is said to be worth zero, as the value of its assets is equal to that of its liabilities (i.e., everything I own I owe). If assets go down
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The Number That Killed Us in value, those losses must be absorbed by the equity side of the balance sheet (equity is actually defined as the overall amount of an entity’s loss-absorbing capital, or the maximum losses an entity can incur before it defaults on its liabilities); if those losses are severe, the entire equity base may be erased before there’s time or chance to raise some more, leaving the bank insolvent. Therefore, the more equity capital (i.e., the less leverage), the more a bank can sustain and survive setbacks. Shouldn’t then banks try to finance their assets with as much equity as possible? After all, bank executives are supposed to be trying hard to preserve their firms’ salubriousness. Well, it’s not that simple. Banks, almost by definition, must run somewhat leveraged operations, otherwise making decent returns might be hard; after all, the prospect of such positive results is what attracts equity investors in the first place. At the same time, equity capital can be expensive (since equity investors, unlike creditors, have no claims on a firm’s assets and are first in line to absorb losses they would demand a greater rate of return) and inconvenient (as new shareholders dilute existing ones and may imply a redesign of the firm’s board of directors) to raise, especially when debt financing is cheap and amply available. So banks will almost unavoidably have x amounts of equity backing several times x amounts of assets. Leverage, in other words, is part of banking life. Gearing needn’t be destructive as a concept. But if the size of the gearing and/or its quality get, respectively, too large or too trashy big problems could beckon. If a bank has $10 million in equity backing up $100 million in assets (a 10-to-1 leverage ratio), a 1 percent drop in the value of the assets would eat away 10 percent of its equity, an ugly but possibly nonterminal occurrence. However, if those same $10 million had now to sustain $500 million in assets (50-to-1 gearing), for the same decrease in assets value the decline in equity would be 50 percent, a decidedly more brutal meltdown. The key question, naturally becomes: What’s the chance that the assets will drop in value? If we believe it to be zero, then perhaps a higher leverage would be the optimal choice even for those banks most eager to run a safe and sound operation: If assets are not going to fall by even that modest 1 percent, I would rather go with the 50-to-1 ratio, as any increase in assets value will yield a greater return on equity (in this case, plus 50 percent versus plus 10 percent). Thus, if the assets being purchased are iron-clad guaranteed to never descend in worth, more gearing will be no more harmful, return-wise, than less gearing while offering more juice on the upside. Leverage, in other words, can be a great deal when asset values go up all the time (or almost all the time) since for every increase in value, I get wonderful returns on capital. That is why banks often prefer a lot of leverage rather than just a little bit of it. It is obviously better to make 50 percent positive returns on capital than 10 percent positive returns on capital. Traders and their bosses get bigger bonuses when they are generating 50 percent returns on capital than when they are generating 10 percent, so building up massive leverage is a big temptation for them. VaR can be wonderful for those purposes, given how easy it is for the model to churn out very low capital requirements. But this only works fine if
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Pablo Triana your trading portfolio is behaving well, otherwise the plus 50 percent bliss could quickly transform into a minus 50 percent nightmare. Of course, in real life few assets (if any) come with a guarantee never to lose value. Since even the soundest-looking possibilities can be worth less, more leverage can be safely ruled as more daring than less of it, for a given asset portfolio. Having said that, the nature of the portfolio can also dictate whether the leverage ratio is prudent or not. Whether a larger leverage ratio will be a more harmful choice will depend on the quality of the asset side of the balance sheet. A 10-to-1 ratio can seem wisely conservative or recklessly wild, depending on what type of assets we’re talking about. Illiquid, complex, toxic assets that can sink in value abruptly and very profoundly may render the $10 million cushion extremely insufficient, extremely rapidly. Relatively more trustworthy and liquid plays, like Microsoft stock or World Bank bonds, should (in principle) be more foreign to sudden debacles, rendering the $10 million grandiosely sufficient. In fact, a, say, 30-to-1 gearing ratio exclusively on standard assets may be considered a safer, more insolvency-proof capital structure than 10-to-1 gearing exclusively on toxic assets, as it could be deemed more likely to witness a 10 percent tumble in the weird stuff than a 3 percent decline in the vanilla stuff (of course, this cuts both ways: During good times, a rapid 10 percent rise in complex securities may be more feasible than a 3 percent vanilla uplift, which is naturally why the nasty stuff can be so tempting). Naturally, the very worst thing would be a higher leverage structure comprised largely of high-stakes punts; essentially, a recipe for sure disaster. Encouraged and enabled by the low equity requirements sanctioned by VaR and other tools as well as by the very economical access to short-term credit, most of the world’s leading financial institutions spent the first years of the twenty-first century hard at work arriving at such a perilous state of affairs. Banking leverage was not invented by VaR; it existed before the model showed up. Not even very large leverage was invented by VaR (in the pre-VaR days, the rules essentially allowed banks to build unlimited leverage on debt securities issued by developed countries, an asset class that, as more recent events have showcased is not exactly devoid of problems). But VaR did signify a revolutionary, potentially very chaotic development, pertaining to banking gearing: thanks to VaR, vast leverage on vastly toxic assets was now possible, something that the pre-VaR financial police did not allow. To continue...
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Paper Money Collapse
Paper Money Collapse The Folly of Elastic Money and the Coming Monetary Breakdown
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Detlev S. Schlichter 978-1-1180-9575-1 • Hardback • 288 pages September 2011 • £26.99 / €32.00 / $39.95
Chapter 1 The Fundamentals of Money and Money Demand Money is the medium of exchange. Money is useful only if there is exchange, and exchange is possible only if property or, more precisely, private property exists. In a communist commonwealth, where every resource is owned and allocated by the state, there would be no place for money. In contrast, capitalism can be defined as “a social system based on the explicit recognition of private property and of nonaggressive, contractual exchanges between private property owners.” In such a system money will quickly become indispensable. Of course, private property owners can exchange property without the help of money. But in such a barter economy people cannot realize the full benefits of trade because transactions are possible only whenever both parties want precisely what the other party has to offer. Person A will sell his good “p” to person B only if whatever B has to offer in exchange, let us say good “q,” is precisely what A wants. The same is naturally true for person B. If one of the two parties has nothing to offer that the other party has use for, then the trade will not take place. Economists call this condition “double coincidence of wants,” and it severely restricts the number of transactions that will occur in a barter economy. An additional impediment to trade is that many goods are indivisible. Double coincidence of wants and limited divisibility hamper not only the exchange of physical goods for other physical goods but also the exchange of services. Despite these inevitable drawbacks of a barter economy, the exchange of goods and services started most certainly on such a limited scale with people exchanging what both parties to the trade found immediately useful. It was inevitable that over time certain goods came to be accepted in exchange not because they were themselves of direct use to the recipient but because they could easily be traded again with someone else for other goods or services. These goods could be cloth, beads, wheat, or precious metals. Whatever they were, they acquired a special place in the universe of traded goods in that they became the most marketable, and thus could help facilitate more transactions. Now person B can buy product “p” from person A, although A has no use for B’s product “q.” B can instead sell “q” to C, D, or E, accept the medium of exchange from them as payment, and use that to buy “p” from A. Person A will accept the medium of exchange in the knowledge that others will also accept it in exchange for goods and services.
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Detlev S. Schlichter Thus, no more than rational self - interest on the part of trading individuals is required to explain the emergence of media of exchange. It is in the interest of everybody who wants to participate in the free, voluntary, and mutually beneficial exchange of goods and services to use media of exchange. Indeed, it is in the interest of everybody to ultimately use only one good as medium of exchange, the most fungible good, and that good is called “money.”
The Origin and Purpose of Money Money is not the creation of the state. It is not the result of acts of legislation and its emergence did not require a society - wide agreement of any sort. Money came into existence because the individuals who wanted to trade found a medium of exchange immediately useful. And the more people began to use the same medium of exchange, the more useful it became to them. Money is a social institution that came about spontaneously. Other such institutions are the concepts of private ownership and of clearly delineated property and the rules and standards according to which property titles can be transferred. All these institutions came into being because people saw the immediate benefit from extended human coop eration, of cooperation that goes beyond the immediate family or clan. Such cooperation allows an extended division of labor that enhances the supply of goods and services for everyone who participates in it. Such wider human cooperation requires markets; it requires trade and thus private property and money. It is my impression that today many people would argue that we need a state, that is, a territorial monopolist of legalized coercion and compulsion, to provide society with money, to protect property, and to establish the laws and regulations to allow for peaceful exchange. Their assumption seems to be that without the state there would be no money, no laws, and no rules of exchange, and no respect for private property. This is, in my view, a misrepresentation of the historical record and a misunderstanding of the essential power of voluntary cooperation of self - interested individuals as explained by the science of economics. Not only does the existence of money not require a state organization to issue it, but it is also inconceivable that money could have come into existence by any authority (or, for that matter, any private person or institution) declaring its unilaterally issued paper tickets money. That money does exist in this form today is obvious. Yet, as the Austrian economist Carl Menger showed more than one hundred years ago, money could have come into existence only as a commodity. For something to be used, for the very first time, as a medium of exchange, a point of reference is needed as to what its value in exchange for other goods and services is at that moment. It must have already acquired some value before it is used as money for the first time. That value can only be its use - value as a commodity, as a useful good in its own right. But once a commodity has become an established medium of exchange, its value will no longer be determined by its use - value as a commodity alone but also, and ultimately predominantly, by the demand for its services as money. But only something that has already established a market value as a commodity can make the transition to being a medium of exchange. Which commodity was used was up to the trading public. Not any good was equally useful as money, of course. Certain goods have a superior marketability than other goods. As previously mentioned, it is no surprise that throughout the ages and through all
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Paper Money Collapse cultures, whenever people were left to their own devices and free to choose which good should be used as money, they most always came to use precious metals, in particular gold and silver, as these two possessed the qualities that were ideal for a medium of exchange: durability, portability, recognizability, divisibility, homogeneity, and, last but not least, scarcity. Indeed, the very rigidity of their supply made them attractive. The fact that nobody could produce them at will made them eligible. They could be mined, of course, but that took time and involved considerable cost. And their essentially fixed supply contrasted with the inherently flexible supply of the goods and services for which money was being exchanged, thus ensuring that exchange - relationships were not further complicated by a volatile money supply. To the extent that a good begins to function as money, its value is no longer determined alone by any specific use - value that the money commodity may otherwise have but also by its monetary exchange value, by its function as facilitator of trade. When gold and silver became media of exchange their market value was no longer determined solely by their original use - value as metals in industrial production or as jewelry. Now people had demand for gold and silver as monetary assets. This additional demand, and any changes in this demand, naturally affected the prices of these metals. When the demand for money went up, the prices of gold and silver went up, assuming that all else remained unchanged; and when the demand for money fell, the prices of gold and silver fell, again assuming that all else remained the same. Gold and silver acquired an additional element of value independent of their use - value, and that was their pure exchange value as media of exchange. Once a commodity is accepted as a medium of exchange, its usefulness as a medium of exchange cannot be enhanced by additional creation of this good. The serviceability of money is not increased by a bigger supply. Other goods deliver a more satisfying service to the public if their supply is increased. More cars can transport more people; more TV sets can entertain more people; more bread can feed more people. These things are goods because they have use - value, they can directly satisfy the needs of their owners. This holds likewise for the means of production, such as tools, plants, and machinery. Although they do not satisfy the needs of consumers directly, their usefulness lies in their ability to help in the production of goods and services that will ultimately satisfy the needs of consumers. However, to the extent that a good is used as money, its usefulness does not lie in any ability it may have to meet any needs directly but lies exclusively in its marketability, in its general acceptance as a medium of exchange. Its value to its owner lies in its exchange value, not its use - value. Money is valued because of what you can buy with it. If an individual has more money, that individual can buy more goods and services from the producers of goods and services. But if society overall has more money, meaning that society has a bigger quantity of the money substance, society is not richer. It has more of the medium with which to exchange things but it has not more things to exchange. The exchange - value, the purchasing power of every unit of the money commodity or money substance, will be different but this is unrelated to society’s overall wealth, meaning the overall quantity of goods and services. It follows from this that — outside of the extreme cases of acute scarcity or abundance of the monetary asset — any amount of the good money is optimal. Any quantity of the money commodity or money substance will be
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Detlev S. Schlichter sufficient to allow the money commodity to fulfill all functions of a medium of exchange. To illustrate this important point, let us revisit the community of A, B, C, D, and E that we met earlier in this chapter when demonstrating the benefits of money. Let us assume this community uses gold as a medium of exchange and the available supply of gold and the various preferences of the trading individuals result in an exchange relationship of 1/10th of an ounce of gold for 1 unit of A’s product “p” and 1 unit of B’s product “q.” Person A is willing to sell his product “p” to person B and accept 1/10th of an ounce of gold in return for it. Person B has acquired the gold by selling his product “q” to another member of the community. Person A can equally use the gold to buy goods and services from C, D, or E. The benefit that this community derives from using the available amount of gold as a medium of exchange is the same as if the community had a smaller or larger supply of the precious metal at its disposal. Let us assume that the supply of gold was smaller and that the exchange ratio would turn out to be 1/20th of an ounce of gold for 1 unit of “p” or “q” . Or, we could imagine a third scenario, in which the community had a much larger quantity of gold and the exchange ratio would be, let us say, 1/5th of an ounce of gold for 1 unit of “p” or “q”. Obviously, with different overall quantities of gold being available, not only would the exchange relationship between gold and the products “p” and “q” be different, but also would the exchange relationships between gold and any other tradable good and service. If the amount of the medium of exchange that is available to the community is different, it follows naturally that the purchasing power of each unit of the medium of exchange is different. However, this does not — and, logically, cannot — affect the usefulness of the medium of exchange. The benefit that society derives from using gold as a medium of exchange is identical in every one of these cases. As gold functions as a medium of exchange and does not deliver use - value but only facilitates trade, the size of its available supply is entirely immaterial. Once a good is used as money, practically any amount of that good is optimal for fulfilling all the functions that a medium of exchange can fulfill. As long as the good in question has all the attributes listed here and is therefore the most fungible good and widely accepted, nothing stands in the way of it delivering all the services that a medium of exchange can ever deliver. All the benefits that society can derive from using a medium of exchange can be derived from any amount of the medium of exchange. The goods gold and silver fulfilled two functions, one as industrial commodities and items of jewelry, the other as media of exchange. If we consider only the former, then more gold and silver means more industrial commodities and more beautiful things that fulfill our desire for decoration and beauty. In this respect, more gold and silver means more wealth. But if we consider only gold and silver’s role as media of exchange, then an increase in the supply of gold or of silver does not enhance their serviceability as money and does not enhance overall wealth. To the extent that a society uses its gold and silver exclusively as money, this society is not richer if it has more gold and silver. Today, money is simply a piece of paper with numbers printed on it. Whether a pile of banknotes adding up to ten thousand dollars is a lot of money or not depends entirely on what you can buy with it. When there was a much smaller quantity of dollar banknotes, or book entry claims to dollar banknotes, circulating in the U.S. economy, ten thousand dollars could buy you more goods and services than today. The exchange
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Paper Money Collapse value of money is different — its purchasing power is different — if the supply of money is different. This is true for any type of money. But this is all. The U.S. economy does not work any better or any worse if the overall supply of what is used as money, whether it is gold, silver, or specific paper tickets, is larger or smaller. This is the logical consequence of money having pure exchange - value and no direct use - value. Societies that have more goods and services are richer. Societies that have more “paper money” or book entry money are not richer. Societies that have more commodity money are richer only to the degree that the monetary commodity can be reemployed as an industrial commodity or as an item of jewelry. To the extent that the monetary commodity is used as money, society is not richer if it has more of it at its disposal.
The Demand for Money An important concept that leads to much confusion and misunderstanding is the concept of the demand for money. How much of the monetary asset is desired? Demand for money is not demand for wealth. In colloquial speech it is often assumed that everybody wants more money, that the demand for money is therefore limitless. But what people mean by this is the demand for wealth, for control over goods and services, but not demand for the medium of exchange as such. Money has no direct use - value. Goods and services have use - value. Thus, nobody would want to hold all his wealth all the time in the form of money. He would at least have to exchange some of his money for food, clothes, and accommodation, thus converting some of his money holdings into goods that have use - value. And even a person who has sufficient wealth to acquire all the consumption goods that he presently desires would probably not hold the remaining wealth entirely in the form of money but invest it in debt or equity claims or other investment goods. The monetary asset has important disadvantages to other goods and services and claims to goods and services. It neither satisfies needs directly as consumption goods do, nor does it help produce consumption goods in the future as investment goods do. Holding the monetary asset thus involves opportunity costs. The one essential advantage that the monetary asset has over all other goods and services is its general acceptance in return for goods and services. Like no other asset, it can be exchanged for any other good or service instantly and with no or minimal transaction costs. This marketability gives its owner a flexibility that no other good can provide. The demand for money is demand for readily usable purchasing power. People have demand for money because they want to be ready to trade. The demand for money can also be called the demand for cash holdings although the term demand for money will be used here. It is that part of a person’s overall possessions that is most readily exchangeable for goods and services on the market. It is the uncertainty and unpredictability of life that causes people to hold the monetary asset. People hold some of their wealth in money because they want to have the flexibility to engage in exchange transactions quickly and spontaneously. The relationship between the demand for money and the number and volume of overall transactions, however, is tenuous. We can illustrate this with the following thought experiment: If we imagine for a moment an economy in a state of equilibrium, or, as the
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Detlev S. Schlichter economist Ludwig von Mises, whose work we will come across many times in the course of our investigation, put it, an “evenly rotating economy,” an economy in which the same procedures and activities unfold with unvarying regularity again and again and in which therefore every transaction is completely predictable, there would be no need for anybody to hold money. Everybody could precisely match the time and the size of their outlays with the time and the size of their incoming revenues. Excess income could always be fully invested. In a world of no uncertainty, there would still be transactions but no need to hold a monetary asset. Everybody simply needed an accounting unit but nobody had any actual demand for money holdings. Of course, such an economy is pure fantasy. It is entirely a theoretical construct that helps the economist mentally isolate, analyze, and describe certain procedures. It could never exist in the real world. The mental construct of the evenly rotating economy is, within limits, useful for economic science. But these models struggle to account for the demand for money, which is a phenomenon of the real world of uncertainty and unpredictability. How much of the monetary asset anybody wants to hold is ultimately subjective but it is clear that it depends crucially on the purchasing power of the monetary unit. In our example above of a community of A, B, C, D, and E, how many ounces of gold a person will want to hold as his cash balance will be different in each scenario. If the community has relatively large quantities of gold available for use as money then the purchasing power of each unit of gold will be — all else being equal — relatively low. Let us assume that exchange relationships determined by market exchange come out at 1/5th of an ounce of gold for one unit of “p” or “q” . In this scenario the same person will want to hold more gold than if the community overall had relatively small quantities of gold and the purchasing power of each unit was relatively high (for example 1/20th of an ounce of gold buys one unit of “p” or “q” ). The purchasing power of each ounce of gold is different in the two scenarios. Therefore, the flexibility that each ounce of gold provides as a medium of exchange to its owner is different. As demand for money is demand for readily exercisable spending power, a person with an unchanging demand for money will hold different quantities of the monetary unit if money’s purchasing power is different. The same applies to fiat money. Nobody has demand for a specific quantity of banknotes or a specific number of coins, just as under a gold standard nobody has demand for a specific amount of gold. Demand for money is always demand for readily exercisable purchasing power. It is purchasing power that one demands, not the money substance as such, whatever it happens to be. It follows that every quantity of the monetary asset is sufficient. Different quantities of the monetary asset only mean that different exchange ratios to goods and services develop, that the monetary unit’s purchasing power is a different one. And it is purchasing power that we demand when we demand money. Naturally, every person has it in his power to adjust holdings of the monetary asset precisely according to personal preferences. Of course, a person’s overall wealth sets a limit to how much of the monetary asset the person can own. Also, every person must have a bare minimum of nonmonetary goods to stay alive (food, shelter). But within these limits every person can hold exactly the amount of money he wants to hold. If a person wants to hold more money, he can sell assets or reduce money spending. If a person wants to hold less money, he can spend the money on goods and services. It would be
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Paper Money Collapse absurd to make the claim that a person really wanted to hold less money but cannot reduce his money holdings. If nobody in the economy accepted the surplus money in exchange for goods and services, then this form of money would have ceased to function as money. After all, general acceptance is what makes money money. By the same token, no person could claim to want to hold more of his wealth in the form of money but be unable to exchange his other possessions for money. In that case, one would have to question if the person’s other possessions were not worthless and if the person already held his entire wealth in the form of money. Because of the high marketability of the monetary asset, which is the precondition for its function as money, every person holds exactly the quantity of money that the person desires to hold. But what if everybody in society wanted to increase money holdings? Would that not require somebody to come up with a plan to produce money? The answer is no. The demand for money can always be satisfied by a change in money’s price, meaning its purchasing power. If people have a higher demand for money, they will sell goods and services to raise their money holdings. This is, as we have seen, what every single individual does in order to raise money holdings. If the desire for higher money balances is widespread or, as we may assume to make the point very clear, if everybody wanted higher money holdings, everybody would start selling goods and services or reduce money - spending on goods and services. As a result, the money prices of goods and services would fall and the purchasing power of the monetary unit would rise. But the rise in money’s purchasing power is precisely what will satisfy the additional demand for money. This process will last until people are again happy with the quantity of money they hold. The increased demand for money is increased demand for purchasing power in the form of money, and this demand will be fully met by a fall in money prices, meaning the rise in the purchasing power of every unit of money. The key difference between money and all other goods and services is again that money has only exchange value and not use - value. If demand increases for any other good, somebody has to produce more of that good for this demand to be satisfied. Additional demand for TV sets and cars can be met only by producing additional TV sets and cars because only additional units of these goods can satisfy additional demand for their services. Demand for cars and TV sets is demand for the use - value that these goods provide. Money, however, does not need a producer. Every amount of money is optimal. If the public wants to hold more money, nobody has to produce more money. As money has exchange value, the extra demand for money is synonymous with extra demand for money exchange value and can be met instantly by a drop in prices, that is, a rise in the purchasing power of the monetary unit. By selling goods and services in order to raise money balances, as all people do who want to raise their individual money balances, the community collectively exerts downward pressure on prices and the result ing drop in prices is in itself sufficient to satisfy the increased demand for money. No new money needs to be produced to meet additional demand for money. Conversely, if the demand for money declines, people will “sell” money holdings for goods and services. The result will be a rise in the money prices of goods and services, meaning a drop in the purchasing power of money. This is the unique feature of a medium of exchange. Demand for and supply of money are coordinated by changes in purchasing power, not by adjustments to the physical supply of monetary units. Just like all individuals can hold,
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Detlev S. Schlichter at every point in time, exactly the money purchasing power they desire simply by buying or selling goods and services, so the economic agents in aggregate can hold, at every point in time, exactly the money purchasing power they desire simply by selling or buying goods and services and thereby adjusting the purchasing power of the existing stock of money. Here is another way of looking at this specific feature of money: It is a fact of history that fundamentally different substances have functioned as money. Nobody will deny that gold and silver functioned as money, and nobody can deny that, today, pieces of worthless paper and even electronic book - entry claims to such pieces of paper function as money. What made these substances “money” was evidently their acceptance in voluntary exchange for goods and services rather than any ability of these substances to satisfy needs directly. But if money is money only because it is generally accepted as money in exchange for goods and services that have use - value, then its value must be pure exchange - value. Once we agree on this point, all the conclusions of this chapter follow logically: Once a good is established as money, no additional quantities of this good are needed. The performance of an economy is independent of the supply of money. Within reasonable limits, any quantity of money is optimal. Money production is redun dant. Supply of and demand for money can always be brought in line by changes in money’s purchasing power. Society overall and every individual in society can satisfy their demand for the monetary asset without the help of ongoing money production. These conclusions are necessarily true. The reader can check them for himself. As a user of money the reader will know why he holds money and what determines the amount of money he wants to hold at any point in time. We all hold cash balances because we want to be ready to trade. If we did not value the flexibility, the readiness of instantly engaging in economic transactions with others, we could as well put all our wealth in consumption goods that satisfy our needs or in investment goods that generate returns and that deliver more consumption goods to us in the future. Holding cash involves opportunity costs. We hold money balances only to the extent that we value the flexibility that they give us higher than the additional things we could enjoy if we spent the money. How high we value that flexibility is subjective. It varies from person to person and for the same person will change from time to time, depending on personal circumstances. What drives the desire for flexibility does not have to concern us here. But whatever our desire for “spending flexibility” is, how this translates into demand for a specific quantity of money naturally depends on the purchasing power of the monetary unit. Demand for money is therefore demand for purchasing power in the form of money. It follows that changes in money demand can always be met by changes in money’s purchasing power. This explains why societies can function and grow with inelastic commodity money. Inelasticity of supply is no hindrance for a commodity to be used as money. Or to put it differently, there is no basis for the widespread belief that somebody has to meet the growing demand for money in a growing economy — or in an economy that may for other reasons have a growing demand for money — by creating more of the money substance. This fallacy is based on an inappropriate transfer of the laws of supply and demand from the sphere of goods that are demanded for their use - value to the sphere of money, which is demanded only for its exchange - value. To continue...
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The Little Book of Trading
The Little Book of Trading Trend Following Strategy for Big Winnings Michael W. Covel
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978-1-1180-6350-7 • Hardback • 210 pages August 2011 • £13.99 / €16.00 / $19.95
Chapter 1 Stick to Your Knitting While today Sunrise Capital is a very successful money management firm, it did not start that way. It began with three visionary men who dared to be different. They saw opportunity and chased it. One of the founders put it this way: They stick to their knitting. They follow their trading rules. I said this in the Introduction, but it bears repeating: To learn trend following trading, to make a great deal of money with this strategy, requires confidence. The best way to instill that confidence in you is to show you, start to finish, successful traders’ paths. As you read this book you may find yourself asking why it is relevant when these traders started. You may be asking why it is relevant to learn about their performance in the 1970s, 1980s, 1990s, and so on. It’s relevant because it shows consistency of strategy. This is not some “got lucky trading” method that works for one month, one year, or one decade. It has worked literally month by month for decades. In fact, by the time you finish this book I hope you look carefully at consistency of performance at all times for all strategies—not just trend following. If you find a strategy that doesn’t have performance proof behind it, you’re gambling. With that out of the way, let’s jump in. If you learn anything from this book, let it be the simple lesson: Stick with it. There will always be distractions: Breaking news banners, surprises, and unpredictable chaotic events are everywhere, but you can’t let yourself be fazed. Here is one big secret: Top traders don’t pay attention to that stuff. They have found, through hard work, diligent study, and perhaps a little luck— that their ability to stick with a trading plan is far more important than knowing or worrying about what their neighbor is doing. Go back with me to the mid-1970s. Jack Forrest, a doctor practicing and teaching in San Diego, had built up his savings to begin trading his own account. It wasn’t a lot of money, but it was enough to get going. He began investing in stocks, but it didn’t take long for him to see that commodity futures, and their big up and down moves, would be much more lucrative. Like many, Forrest got his start trading with fundamentals— understanding balance sheets, supply, demand, and so on. He realized that his ability to analyze markets was not very good. He talked to local brokers and they had no clue either. No one seemed to have a logical or systematic approach— a trading system. Many were just gamblers. Others chalked up their trading to having a feeling for what was going to happen. We have all had those
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Michael W. Covel experiences. That’s how most everyone is initially exposed to the markets. Some people say, “Boy, it really looks like fundamental analysis has a lot of potential.” If you ask why it has potential, the usual response is “It just does.” But when you realize that a seat of the pants approach to the markets, otherwise known as using fundamentals, doesn’t work, what can you do? Head toward systematic techniques to trade the markets. That means looking at what has happened historically. It starts with reading stories about famed investors such as Jesse Livermore, Dickson Watts, and Richard Donchian, and other great traders who have used systematic approaches throughout the years. There is no shortage of these kinds of books to check out. One major commonality from these authors and their decades ago wisdom: Get on the big move and stay with it. The obvious questions: “Well how do you get on the big move?” “Try different things?” “What are those things?” “Buy a set of trading rules from someone else?” Forrest started experimenting with technical trend trading ideas, and the idea of channel breakouts. Channel breakouts occur when a stock or commodity is trading in a tight channel, then starts trading at a price higher than the top of the channel. What do I mean by tight channel? Apple is trading at 300, 305, 300, 305, 300 and then boom jumps to 325. It is breaking out of the “channel” of tight prices. As Forrest went along experimenting, buying breakouts was working well, so Forrest began trading that way. Some traders take years to find a profitable system, but Forrest had some luck on his side in that he found the right kind of approach—an approach very different from what most others were practicing. With these kinds of trading rules you can become totally systematic. You can write your rules out and follow them with rigid discipline. Forrest’s first system was very simple: buying weekly breakouts. It was a 12-week breakout system. Enter long or enter short when the market makes a 12-week high or low. What markets can you trade like this? While the markets were different when Forrest started—all physical commodities—systematic trend following rules allow you to trade almost all markets today. That means stocks, currencies, gold, oil—you name it.
Night Class While Forrest was doing his own research and trading, he had an interesting experience early on. He took a night class from legendary trader Ed Seykota, during the early 1980s. Seykota reinforced trend trading rules and trading psychology. Seykota was teaching a four-week channel breakout system with a filter—only to be applied if the market was going up (from the long side). He did not apply the system if the market was decreasing (no short selling). A filter is set up as a hurdle for taking a trade signal (your breakout). You would only trade from the long side if the most recent six-month breakout was up. Trend following can be simple, but sticking with it is the hard part. It was more than just rules though. Because Seykota had been so successful with a systematic approach, it gave Forrest the confidence that he too had a shot at that type of
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The Little Book of Trading success. It’s the same reason I want to introduce you to successful trend following traders throughout this book: to give you that same confidence.
Teaching Friends Jack Forrest and Gary Davis were both doctors working in research at the University of California—San Diego. They were also tennis partners. Forrest desperately wanted someone to bounce trading ideas off of and who could trade his same systematic trend trading way, but he had no luck initially finding a trading comrade. Forrest had about a five-year start on Davis before they even began discussing trading. Even though they were good friends, Davis had no idea of Forrest’s trading passion. How did Davis finally learn of Forrest’s passion? It all started with the mention of pork bellies while sitting on the beach after a tennis match. Yes, they were talking pork belly futures contracts—the type traded at the CME. Pork bellies? Just a fancy name for bacon. While talking about pork bellies on the beach that day, Forrest said that he had “all of these books on trading” and told Davis that if he was interested in learning about the markets he was welcome to borrow them. Davis powered through almost 20 books in a week’s time. It was the beginning of his trend following trading career. Does this sound like an accident? Does this sound like Davis had no preset plan to be a trader? You would be correct. Davis enjoyed his faculty work, but never thought it was the perfect spot for him. He felt like a misfit among the rest of the faculty.
The First 17 Trades—Losers—or Don’t Ask Around Davis was just about to turn 34 as he started trading with a trend following program he had learned from author J. Welles Wilder, Jr. He lost on his first 17 trades, but once he made one tweak, which he believed is the only reason he is still trading now, he was back in the game. What was Davis’s Aha! moment? Dissect people who have been successful in almost any form of trading long-term and who have been trading some form of trend following or momentum trading. Successful fundamental traders often have great success because they’ve been in the right place at the right time. After recovering from his first big losing streak, Davis realized that he had no idea what anybody else was doing—beyond his book reading. One thing he did know was that most traders last six months and lose all their money. Worse yet, it seemed successful traders lasted three years and then lost all of their money. He expected that his trading career would follow in a similar fashion. More apt to be involved in independent study, Davis never did like talking to other traders much. He felt the key to his trend trading strategy was to stick with his plan, not changing rules around after looking at someone else and saying, “He has got this great idea. Oh, I’ll try that.” As Forrest and Davis were each going down their separate, and growing trading paths, their future partner, Rick Slaughter, had already known for some time that the markets were where he wanted to be. He could remember literally being at his grandfather’s knee learning about stocks. As a young man, corporate law was Slaughters’ interest, but plans shifted. On his
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Michael W. Covel twenty-first birthday he placed his first trade. He was one of the first to program a trading system into a computer in the 1970s. Not long after, Slaughter set up shop and was trading trend following systems for clients.
Friends and Family Plan Davis came to the conclusion, after a period of rigorous and profitable testing with his own money, that there was significant potential in scaling the size of his trading strategies. He sought the help of friends and family for capital to seed a larger pool of money. Davis founded and launched what would come to be known as Sunrise Capital Partners (known as Sunrise Commodities at the time of inception) in 1980—with the gentle prodding of Ken Tropin (who then was with Dean Witter brokerage, but who today runs one of the most successful trend following firms in the world). Davis was not super high tech at the time. He preferred handwritten charts and price quotes from the print version of the Wall Street Journal. That should be an inspiration for those of you who want to make excuses for not having the perfect this or that. Just do it, right? However, there is an even larger lesson at play here. Today, many are at a disadvantage in testing their trading ideas. It is a computer-generated love affair now with commercials promoting 24/7. However, it takes experience to be able to recognize what’s real and what’s luck coming out of the data. Back in the days before the popularization of computers, testing was done by hand. You saw every trade on paper. Everything was obvious. Back then all you needed was to look at a chart, and the longer you looked at a chart, the more you realized how similar they were. The latest gizmo or hype is not the key to your trading success. Davis continued on his trajectory of success with Sunrise, and by the mid-1990s was successfully managing over $200 million and routinely delivering double-digit annual returns for investors. Forrest at this point had met and become partners with Rick Slaughter. The two were enjoying success as a team, albeit at a more modest level of assets under management than Davis. Acting on instinct in early 1995, the three industry pioneers merged to form Sunrise Capital Partners.
Markets Are Not Efficient Many people think you can’t beat the market. Markets are efficient they say. The academics believe it as religion. The story goes something like this: Even if you see a dis crepancy in the markets, by the time you try to take advantage of it, it will be gone. So, instead buy a mutual fund and hold on until you are six feet under. Trend followers don’t accept that jaded worldview. Rick Slaughter may have been young, and a touch arrogant about some things in life and perhaps in the markets, but he never bought the efficient market hypothesis. When he was exposed to Eugene Fama, the founder of the efficient market hypothesis, he was in graduate school and the theory was just taking hold. Slaughter perceived a hole in it. He could not see how markets were efficient, when he and many of his peers were consistently making money. His thinking, then and now, is vastly different from that of almost all typical Wall Street views. The reality? Markets are often in “tail” situations that can produce sizable profits—
35
The Little Book of Trading profits that, over time, will significantly outweigh losses that may occur when markets are not operating within tails. When I say tail, think back to that stats class you probably hated. The tail of the bell curve is what I mean: extreme events that are supposed to be very rare, but actually happen quite regularly in the markets. Meaning, we all know the world is chaotic. We know surprises happen. We know that trying to explain the world with a perfectly symmetrical bell curve, a normal distribution, is not smart . . . so why not build a trading strategy to take advantage of that? How do you do this? Once a potential trend signal is hit within a market, various filtering techniques take place (not exactly the early ones mentioned with Seykota, but in the same spirit). You need to look at the volatility of the market in question and determine whether the movement is simply noise or, instead, the onset of a price trend. Because it is impossible to know the difference in many instances, as a general rule, you should scale back the size of your initial trade in a situation where there is high volatility, placing relatively larger initial trades in times of lower volatility. The key is to make sure you never miss a potential big trend. You always want to put some kind of trade on when your system says enter as your price trigger hits. If you are wrong, you have stops to protect your capital, to protect your downside. Believe in the basics: The trend is your friend. It is a powerful tool and that means you can never miss a trade. After all, you never know which move is going to be the mother of all moves. One of the lessons you can learn from the men at Sunrise: They jump on every trade; however, how much they risk on those trades changes over time, as well as how many pieces those trades are broken into. Are most trades going to be profitable? No. But you don’t know which ones are going to be winners or losers, so you have to move on every trade. Am I being redundant? Just a little! But this is so important to accept. Just as you move on every trade, you must protect yourself on every trade. Protecting your downside is critical to trend following success, but sorely taken for granted by most investors—even by the so-called legendary fundamental investors who pollute TV regularly.
Follow the Leader Logical rules are mission critical! So do like the leaders do. At the time a trade is placed, regardless of its size, assign it a pre-set stop loss so that in the event a perceived trend immediately reverses, only a very small amount of capital is lost. In addition to this predetermined money stop, all trades should be assigned a pre-set trailing stop that will activate, and then accelerate if a perceived price trend begins to fulfill itself. You do this so if a trend reverses after a run-up in price, at least some of the profits earned from the trade are realized. You want to try to have the highest exposures on when a trend is most likely to continue and the lowest exposures on when a trend is least likely to continue. Generally speaking, you want to trade all markets in a similar fashion. However, there are some markets and sector-specific rules that help differentiate them. It is not unusual to have money stops, trailing stops, and profit targets in a market such as wheat that are different from those used in the euro. To continue...
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Ken Fisher with Lara Hoffmans
Markets Never Forget buy now (But People Do) How Your Memory Is Costing You Money and Why This Time Isn’t Different Ken Fisher with Lara Hoffmans 978-1-1180-9154-8 • Hardback • 240 pages November 2011 • £19.99 / €24.00 / $29.95
Preface Hope Springs Eternal Bob Hope (1903–2003) was huge when I was young. Funny, funny, funny! Whether in the Road to . . . movies with Bing Crosby (Hope was in 52 major flicks), with the US armed forces overseas wherever conflict occurred at his own personal danger, on TV, doing stand-up, etc. Hope was everywhere. And every performance since 1938 included his anthem song, Thanks for the Memory (words by Leo Robin, music by Ralph Rainger and first recorded by Hope and Shirley Ross). Hope was huge and beyond great. And hope springs eternal. Then and now! But, sadly, our memories aren’t so functional. Fact is, our memories are beyond terrible when it comes to economic and market realities. People forget. So much! So often! So fast! Stuff that happened not long ago—and more often than not. And it causes investing errors—pretty commonly humongous ones. Maybe Hope should have been singing, Pranks for My Memory. Because for a fact our memories play pranks on us in markets, and always have and we never learn. We forget facts, events, causes, outcomes, even feelings. And because we forget, we tend to be hyper-focused on the here-and-now and immediate past—behavioralists call it myopia. We tend to think what we see is new and different—and significant— when pretty often we’ve seen the exact same thing before or something so close to it and history is littered with similar examples. This species-wide tendency to myopia isn’t accidental—it’s evolutionary. Humans evolved over millennia to forget pain fast. If we didn’t, we wouldn’t do crazy things like hunt giant beasts with sticks and stones, or plow our fields again after drought, hail, fire, what-have-you destroyed our crops. And for sure no female would ever have more than one kid! But we do forget, and fast. Forgetting pain is a survival instinct, but unfortunately, that means we also forget the lessons. Then, too, though people individually forget, markets don’t. History does not, in fact, repeat—not exactly. Every bear market has a distinct set of drivers, as does every bull market. But human behavior doesn’t change—not enough and not very fast to matter. Investors may not remember how panicked/euphoric they were over past events. They may not remember they had the exact same repeating fears over debt, deficits, stupid politicians, high oil, low oil, consumers spending too much, consumers
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Markets Never Forget (But People Do) not spending enough, etc., etc., etc. But markets remember very well that details may change, but behavior generally doesn’t. For decades I’ve heard otherwise intelligent business folks express (as fact) opinions about current phenomena being extreme when history shows they’re not extreme or even unusual. Examples are plentiful and throughout this book. But if you point out to someone that his opinion-stated-as-fact is actually false, you will run into a brick wall because he simply won’t believe it. They know. They read it in the media or online. Their friends agree. It’s a fact to them. It may also be a false fact and one easily known if we didn’t simply forget so easily. But because we forget as individuals, we do so as a society, too. This is why investors, as a group, make the same mistakes repeatedly. Don’t think investors are error-prone? CXO Advisory Group measures so-called gurus—folks who make public market forecasts in a variety of forums. Some also manage money professionally (as I do—they include me in their guru rankings), some don’t and instead do newsletters, write columns, etc. But everyone on the list is a professional in some way at making public market proclamations. And the average accuracy of this group, as measured by CXO? As I write, it’s 47%.1 (See Chapter 1 for how they rate me.) I can’t ever recall seeing that average over 50%. And these are pros! This group of well-known, professional market prognosticators is, on average, right less than half the time! If that’s the case, you know non-professional do-it-yourselfers can’t have a much better record. (In fact, the average non-pro investor likely does much, much worse. See Chapter 2.)
We Can’t Remember That We Forget Why do investors fail to be right even half of the time? A huge single reason: We forget! And hence, we don’t really learn from past mistakes. Investors get overwhelmed by greed or fear but also forget that being greedy or fearful didn’t work out for them in the past. But they also forget they were wrongly greedy or fearful, because feelings now seem so much stronger (even though they’re probably not). They get head-faked by what later turns out to be normal volatility—because they forget they’ve lived through volatility many times before. They overreact—either too bearish or too bullish—based on some widely dispersed media report that later turns out to be highly overstated or just plain wrong and often backward. Why? They forget the media is often and repeatedly wrong for the exact same reason—it’s made up of humans. They get terrified, for example, by huge market volatility in 2008 that’s fairly consistent with the bottoming period of any bear market, though they lived through something similar in 2003 and more so in 1974. And they missed the huge boom off the bottom in 2009—never could imagine stocks could move up so fast—though we saw something similar (to a lesser degree) in 2003. (And 1975-1976—and again and again and again in past bear markets and new bull markets—but 2002 and 2003 were just a few years ago and investors should at least remember that!) Yes, 2008 was volatile relative to recent history, but not compared with a bit longer history—but investors forget to check history, too. Learning from history is scant
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Ken Fisher with Lara Hoffmans in our world. First, history is usually boring to most. And second, most folks can’t quite believe in their myopic minds that what happened a few too many decades ago has any bearing on today. In reality, markets don’t change much in the basics of how they function because the people whose interactions make them work don’t change much over time. One of the most basic lessons of behavioral psychology is that humans are slow to change and learn. More examples: Investors believe their favorite politician from their political party is just better for stocks, even though very recent history should teach that no one party is better or worse overall for stocks (Chapter 7). They think their favorite asset class is just better over time, forgetting the not-so-distant past when they were proven wrong (Chapter 6). And they forget that they forgot the last time because it is too painful to do otherwise! And the time before that! Repeatedly making the same errors based on the same misunderstandings and misperceptions. Fortunately, you needn’t be right 100% of the time to do well at investing. Such a thing is impossible. And if you’re banking your financial future on being 100% right, you’ll be sorely disappointed—for a fact because no one is ever right all the time. Rather, you want to aim to be right more than wrong. The all-time best investors were wrong an awful lot. In investing, if you’re right 60% of the time, you’re a legend—and 70% of the time you’re a god. Just being right slightly more than 50% of the time means you likely do better than most investors—including the overwhelming bulk of investment professionals! In my view, a good way to improve your results is aiming to reduce your error rate. If you see the world more clearly and don’t fall prey to the same misperceptions that plague most other investors, you can start making fewer mistakes. This is, in essence, what most of my books, Forbes columns and other writings are about and have always been about—looking at the world and trying to see it differently but more correctly (in my view) and then determining how to act or not act—all largely centered on error rate reduction. And you’ll still make lots of errors, but that’s ok. And one great tool for seeing the world more clearly and reducing your error rate is simply improving your memory by a steady and regular application of even just a bit of market history. This book shows you how.
History as a (Powerful) Lab If you go to work tomorrow wearing a green shirt and say, “I’m going to win a million dollars today, because everyone knows when you wear a green shirt on Tuesdays, you win a million dollars,” your colleagues will grab a giant butterfly net. You’re predicting an outcome that 1) has no historical precedence and 2) lacks any rooting in reality. You see that clearly. Yet every time I talk about history’s role as a powerful tool in capital markets forecasting, inevitably some say, “Past performance is no indication of the future!” Well, that’s not why you should look at history. Use history as a laboratory—to understand the range of reasonable expectations. For example, when event X happens, the outcomes are usually B, C or D, but can be anywhere from A to F. So, I know that anything could happen, but odds are greater something like A through F
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Markets Never Forget (But People Do) happens, with odds still higher on B, C and D. And the odds of something outside that range happening is very, very low, so it would take exceptional extra knowledge to bet on something like that happening. Then, too, you should consider other factors that might affect the outcome—the world of economic, political and sentiment drivers. Maybe Event Y is happening simultaneously, which likely reduces the odds of D happening and increases B. Heck, maybe Event Z is likely to happen soon, which usually near-guarantees a Q, so even though it’s an outlier, I know to throw that into my bucket of probabilities. That’s how I would have you think—in terms of the probabilities. At its basics, investing is a probabilities game; it’s not a certainty game. But what’s interesting is the same people who huff that history isn’t a useful guide will still say, with absolute certainty, things like: “This high debt will ruin the economy and drag down stocks.” Or, “The economy can’t recover with high unemployment.” Really? And what’s the basis for that? Presumably, if you say with certainty some condition leads to some other condition, that’s because you’ve observed that in the past or can otherwise measure it historically. Either that, or sound economic fundamentals says it must be so. Fair enough? And if a lot of people say Event X must cause Outcome Y, there’s no harm in checking to see if that’s what happened historically most of the time. Because if it hasn’t happened before, it’s unlikely to happen now whether most folks think it will or not. Yet most people in the media, blogosphere or social circuit go nuts when I say there’s absolutely no historical precedence—zero—for this particular thing causing that particular outcome once it has become socially accepted that it will. I’ll not cite facts and history here—because we will later in the book. But more of the time than not, things people think of as new, bigger-than-ever, worse-than-ever and certainly causal of predictable outcome are babbling about things we’ve seen many, many times before and can document don’t cause the outcomes that are widely and socially expected. Critics love to criticize the use of market history to debunk widely held views. Yet, when people claim things like the economy can’t expand because unemployment is too high, they too are trying to make a historical claim. Just so happens theirs doesn’t hold up since we have a long history of levels of unemployment here and around the world to measure the claim against. In effect, saying high unemployment causes economies to slow or stocks to tank is identical to the magic green shirt claim. It provably isn’t so. It’s not observable in a lab (i.e., history) and it makes no economic sense for a firm to start aggressively hiring if its sales haven’t recovered. Sometimes, weird stuff happens. You wear your magic green shirt and you do win the lottery! Hooray! But, no one in their right mind would bet on you winning the lottery again, even if you wore your green shirt and bought 1,000 lottery tickets. Winning the lottery is a possible outcome—the odds are just near-immeasurably low. And there’s not good evidence the green shirt was a material driver in the previous win. And that you may feel good in green (my favorite color) doesn’t change the odds one iota. That’s why history is powerful. Investing, as said earlier, is a probabilities game, not a certainties game. No one can ever say with any certainty what will happen.
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Ken Fisher with Lara Hoffmans (Anyone claiming otherwise is probably trying to sell you something very bad for you—or just rob you blind.) Just so, while investing is a probabilities game, it’s not a possibilities game. It’s possible you wear a green shirt and win a million dollars! It’s possible an asteroid hits Earth and obliterates life as we know it. It’s possible you buy a penny stock that turns out to be the next Microsoft. There are endless, almost infinite possibilities. But you can’t bet on things just because they are possible. You can’t build an investment portfolio around endless possibilities—whether good or bad. (You probably wouldn’t get out of bed in the morning if you dwelt on every possibility.) You must instead consider the range of likely outcomes and then form forward-looking expectations based on probabilities. You will be wrong—a lot. Expect it. But if you can craft reasonable probabilities, you likely start getting better results over time (while still being wrong an awful lot). If you suffer memory loss, that gets very tough to do. But if you remember that you have a lousy memory and can train yourself to use history to understand probabilities, you can better understand what’s likelier (or not at all likely) going forward. And you can begin reducing your error rate.
A Walk Down Memory Lane Throughout the book, I use quotes from old news stories. They’re meant to be illustrative, not comprehensive. For example, if I want to show that people frequently fear a double-dip recession early in a new recession—and this isn’t a new phenomenon indicative of uniquely new trouble—I show a selection of historic quotes from older news stories. They’re meant to show that the sentiment existed. Could I have found quotes saying, “No way! Double dippers are crazy! There’ll be no double dip,” to counter every instance? Sure! But I don’t think that’s useful to you. Typically, people tend to seek things reconfirming what they already believe, and ignore or discount things not supporting their worldview. This is a known cognitive error people who study all forms of behavioralism (including behavioral finance) call confirmation bias. We find evidence to confirm our biases and make ourselves blind to evidence contradicting them. Behavioralists have documented why this is basic to the human condition of successful evolution. It makes us more confident and willing to try harder repeatedly in the face of the brutishly difficult conditions we’ve faced in normal human evolution. But it hurts in markets. Further, more investors are prone to be naturally skeptical—bearish—than are prone to be naturally optimistic. Not always and everywhere, and even the most dugin bears can have times when they’re euphorically bullish (though it’s usually a bad sign when dug-in bears become bullish). But overwhelmingly, since stocks rise much more than fall (over two-thirds of history), folks counterintuitively tend to be bearish more than bullish. That concept—that people overwhelmingly tend to be fearful when they shouldn’t—is at the very core of why so many fail to get the long-term results they want. It’s behind the quote Warren Buffett is famous for (though it’s not his—he just made it broadly popular): You should be greedy when others are fearful and fearful when others are greedy. I’m not advocating contrarianism. That doesn’t work, either. Just because people mostly think one thing doesn’t necessarily mean the opposite will occur, which is the
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Markets Never Forget (But People Do) pure definition of contrarianism. Instead, I advocate to not blindly follow the herd. The fact is, most people, if already bullish or bearish, usually seek out and believe news stories and pundits supporting their existing view. So, yes, you can find plenty of news stories that rationally say at any given time, for example:
• A recession isn’t likely. • This is likely just a correction. • Global growth is fine. • Corporate profits are healthy; don’t panic. • And so on.
But, if you fail to remember history and are misguidedly bearish more often than not, you likely discount the non-alarmist stories and seek out those that bolster the views you want to have, anyway. Ditto if you’re misguidedly bullish. Which is why I decided to highlight just a smattering of quotes instead of turning this into an 800-page academic tome. (Plus, it’s just fun to see how in history, people have the same exact fears we have now, and will have 1, 3, 7, 23 and 189 years into the future.) So feel free to quibble with the quotes I pulled. I don’t expect to change most readers’ views because I know most readers are hard-wired to find evidence that confirms their prior biases and make themselves blind to evidence that contradicts them. But you should feel free to have fun with your own hunt for past stories, headlines, quotes—Google’s timeline feature is simultaneously useful and insanely fun. The New York Times also has a huge archive of past issues you can access online. And any decent-sized library will have tons of back publications on microfiche—a bit less high-tech than Google, but will surely bring back memories of study carrels in the college library (if that’s your thing). My point is, none of the sentiments or behaviors I write about here are anything new. And you can use that to your advantage if you can start using history as a tool to counteract what can sometimes be a faulty memory. Also, this is my eighth book—which I can hardly believe. Though my outlook from year to year changes based on my expectations for the next 12 months or so, my overriding worldview changes much less. I’m a firm believer in capitalism and the power of the capital markets pricing mechanism. As such, I believe supply and demand are the two sole primary determinants for stock prices—though there are myriad factors impacting both supply and demand. Therefore, if you’ve read my past books, you may notice some charts are repeated in some books (though updated with the most recent data). And that’s intentional—if there’s a powerful way to illustrate some concept, I don’t mind re-using that. However, I may describe the chart in a new way or use it in an entirely new context. In fact, in this book I use quite a few charts from my 1987 book The Wall Street Waltz—many of them were too good to not use again. After all, in a book about the usefulness of history, I think it’s only fair I use a bit of my own history. So I hope you’ll forgive me if you’ve seen some images before—some market truths endure not just the decades of my 40-year professional career—but much, much longer. So let’s get to it! And thanks for the memory.
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Alan Bjerga
Endless Appetites How the Commodities Casino Creates Hunger and Unrest
buy now
Alan Bjerga 978-1-1180-4323-3 • Hardback • 208 pages October 2011 • £18.99 / €22.40 / $27.95
CHAPTER 1 Floors, Fields, and Famines Greg O’Leary is walking the Chicago Board of Trade wheat pit near the close of a day’s session in mid-December, 2010. Prices are up today. Egypt, the world’s biggest wheat buyer, has bought 110,000 tons of hard-red winter wheat from the United States, which ships more of that crop than any other country. Jordan has bought another 150,000 tons. Exports have boomed since a summer drought pushed Russia, Egypt’s main supplier, to slap an export ban on its harvest. That’s driving North African and Arab nations to U.S. sellers to stave off food shortages and higher prices. The day’s most traded wheat contract, the one that requires delivery in March, ends the session up one-and-a-half cents, closing at $7.6475 a bushel—the exactness of buyerand-seller haggling in Chicago means futures prices are rounded to the hundredth of a cent. It’s an up-and-down day in the pit. Prices had been as high as $7.71 earlier, which would have been the biggest jump in a week. Then the dollar started strengthening, and that made buyers worry that the exchange rate may make U.S. wheat less competitive than Canada’s or Australia’s. Wheat prices are up 41 percent for the year, and investors who had stayed on the sidelines during the global financial crisis are piling back in. After the market closes, Barclays Capital will announce that commodity assets under big-bank management have reached a record $354 billion. That’s one-third more than one year ago and four times what it was five years ago. The world economy is growing again. That means more meat, more metal, and more gasoline as the world’s producers try to meet the planet’s endless appetites. O’Leary is on the floor partly to make money, partly to share market gossip with his friends, and partly out of nostalgia. He started working in the pit in 1980, a farm kid from Newton, Illinois, fresh out of high school, running messages for a trader. The frenetic pace didn’t leave time for college—“I went to the college of the Chicago Board of Trade,” he says—but over three decades he accomplished something much more difficult than what many degrees require. He mastered markets—the math, the methods, and the willpower needed to successfully buy and sell soft-red winter wheat, the variety of the grain traded in Chicago. O’Leary makes his money watching the spread in prices among different wheat contracts, looking at the differences between March, May, July, September, and December
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Endless Appetites prices and pouncing when one seems out of line with another. Profits off the spread can be very small, but they add up over time. Chicago trading is all-consuming and high-risk, with fortunes made and lost in a day—as long as you can keep your accounts in order, you can keep playing, and for more than 160 years, it’s been a way of life. Collectively, the bets average out into some of the most stable food prices in the world. The runner from Newton became an independent broker in 1993. Today O’Leary heads his own firm, a member of the world’s most important commodities exchange. He takes his spot in the octagon, gets an employee’s update on the flow of the market, and readies for the close. He doesn’t actually have to do any of this. Electronic trading has swallowed open outcry in the Board of Trade futures pits. On a platform where more than 150 traders used to elbow one another for position in the terraced octagon where they stand to make their bids and their offers for wheat, maybe one-tenth that many are present for today’s 1 p.m. close, which, along with the opening bell, is the most heavily traded period. The pits where traders buy and sell options contracts, a more-complex instrument that’s tougher to translate to the electronic world, are still close to full. In the adjacent futures pit some traders are sitting on the top step, reading newspapers, chatting, or gazing elsewhere, counseled by their thoughts. All of them, including O’Leary, have wireless laptops slung over their shoulders so they can buy and sell electronically—which they do in their offices, at home, and on their vacations—while anticipating a stray offer to be made on the physical floor. Commodities exchanges from Sydney, Australia, to Minneapolis, Minnesota, have ended open outcry altogether. Chicago’s remaining pit traders also trade electronically, where more volume and greater volatility—and thus greater potential for profit and loss— awaits. O’Leary says the floors still serve a purpose. Sometimes a seller doesn’t want the electronic universe to immediately know he’s selling grain. Sometimes, a seller just wants to negotiate with another human being. “Some days I get mad and I’m like, I’m not even going to go electronic,” O’Leary says. “I’m just going to bid and offer. I don’t want to play pinball.” He sighs. “Eventually it’s all going to be gone. You’ll reach a point where you’re not going to be able to sell it the way we do it.’’ A bell rings to note that closing is moments away. O’Leary leaps to place his bids, and for two minutes, sales fly fast, like old times. Trading closes. Everyone goes back to their e-mail, except for a couple younger brokers who have challenged one another to a pingpong game upstairs. Chicago is covered in snow. The market settles its last contracts, and the floors are swept of a court of confetti-like receipts, artifacts of momentary profits and losses. Traders linger at their desks, mull their fortunes or lack thereof at nearby bars, and step into the cold Lake Michigan air, hustling home through the holiday night. Chicago is asleep. Morning is warming Tunisia. Mohamed Bouazizi, who supports his mother, uncle, and younger siblings by selling produce from a street cart in Sidi Bouzid, a four-hour drive from the capital, Tunis, begins his daily walk from his three-room stucco house to the market in his hometown, where nearly one-third of the workforce is unemployed and the nearest movie theater is 80 miles away. Bouazizi buys produce from farmers and sells it to passersby. Sometimes his sales are stymied by authorities, who harass him and block his efforts to sell fruit, saying he doesn’t have a proper permit.
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Alan Bjerga Today his food, which he bought on credit, is confiscated. His mother later says her son is publicly humiliated by a city official, a woman who slaps him when he tries to protect his apples. His scale is taken, too, and his cart is overturned, scattering its contents. Food prices are rising in Tunisia, a country that imports more than twice as much grain as it produces. Bouazizi has had enough. He heads to the local government office to complain. No one listens to him. Outraged by his treatment, shortly before noon he douses himself with paint thinner and sets himself on fire in protest. The fire sears his clothes onto his body and burns off his lips. He lingers in his hospital bed while his rage at Tunisia’s gov ernment sparks nationwide protests against high unemployment, political repression—and the high cost of the food sold from street carts and supermarkets. The protests spread. President Zine El Abidine Ben Ali, for more than two decades the strongman of Tunisia, unsuccessfully attempts to defuse the disturbances by announcing a massive jobs program to lower youth unemployment, belatedly visiting Bouazizi at his bedside, and feigning sympathy for the frustration his own government has created. The protesters greet his gesture with derision, attacking police stations and government offices. Bouazizi dies of his burns in less than three weeks. Ben Ali’s regime outlives Bouazizi by 10 days. The street vendor’s death intensifies the protests, and the violence, and the president flees the country. Riots spread to Algeria, shortly to be followed by protests in Egypt, where an annual $3 billion in subsidies for food-buyers isn’t enough to curb outrage at rising bread prices. Tensions are building in Libya, which imports 90 percent of its grains. Bread becomes a common theme of the North African and Middle East revolutions that erupt. Baguettes are held aloft by protesters. Frying pans, tin-pots and water buckets are the new suits of armor—an unleavened pancake taped across one’s head is useless against a bullet but powerful as a symbol. Chicago wheat is still rising. The United Nations has officially put world food prices at a record high. In Tunisia, Algeria, Egypt, Syria, and Yemen, throughout North Africa and the Middle East, bloodshed is an additional cost. The price of food—the cost of a loaf of bread in a supermarket, brought to you via a global system of farmers, purchasers, processors, distributors, retailers, and consumers— some with more money than others—some with more information than others—some with more varieties than others—the system that in many ways decides who gets to eat and who doesn’t—the system that connects Greg O’Leary, to a family budget, to Mohamed Bouazizi, to a revolution, to you—starts with a simple question: What’s it worth? For Hugo Alejandro and his buyers, it’s worth the long haul. The white-gravel road from Estili, Nicaragua, grinds nerves and revives old injuries. The drive to the tomato farm is supposed to take 20 minutes. I’ve spent more than an hour veering among outcroppings of white-chalk rocks and ribbons of pavement that are modern for one mile and moonscape the next, trying not to crack my skull against the ceiling of the SUV—a veteran of the winding roads of rural Nicaragua—and still, no tomato farm in sight. Just rocky road and mountains and endless, disorienting turns. Santos Palma, the Catholic Relief Services manager driving the SUV, jokes that the drive will do me good. “Tienes que ver el campo para saber donde comprar su finca en Nicaragua,” he says—you have to see the countryside so you know where to buy your farm in Nicaragua. My Spanish is limited, so I don’t try to tell him I’ve heard a variation of
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Endless Appetites his joke before. I fiddle with my camera, which isn’t working right, and hope this ride ends soon. This is the last day of my five-month, four-continent quest for answers. I would like to end it with bones intact. We’re wondering if we’ll have enough gas to get back to Estili. I am not looking forward to being stranded on an isolated rural road the night I’m to leave Managua. Santos is unworried—of course, he started his Catholic Relief work as an emergency coordinator immediately after Hurricane Mitch hit in 1998, so he’s dealt with bigger concerns than my red-eye flight. Just when we start serious discussions about turning back, we arrive at the farm of Hugo Alejandro. The farmer grows six acres of tomatoes, corn, cabbages, and onions in a field nestled in the sparsely populated highlands of northern Nicaragua. He’s lived in the region his entire life, and he carries a daily reminder of its turbulence: a wrist that bears a silver-dollarsized lump that’s the legacy of a Contra rebel bullet that pierced his body and ended his two years as a draftee in the Sandinista army during the 1980s, fighting for control of the country. When asked to sign his name, Alejandro, now in his midforties, hands the notepad to his wife. He has never spent a day in school. And until four years ago, his tomatoes seldom traveled far from his farm. Alejandro has become an expert in the latest methods of growing tomatoes, as have his children, all of whom have made it through at least sixth grade. The perishable, but profitable, fruits and vegetables he grows are aided by drip-irrigation technology that reduces energy and water use, and they’re being sold in supermarkets owned by a new buyer that demands consistent quality and exact food-safety standards—Walmart, which has expanded into groceries in Latin America. ACORDAR, a U.S. Agency for International Development project with partners that include Catholic Relief Services and Lutheran World Relief, is helping Alejandro’s family with training and financing. The spring harvest is beginning. Alejandro is holding ripened tomatoes in his stronger right hand. “We have to produce better vegetables if we want the supermarket to buy vegetables from us,” he says in Spanish. “People who buy in the supermarket have money, and they want quality for their money.” We spend about half an hour on his property, talking about irrigation, his children, and how the new supermarkets give him extra income he uses to buy fertilizer to boost yields of the crop that feeds his family as well as the grocery shoppers of Estili and Managua. Time is short because the drive took too long, and it’s best to be on the highway before dark. We settle in for another bone-rattling hour, likely the last I ever spend on this road. Tomorrow I’ll be back in the United States at a reception toasting press freedom near the U.S. Capitol dome. Alejandro will have his harvest, and these roads. To haul tomatoes. Abebech Toga, an Ethiopian farmer and mother of six living in the country’s Southern Nations region, wants to send her children to college. She markets her corn and her fairtrade coffee through her local cooperative, and she studies market trends everywhere from the local outdoor bazaar in her town of Sodo to the Chicago Board of Trade. She hears the latest prices over the radio and through her cell phone, and the information— soon, she hopes, to be accompanied by better roads—connects her to the local, regional, national, and international marketplace that needs her crops. Like Alejandro, Toga is a smallholder farmer, called such because she farms a small
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Alan Bjerga plot of land in places where subsistence production and incomes are common. The walls of her mud-hut home are decorated with posters of the Periodic Table, the English alphabet, and President Barack Obama, all meant to inspire her children. She is the designated trainer of other farmers in her village, showing them how to reduce moisture in their crops and prevent losses after harvest through an initiative offered through the World Food Programme called Purchase for Progress. The initiative attempts to create a market for growers of corn like Toga who need reliable buyers for the surplus they don’t consume themselves. Eventually, when the program exits her area, the hope is that she will have the training and experience to sell high-quality corn at fair market prices to become a competitive businesswoman in a better-fed Ethiopia. “A farmer needs a market,” she says. Toga and Alejandro are trying to do what every human tries to do—stay nourished, be healthy, and create a better life for their families. For many of the world’s poorest people, many of them farmers in rural areas but also living in cities, many of them living in impoverished nations but some of them in the richest nations on earth, that task is becoming more difficult. For nearly one billion, it is at times impossible. The world is in a new era of rising and shifting food costs that thwart solutions even as suffering increases around the globe. Hunger that declined for decades now stubbornly refuses to fall further as high prices and turbulent weather have stopped three decades of progress in its tracks. In 2009, hunger affected a record number of people as costs fluctuated after a price spike that began in 2007 started pushing more people into poverty. Another surge in 2010 sent prices to a new record early the next year, at levels twice where they were five years earlier. From 2007 to 2009, more than 60 food riots erupted worldwide, leading to violent deaths in Egypt, Cameroon, and Haiti and putting the number of global hungry on a trajectory that, in 2009, topped a billion for the first time. (See Table 1.1.) The food-price spike of the past decade has returned in this one. Starting with the drought that withered wheat in nations of the former Soviet Union in 2010, a new round of unrest began with food riots in Mozambique in September, gained traction in Tunisia, and ultimately became a crucial part of the volatile blend of youth unemployment, long-simmering dissatisfaction with corrupt rulers, and political awakening that has touched off demonstrations from Morocco to Oman, toppled dictators in Tunisia and Egypt, and fed civil war in Libya. Frustration with the price of bread, gasoline, and other consumer staples fed the riots, with governments unable to calm the discontent. Low-income countries are especially vulnerable to instability when food prices rise and have been for decades, a 2011 International Monetary Fund report found; more frequent rises in food prices creates more frequent unrest. Dissatisfaction with the price of groceries, and its part in an explosive mix of politics and outrage in developing regions, has brought crop supply-anddemand, normally the realm of agricultural economists, to public attention. By April 2011, World Bank President Robert Zoellick warned that the planet was one more shock away from a full-blown food catastrophe. As high food prices pushed an estimated 44 million people into poverty, according to the World Bank, forecasts for global hunger were rising, and the United
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Endless Appetites States, food supplier to the world, struggled through a flooded spring and scorching summer just to keep up with demand.
TABLE 1.1 Number of Undernourished People in the World (in Millions) and Proportion of Undernourished People in Developing Countries
Source: “The State of Food Insecurity in the World,” United Nations Food and Agriculture Organization, 2010.
The losses due to hunger aren’t only today’s. Malnutrition stunts children’s growth, weakens immune systems, and permanently lowers mental development, ending what little chance poor economies may ever have of developing their human capacity and competing with the rest of the world, according to Jeffrey Sachs, head of the Earth Institute at Columbia University and former director of the UN Millennium Project, which fights poverty in famine-prone regions. “This isn’t a short-term problem or fluctuation,” he said. “The effects of hunger now last for generations. What we have right now is a large and rapidly growing world economy that is pressing against its limits. We’re facing a world of scarcity.” The failure to bring food security—the condition in which people know they will have reliable access to affordable nutrition—to the world isn’t presently a failure of having enough food. World agriculture produces more calories per person, per day, than it did in the 1970s, even as the planet’s population doubled. Crop and livestock production today is adequate to feed everyone, with food to spare—the world produces almost 2,800 calories per person each day, well above the 2,100 needed for adequate nutrition. Hunger comes from a lack of available food, caused by the disruption or disappearance of supplies or an inability to buy what’s in stores. In a cruel irony, the people most trapped by hunger are often farmers themselves, stuck at subsistence levels that tip toward famine when crops fail and money is unavailable for necessary nutrition. Uncertainty over one’s next meal isn’t strictly a developing-world problem: About one in six Americans struggled to have enough food at some point in 2009. Hunger in richer nations, however, is less connected to volatile prices than in poorer regions. Food is more available in developed nations, as evidenced by the coexistence of hunger with obesity, which affects more than one-third of the U.S. population and more than 20 percent of the population in a half-dozen other countries. Problems with food waste, a major factor of inefficient food distribution, are also different. Rich countries throw away food bought from a store, while in poorer places food never even gets there because of inadequate storage. About 40 percent of food waste in sub-Saharan Africa happens in farms or warehouses. Better storage alone would save up to 20 percent of African grain production that is lost to
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Alan Bjerga microbes, pests, and lack of access to markets, according to a U.N. study. Hunger may worsen in coming decades. The world’s population, topping 7 billion in 2011, is expected to rise to 9 billion by mid-century and surpass 10 billion by century’s end. Food demand will rise more steeply—70 percent by 2050. More people will want more food. They will also want better-quality nutrition, more convenient access to it, and more variety in their diets, as poor consumers become middle-class consumers in China, India, Brazil, and other emerging countries. Bigger crops that can stave off famine will need to be grown without major expansion of land devoted to farming. Global growth in farm yields that averaged 2 percent per year from 1970 to 1990 have since stalled at just over 1 percent. Stagnant growth may continue as climate change and soil degradation trump new technology in the struggle for more productive land. Much of the additional land that is available is in sub-Saharan Africa, the world’s most hunger-prone region. Still, about 90 percent of food increases will have to come through intensification higher yields on efficiently used cropland, much of it already under cultivation, according to the UN. Exhausted soils, depleted water, and pests will require sustainable farming practices, the UN said: “The food price spike of 2008 and the surge in food prices to record levels early in 2011 portend rising and more frequent threats to world food security.’ A globalized economy is interdependent, with more people wanting more food from beyond their own borders. Most of the food shipped around the world still is sent from the world’s richer nations—the United States, the European Union, Canada, Australia—to the poorer, while rising powers like Brazil become more important. Go to a G-8 summit of the world’s leading economies, and the people there will look very, if not exceedingly, well-fed. This global food market has brought wealth to some places—U.S. farmers in 2011 may see both record exports and profits. Farmers today produce greater varieties of food for ever-more-diverse diets, from more meat in Asia to organic foods in the European Union and fresh-food farmers’ markets of locally grown goods across the developed world. Yet, more than half of respondents in a global survey conducted in mid-2011 said they had changed their diets in the previous year because of higher food prices, in some cases by cutting back on fruits and vegetables. Malnourishment is making a comeback. Evidence of the market turmoil is the volatility of global commodity prices that’s rising just as millions of investors have found new ways to speculate in crop prices, ironically in a quest for financial stability. Global financial instability and volatile markets are “contaminating” commodity prices, the newly elected head of the United Nations Food and Agriculture Organization, Jose Graziano da Silva of Brazil, said in his first press conference after being selected to head the agency starting in 2012. World prices set on trading floors that smoothed prices for decades are exporting volatility and creating unrest, even as a new class of investors—us, through our 401(k) plans and mutual funds—tie the fortunes of rich-nation wealth seekers to poor-nation consumers and farmers who struggle to feed themselves. Investment in vehicles tied to commodities prices—the energy, food, and metals that comprise the raw materials of human life—by early 2011 was 55 times larger than in 2000, directly connecting rich-world investors to volatile food costs. The effects of commodities trading on food prices is controversial. Regardless of cause, the price swings of global crop and energy markets have turned a quarter-century of stable food costs into a marketplace casino where demand pushes prices higher—and droughts drive them
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Endless Appetites higher still—while a cooling economy or an unexpected gain in supplies cascade them down faster than any changes in how much people actually eat. From mid-2007 to mid 2008, world food prices rose 46 percent, then plunged 34 percent in the second half of that year, bottoming out in February 2009, even as U.S. prices, where commodity-price increases are more smoothly integrated into grocery costs, rose more slowly and steadily. From June 2010 to 2011, prices rose another 39 percent (see Figure 1.1). High prices are more harmful in countries that depend on imports for food and where poorer citizens spend a larger percentage of their income on food. The U.S. share of income devoted to food is less than 10 percent. People in impoverished nations may spend 70, 80 percent on a meager diet.
FIGURE 1.1 U.S., World Food Costs
Source: Bloomberg.
Our appetite for food is accompanied by a thirst for energy, which raises foodtransport and processing costs. The price of a barrel of oil, barely over $10 at one point in 1998, reached more than $147 a decade later, placing an added tax on nutrition. Efforts to combat climate change and encourage alternatives to oil have increased production of biofuels, whose backers promise freedom from energy dependence while drawing acreage and production away from food in pursuit of that goal. As those demands increase, so does their pressure on food prices. Weather has always been central to food markets; in the past century, everything from floods in South Asia to multiyear Dust Bowl droughts in the United States have crimped supplies. In a world of rising populations and food needs, destructive weather creates supply swings and trade disruptions that shutter borders and throw prices into chaos. Globally, changes in weather patterns may double food prices by 2030, with half of the increase attributable to climate change. Water requirements may rise 40 to 100 percent, numbers that have been boosted by global warming. Irrigation has been crucial to increasing food supplies, but it’s being used inadequately in some regions while in others— including Saudi Arabia—over-reliance on irrigation depletes water tables and creates foodsecurity mirages that won’t last another generation. In 2000, half a billion people lived in countries short of water. By 2050, it will be 4 billion. Governments also contribute to higher, volatile prices, erecting trade barriers that
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Alan Bjerga inhibit the flow of goods from places of surplus to places of need. And in the most direct expression of the go-it-alone approach, some of them have turned to snapping up land in less-developed countries to grow food for their own consumers, a new land grab of questionable benefit to poorer nations. The list goes on. Declining crop surpluses have made food prices more sensitive to small shifts in supply and demand as a just-in-time model of food inventories leaves the planet vulnerable to shortfalls between harvests. A weaker dollar, the global food trade currency, raises export costs. In the past half-decade food prices have spiked twice—in 2008 and in 2011—with riots and revolutions as results. The farmers who underpin global food security can raise production in response to higher prices and, over time, lower consumer costs while lifting themselves. But the fast ups and downs of the market add risk that poorer farmers can’t take on. And so riots rise again, in Algeria, and Tunisia, and Egypt, in Oman, in Bahrain, in Uganda. . . . Globalized supply and demand turns problems in one region into crises in others. Still, from that failure comes a chance for solutions that can help lift millions of the world’s poorest people from poverty—with the right access to markets and incentives. Today’s casino is tomorrow’s opportunity for the world’s smallest farmers, its biggest businesses, and the consumers in between. The casino can be tamed, the planet can be fed, and famine can be banished to the past. In Sabasaba, Kenya, a new agribusiness center is creating a gathering place for storing and selling bananas to shoppers in Nairobi and other growing Kenyan cities. Rebecca Wairimu Njoroge sells her fruit at the Sabasaba Agribusiness Centre in the Muranga’a region and helps organize sales for her self-help farmers group, which local growers formed to bunch their bananas and finance investments in higher production. “People are waking up, because what happened before was that we had produce, but we had no market,” she said. She and her fellow farmers now benefit from connections to one another and to other customers, she said. Njoroge, whose education was limited at first because her brothers’ training came first, eventually became a nurse. “In the old days, the girl had nowhere. It was not necessary to educate that girl. The boy was preferred. But today they are equal, even in job opportunity,” she said. Now retired and returned to farming, she has extra money she uses to visit her son, who is a minister. In Ohio. In Nakhon Sawan province, in the heart of Thailand’s rice bowl that feeds hundreds of millions around the world, Ronnachai Ruasrichan left nine years at a Taiwan factory making air-conditioning units for cars so he could return to the rice-growing he learned as a child. “I didn’t want to live overseas as I got older,” he said. His paddies, on which he has learned to grow high-quality rice varieties, have yielded him enough income to buy additional land and an Isuzu pickup truck. He’s wondering now how he can sustain his fortunes as grain prices rise and fall. And in Soddo, Abebech Toga is showing her fellow farmers how to grow more crops, getting them beyond the age-old famine fears to using their potential to prevent it among others. All of them need a better market. But how to build it? The first clues are found on the floor—the trading floor, in Chicago. To continue...
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The End of Progress
The End of Progress How Modern Economics Has Failed Us
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Graeme Maxton 978-0-470-82998-1 • Hardback • 256 pages August 2011 • £19.99 / €24.00 / $33.99
Chapter 12 We Need to Diffuse the Threats of Conflict War does not determine who is right—only who is left. - Bertrand Russell It is comforting to think that arms are needed only for hugging. Sadly, they are also necessary for fighting battles, subduing the angry, and cowing the desperate. Although we might all hope there will be fewer sources of conflict in the years to come, there is good reason to think that the number of battles between the peoples of the world will increase. And, while Western politicians have frequently exaggerated the need for recent wars, the conflicts of the future are likely to seem more justified. Of course, the problems facing humankind cannot be solved by military action, riots or chaos. But that will probably not stop people trying. There are many potential reasons for wars to break out in the years ahead, and almost all have historical precedent, in the sense that they have been used to justify previous conflicts too. The exception to this is climate change. While there have been many wars fought over access to fertile land, natural resources and water in the past, none were of the potential scale we now face. As sea levels rise, hundreds of millions of people will lose their homes and their means of survival. They will be forced to migrate to places they are not keen to go and are unlikely to be welcome. The tensions concerning declining resources will have an intensity not seen before, because the number of people fighting for their share has never been so large. As the world’s supplies of oil, water, copper and tens of other resources come under strain, as demand exceeds supply, and as prices rise, there will inevitably be fighting over what is left. Countries will put up barriers to stop exports of their dwindling supplies resulting in trade wars too. And, as food prices rise, billions will fight to avoid starvation. In the developed world, millions more will demonstrate against the loss of jobs, cuts in welfare payments, declining standards of healthcare services, and the loss of promised pensions. Humankind will wage some, or all, of these battles in the coming decades, unless we can do something clever and creative to prevent them; unless we can diffuse these threats; unless we can turn off the road we are on. The battles will be between the haves and have nots, as well as between the haves and have mores, as George W. Bush might have said. There will also be a great deal of friction between the public and private sectors leading to rising political uncertainty. We are not dealing with soft issues here. We are dealing with changes that determine
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Graeme Maxton our ability to live, to have our sons and daughters prosper. The difficulty of the struggle is perhaps best understood in the words of George Kennan. In 1948, as head of the US State Department planning committee, he wrote about America’s new found role as the dominant force on earth: We have about 50% of the world’s wealth but only 6.3% of its population. . . . In this situation, we cannot fail to be the object of envy and resentment. Our real task is . . . to maintain this position of disparity without positive detriment to our national security. To do so, we will have to dispense with all sentimentality and daydreaming; and our attention will have to be concentrated everywhere on our immediate national objectives. We need not deceive ourselves that we can afford today the luxury of altruism and world-benefaction. . . . The day is not far off when we are going to have to deal in straight power concepts. —george kennan
We Do Things Differently, Don’t You See? One of the earliest sources of renewed international tension will come from the financial crisis. It already has. Like a pendulum swinging back, world trade will become less open in the coming years. After decades of effort to build a globalized world, of deals signed to reduce barriers to cross-border business, the great weight will swing in the other direction again, just as it has in the past. Capital controls, already back in fashion, will return more broadly, and eventually trade sanctions too. Currencies will become favorite battlegrounds, as will the great shipping lanes along which goods move to and fro. Countries will accuse each other of subsidizing trade, manipulating their currencies and of competing unfairly. Politicians will play to the voters’ gallery, offering protections for jobs and investment, and a vanquished foe, in return for re-election. This is bad for the world, as Smith identified. It is usually better for countries and regions to specialize in what they are good at and to trade with each other. That creates more prosperity and leads to greater social well-being for all those involved. It is also, unfortunately, logical and natural to close the barriers to trade and investment when times get tough. It is hard for a US president, or any other Western political leader, to resist the pressures to restrict Chinese or other foreign imports when the consequences of these imports, albeit maybe only in the short term, are more welfare payouts and higher unemployment at home. That is a tough political “hot potato” to sell when there are many softer and colder ones in the bag. So, just as in the 1930s after the Great Crash when there was a gradual closing down of world trade, at least in part, we can expect much the same in the years to come. More racism will come with it, more nationalism too. That is natural enough too, it seems. But there will also be a new and different battle over economic ideology. Big businesses in America and Europe compete in a different way from big businesses in China. This is not just a question of costs, but also of business models. Both sides see their own model as being fair. Both see the other side’s model as wrong. In the West, a business is expected to survive independently. It is expected to raise finance, compete for resources and people, build a customer base and then make a return, a profit, which is enough to reward its shareholders and to reinvest in the business for the future. Businesses that fail to achieve this balance go bust. In China, the model is mostly different, partially because of the legacy of the country’s communist past. There, big businesses are often state controlled, or at least state directed. Profit is less of a motivating factor, or at least that is not the sole reason why they are in business. They are led, or directed, centrally by the Party, with senior managers often moved
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The End of Progress between domestic competitors on the orders of Beijing. They may have shareholders and listings on stock exchanges, but the reward for investors is meant to come mainly from how well they gamble on the market. Their customer base is often provided: in the Chinese rail business, for example, new contracts are only offered to local companies, to ensure skills and jobs and wealth are kept at home, not sucked away by foreign-devil employers. Their technology is often provided too, removing the need for hefty research and development (R&D) costs. “Leached” away from foreign companies, and then localized, Chinese com panies have frequently acquired their high technology capabilities without the costs. And when Chinese companies go abroad, the state is behind them, like a hand inside a puppet. It helps them gain access to the world’s resources. When they make a bid to build new roads, schools or railways in California, Africa or Eastern Europe, the Chinese state, or one of its banks, will provide the client with low-cost financing, while Chinese companies will provide the low-cost labor, making it impossible for rival European or US bidders to compete. For China, these are strategic investments, a way to beat their opponents in business and win geopolitical influence at the same time. Western companies say it is unfair competition. Despite the complaints of many American and European politicians and business people, the Chinese model is not wrong. It is just different. It does not depend on the free market and profit to survive. It takes a different approach, and perhaps a better one. For the last thirty years, the unrestricted free market was the mantra of the West. Many business leaders in the West were even fooled into thinking that this was the only way to compete, the only way to achieve growth and economic superiority. Not only have Western businesses suddenly discovered that their model does not work as well as they once thought, they are about to find out that there is another way to compete that will undermine their system further still. This will raise all sorts of trade tensions in the years to come and lead to a sharp growth in East-West rivalry. Such tensions risk reawakening other sources of strife between peoples too. As German Chancellor Angela Merkel said in a speech in 2010, there is a growing awareness that multiculturalism has not worked—that the integration of races and peoples of many nations to live harmoniously together has “utterly failed.” If this is the conclusion after fifty years of hard work in integrating people in one of the more open and liberal nations on earth, the risks of greater trade and business rivalry will only fuel the flames of division further. These risks will have two other consequences that will act together as a catalyst to make tensions worse still. When trade barriers rise, when divisions between races and nations grow, when there is more distrust and more nationalism, then economic activity tends to slow. With that comes higher unemployment and, for those countries that have become too heavily dependent on foreign imports, higher costs. They will suffer from inflation, as local companies without the scale and cost advantages try to provide alternatives to goods previously imported. With inflation comes yet higher social discontent, as the spiral unwinds, spinning backwards again after so many decades. This typically fuels further nationalism and spreads the desire for isolationism wider still. The second consequence is political. As the growth slows, and misery and anger mount, as countries shut down again, politicians will emerge from the shadows with simple answers and an inviting, but extreme, left- or right-wing rhetoric. They will appear to offer some false road to a better place, which will be wrong again, just as it was in the past.
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Graeme Maxton The world moves in cycles—economically, socially and politically. Without care, our current world risks moving into reverse in all three.
The Cupboard Will Soon Be Bare Another source of conflict will be about water, food and other vital resources. For years we have lived by exploiting the resources we can and thinking, thanks to faulty economics, that we can pass most of the external costs on to future generations. Now the bill is coming due for payment. According to the World Wildlife Fund (WWF), our demands on the world’s natural resources doubled between 1966 and 2007. Worse, with the population rising, the rate of overuse is accelerating. We are already living 50 percent beyond the earth’s capacity, and by 2030 we will need a second planet if we carry on living as we do today. If everyone used resources at the same rate per person as the United States, we would need four and one-half planets. According to Jim Leape, Director General of WWF, the “developed world is living in a false paradise, fueled by excessive consumption.” Some think the situation is even worse. David Pimentel, an expert on food and energy at Cornell University, says that if the entire world consumed the same way as the United States, humanity would exhaust its fossil-fuel reserves in less than a decade. With the growth trajectory of many developing nations, notably those with large populations like China and India, this does not add up. Either the West has to change its consumption habits, or developing nations will not be able to develop much further. There is a crunch coming, which will become apparent long before 2030. Something has to give. How this will manifest itself is hard to predict. There is likely to be friction regarding access to rivers and aquifers, as well as access to land to grow crops. The arguments in favor of growing food for biofuels will weaken. Countries are likely to introduce limits on food exports, stock-piling for security. Many governments may use their control over resources to win geopolitical influence. When China’s Deng Xiaoping pointed out that “the Middle East has oil. China has rare earths,” he was not making a simple observation. It is not only knowledge that brings power; rare earths, oil, and many other items essential to our standard of living or survival, can too. We can also be reasonably sure that there will need to be changes in the diets of millions. For some, this will be voluntary. In the developed world more people are likely to choose to eat less meat, perhaps as a result of images of the less-fortunate in the developing world. In most places, though, dietary changes will come as a result of the price. Millions will have to eat cheaper food. Tensions are also likely to rise domestically in many countries, with the likelihood of more Malthusian moments over shortages of tortilla flour in Mexico, as well as riots over rice in Africa or kim chi price protests in South Korea. The shortages of food and water will also have an international business dimension. In the last decade, purchases of land in developing countries by developed-country organizations to grow food, have grown ten-fold according to the World Bank. Two-thirds of these purchases have been in Africa, where there has been a generally weak institutional defense. As well as government-sponsored purchases from Asia and the Middle East, there have also been substantial investments by hedge funds, and other financial companies, keen to make a profit from the anticipated shortage of land and food in the future. Big global finance businesses have quietly invested billions of dollars in the last few years, not to grow food, but to speculate on good quality arable land with access to water in these places.
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The End of Progress Both motives are likely to bring trouble in the future. African and other developingcountry governments will tire of their land being exploited by others, with their harvests being shipped off for the citizens of other countries to consume. Many of the citizens of these countries are also likely to rebel against the desire of others to profit from the vital elements needed for their survival. Legislative barriers stopping these sorts of investments will rise. Brazil has already passed a decree to limit the amount of land that can be owned by foreign companies, while Argentina, which is already 7 percent owned by foreigners, is drawing up similar plans. As prices rise and people starve, there will be a growing realization among many governments that their land is not a commodity that can be easily bought and sold for the benefit of people overseas, even including a handful of bankers. Absentee landlords who buy and sell chunks of the earth for exported gain risk having their investments confiscated. One partial solution to these problems is to increase the production of food in countries where there is lots of land and water, and where productivity levels today are still comparatively low. There are a surprising number of places where this is possible. In parts of Africa, such as Congo and Sudan, in much of South America, as well as in Ukraine and Russia, there are vast areas of land that could be turned over to crop production. Climate change may also extend the capacities and productivity of other northern countries to grow crops, although it is also likely to reduce yields in places near the equator. In many countries that have the potential to raise crop yields, however, there are obstacles. In parts of South America, Asia and Africa, the development of new crop land would require further destruction of the rainforests. In many countries too, there would need to be social change to allow the establishment of a high-volume agricultural sector, which would take time. Moving from a system of small-holdings to one with large mechanicallyfarmed fields and a developed transport infrastructure does not happen quickly. There are also concerns about the future cost and availability of fertilizers in some places, as well as political hurdles in some African countries still affected by civil war. Even so, countries with the capacity to export more food are likely to gain geopolitically, with few having as much opportunity as Russia. Not only does it (and many countries within Moscow’s sphere of influence) have great potential to increase grain production, it has huge reserves of oil and gas too. Russia and much of the Commonwealth of Independent States (CIS) also have vast supplies of water and fertilizer. Indeed, Russia has the potential to become one of the great powers of the twenty-first century, if it can reform its agricultural sector and maintain its energy supply network. Moreover, climate change may actually be good for Russia. It will increase the amount of land that can be farmed and also provide easier access to oil and gas fields that currently lie under deep permafrost. There is, of course, considerable irony here. Not only will the means of competition in the business world be challenged by China’s communist ideology, but the ability of the West to wield geopolitical power will be challenged by what it once saw as a defeated communist foe in Russia. In some ways it will seem as if the Cold War never ended. Perhaps the biggest source of change in the balance of geopolitical power, however, will come because of access to oil and other sources of energy. Many African states, long manipulated by Western powers wanting to access their resources or to fight proxy wars on their territory, will find their position strengthened by the arrival of additional Chinese, and perhaps even Indian, investors in their countries. Local African politicians and business people with the skills may be able to play the West off against the newcomers and gain much
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Graeme Maxton in return. On past records, however, this is unlikely to lead to a general improvement in social welfare or the well-being of many African citizens. Nor is it likely to improve standards of education, health or human rights. More probably, unfortunately, the gains will accrue to a minority, wealthy elite. But the power of the West to set the price for oil, uranium and tens of other resources could also be compromised, forcing up prices. Many organizations have undertaken studies into peak oil and the consequences of these shifts in geopolitical power, including the US military and Lloyds insurance. A 2010 study by the German military suggests there will be significant shifts in loyalties. It says we risk a fall in the influence of “Western values” and deteriorating standards of human rights, combined with a greater tolerance of rogue behavior and a rise of more oil-related diplomacy. Out of necessity, the risk of moral hazard and extreme political tensions will grow, making the world more volatile, unless we handle the transition from our current oil dependence with great care. With gas an obvious alternative to oil for applications other than transport, the security of pipelines is also likely to become ever more problematic, says the German report. Those supplying the gas will have even greater opportunity to hold their customers to ransom, while terrorists or the disaffected will have more chance to create havoc by blowing them up. Other conflicts are almost inevitable over territorial disputes, notably in much of Asia and the Arctic where there are long-standing disagreements. Most of these concern islands where oil, gas and other mineral reserves are believed to exist. In several cases more than two countries have staked claims, suggesting these could get diplomatically messy. They will also test the limits of soft power in the Pacific and settle, for a generation at least, the argument about which government is in charge. Will rising China, waning Japan or the US, with a long history of powerbroking in the region, prevail? As the supply of oil becomes more of a problem, the risks from nuclear technology will also grow. Although it will take time to construct the capacity, this source of power will become a necessity for many nations. Critical to how this will evolve and what it will mean, is how governments react to the energy gap—the time between the early effects of an oil shortage beginning and the day when reliable long-term alternatives, such as nuclear power, are available in sufficient quantities. The gap could last more than a decade. Building lots of nuclear power stations also brings additional domestic, regional and international threats. Statistically, the risk of accidents will grow. There will be political battles between those in favor of their construction and those deeply opposed. There is also the issue of waste. And even then, nuclear power does not solve one of the main problems that will result from the eventual decline in oil reserves; airplanes and cargo ships cannot be powered by batteries or reactors—or at least not yet. During the gap, there will also be a source of local conflict in many countries about the choice of whether to grow food for fuel or to eat. In some places constraints on water availability and the effects of soil degradation will add to the complexity. The early effects of peak oil will also result in the politicians and citizens of many countries demanding greater local autonomy over their sources of energy. This may not be realistic or possible in many countries, but that will not stop people trying. Many countries will over-invest in solar, wind, geothermal and other energy sources in an attempt to wean themselves off oil and to reduce the power and political influence of countries with large gas and oil supplies. The stakes on all sides will be high. To continue...
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Exile on Wall Street
Exile on Wall Street One Analyst’s Fight to Save the Big Banks from Themselves
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Mike Mayo 978-1-1181-1546-6 • Hardback • 208 pages November 2011 • £19.99 / €24.00 / $29.95
Chapter 4 The Professional Gets Personal I ultimately spent six years at Prudential, longer than anywhere else in my career to date, but those first six months were probably the most satisfying. Within a year or so, I would run into the usual problems: banks and investors actively trying to undermine me because they didn’t like my ratings. I was still negative on the sector, and this was a tough stance to take at the time because bank stocks were on the rise. I thought that the reasoning behind my calls was as sound as ever, but the prices were moving in the opposite direction. In other words, I felt that I would be right in the long run, and the rest of the market was wrong in the short term. Citigroup epitomized the situation. I have a long and complicated relationship with that bank. In this particular period I was the most negative analyst on the company, while the stock kept rising. This felt like a “short squeeze,” and it’s a painful experience. The feeling is as though you’re expecting the tide to go out when it’s actually coming in, and every minute the water gets a little higher. I thought my argument on Citi was solid: The company had a litany of regulatory and legal problems that reflected poorly on its strategy and culture and—worse—left it potentially exposed to financial settlements that would be required to make these problems go away. Those settlements ultimately would come to pass. But even if my rationale was legitimate, the market wasn’t buying it. For the next year, Citi’s shares crept ever upward, from about $30 to $45 by mid-2003, and I was on the wrong side of that trend. The issue with my view in the short term was that debt markets were improving, which meant that loan quality was likely get better, too. Interest rates were at historic lows, and the real estate problems that would later impact Citi, and just about every other bank on Wall Street, had yet to really develop. During this time, Citi froze me out—I wasn’t given access to the company’s senior managers. The CFO told me, in a needling way, “Mike, the stock’s going up. You’ve got to get this right.” He made it seem as if the stock price was the sole determinant of whether a company was operating well or not. Finally, I had to bite the bullet and upgrade my rating on Citi. I thought the improving debt markets would allow the company to build up a better loan portfolio
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Mike Mayo than I’d originally expected. I also crunched some numbers and thought that there was a good chance Citi would increase its dividend by a significant margin, possibly double digits, which would cause another big bump in the stock (and make my negative call even more vulnerable). I had one more bit of evidence to add to the pile. In July 2003, I was having lunch with an investor at Bice, an Italian place in midtown Manhattan. Between bites of tartar di tonno, I saw the CFO of Citigroup walk in. He stopped at our table to say hello, then sat by himself and opened the New York Post to the sports section. In four working days, the company was going to announce earnings and review the dividend. This is usually the period when the finance department is scrambling to get everything done: reviewing press releases, rehearsing the earnings presentation. Yet the CFO was in here, casual and confident, eating a leisurely lunch by himself and reading about the Yankees. It was like a tell in poker—an action that reveals what someone’s holding. I figured he had to have good news. A day or so later, I changed my rating from a sell to a hold, and at the company’s quarterly earnings announcement, Citi increased its dividend by more than half, causing a short-term pop in the stock. It felt like a classic short squeeze, and my upgrade was akin to covering my position (and also my butt). Much of this time in my career was like that. In part because of the call on Citi, my rankings dipped at Prudential. Analysts get judged on a variety of factors, including votes from clients and from the in-house salespeople that communicate their ratings to those firms. In the past, I’d always done well in those rankings, but in the third quarter of 2003, my numbers internally were noticeably down. My boss was matter-of-fact about the situation. “It’s a pure meritocracy,” he said. In other words, there’s no crying on Wall Street. The numbers are all that matters, and if your numbers aren’t good, it really doesn’t matter how legitimate your excuse might be. In this case, I did have a legitimate excuse. My stepdad—the man who more or less raised me—was in a serious car accident. In mid-April 2003, he called me from a hospital in Florida. He had been making a left-hand turn on a major road when another car ran into him. He had a collapsed lung, among other injuries, so he was having difficulty breathing. That would be the last time he would be able to speak with me. I flew down immediately, and by the time I got there, he was in the intensive care unit, with a breathing tube. He was conscious, though, so we could write notes back and forth. It was a beautiful day, and I remember thinking how much he would have enjoyed going out for a round of golf, like we used to. The hospital gave me a plastic bag with his wallet, keys, money, and a lottery ticket. I stayed at his place during that first trip down, assuming that he would get better, as he always had before. When I got to his apartment, I was happy to see that it was more like a bachelor pad than anything else: a half-made bed, a cigar in a full ashtray. His gun was in the drawer of his nightstand—the same gun he’d always kept within arm’s reach when he slept. In the freezer was a half-full bottle of Absolut vodka and, in the refrigerator, kalamata olives. (His signature drink was
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Exile on Wall Street vodka straight up, a couple of ice cubes, and an olive.) That made me smile. His doctors had told him to stop drinking and smoking, but he’d always lived life exactly the way he wanted to. In his bedroom was a picture of him and my mother, dressed up for some black-tie event. Another photograph showed the words “Mike and Norma” traced in the sand. My mom and stepdad felt that other people always wanted their type of bliss in a relationship and that it was the lack of a love like this that made most people so petty. Nearly a decade before my stepdad’s accident, in 1996, my mom had died at age fifty-nine from a recurrence of breast cancer. During her treatment, I’d adjusted my schedule to be with her in Washington as much as possible. In fact, my stepdad and I had gone through that experience together. I even went with him to the funeral home to pick out a casket. We told her we were just going out for a bit, but she knew. I could tell by the way she watched us leave. The man showed us a room filled with models— pine, poplar, oak, maple, walnut, cherry, mahogany, all with different stains and different designs. My stepdad said, “What’s the difference? You get buried and no one sees you. Just give us the cheapest.” When the man showed us a plain pine box, my stepdad said, “What? I wouldn’t bury a dog in that.” We settled on something more upscale. On the day of her funeral, the hearse that was to take us all to the funeral home got lost on the way. My stepdad hated to ask for directions—when he got lost he used to say “They moved the road”—and we barely made it to her funeral on time. It was one last cosmic joke, and one that I think she would have enjoyed. After her death, my stepdad had been utterly lost for a little while, but once he started to get his bearings, he left Bethesda and moved to Pompano Beach, Florida. He’d been fine for a few years, and then in 2003, he had the car wreck. Just as I’d done with my mother, I started juggling trips down to see my stepdad with other stops throughout the Southeast, meeting investors and bank executives whenever I could. This was during my short squeeze on Citi, and I distinctly remember sitting in a chair outside the intensive care unit at the hospital, checking CNBC and seeing that Citi was up a buck, up another buck . . . The pressure was tremendous, on both a personal and a professional level. When I saw my stepdad a few weeks after the accident, he was dramatically worse. His leg was enormously swollen because of a blood clot, and he had trouble jotting notes down on a pad. Infections were ravaging his body. He laboriously communicated that his former girlfriend had some things he wanted me to collect, including his memoirs. I realized that he wouldn’t be returning to his apartment, which meant I would need to pack the place up. On my next visit, he was on a ventilator, sedated, and swollen almost beyond recognition. It seemed like it should have been a hard decision, but it really wasn’t. I called my wife and also spoke with my two sisters, and everyone agreed: We would withdraw life support. He wouldn’t have wanted to live that way. He had always told us that. The following morning, the doctors removed his ventilator. Life is unlike the
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Mike Mayo movies in so many ways, and this was one. Without the tube, he remained alive, medicated but breathing on his own. So I sat down to wait, alone. I had wondered what this experience might be like, but I hadn’t pictured this scenario. When he died, I did the first thing that came to mind, which was to recite the Shema, the central prayer in the Jewish service. It’s traditional for Jews to say the Shema as their last words, so I recited it for him. Back in New York and in front of our apartment building, I dropped my bags with the doorman and hurried to a nearby synagogue, where services were still taking place even though it was after 9:00 p.m. Not long after I sat down, the rabbi led the recitation of the Mourners’ Kaddish, or the prayer to pay respect to the deceased. The rabbi asked if anyone wanted any names included in the prayer, and I shouted out my stepdad’s name. My stepdad was buried in a plot next to my mother’s, even in the same type of casket—the style he’d chosen for her years earlier. He was seventy-two and had lived every single day of his life the way he’d wanted. When I spoke at his funeral I emphasized this. Yes, he took chances. He drove a little recklessly, drank too much, smoked too much, but all with his eyes wide open. He always said he’d rather live well with risks than play it safe and be bored. That’s something I’ve tried to apply to my own life and career, as well. With everything he’d done—escaping Romania, serving in the Israeli navy for a decade, smuggling black market goods, jumping ship from a merchant vessel to get to America, running businesses here—he was like the protagonist in a novel. I talked about this in my eulogy and summed up his life in two words: No regrets. That didn’t make it any easier at work, though. Besides Citi, my other calls were drawing the predictable backlash from investors and the banks themselves. When I’d initiated coverage at Prudential with nine sell ratings, I held a conference call to discuss my research, and I was on the receiving end of nasty comments about my position on Bank of New York. I got the distinct sense that people at the bank were feeding information to investors who, in turn, parroted the bank’s argument. In some rare cases, the attacks were face-to-face. These were equally unpleasant experiences, but at least I was in the room to defend myself. In one meeting with a large institutional money management firm, I sat down with the firm’s own bank analyst, who repeatedly tried to bully me, insulting me and shouting over me whenever I spoke. I was at one end of the conference table and he was at the other, with a long line of his portfolio managers on both sides. For every argument I offered, he not only put forth a counterargument but added a personal attack, as well. When I said that I had done a 1,000-page research report, he said, “That’s just a data dump. You didn’t even do that work, your assistants did. You probably don’t even know what’s in that report.” The meeting was so bad that I got a call afterward from someone in his firm who called to apologize and disassociate himself from the analyst. After another meeting in New Jersey, one of the more senior portfolio managers offered to “advise” me about my views on the banking industry. The old-timer pulled me into a semidarkened room, just the two of us. “I’ve been doing this awhile,” he said, “and you’ve gotta know when to change your view. You can’t be
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Exile on Wall Street so negative.” He probably meant it as kindly advice from someone who had been around the block, but it came across more like a disciplinarian father scolding his son. His argument seemed to be that as long as the stock prices were going up, the banks’ management and operating strategies didn’t matter. After the tech bubble and collapse of a few years earlier, which showed how far stock prices can deviate from a company’s fundamental performance, I thought that logic was fundamentally flawed. Other companies limited my access to management. Goldman Sachs was fairly up front about it, a rarity in the industry. I had recently initiated coverage on the firm, so I had few established relationships I could leverage. When I told one point of contact at the company that I’d like to have more meetings with management, he told me that the firm wasn’t singling me out—they treated everyone this way. When I pushed a little harder for a meeting, I received a message that we needed to “have a conversation.” Feeling like a student being reprimanded by a teacher, I was told that the most efficient use of management’s time was for the executives to generate money for the firm instead of talking to the twenty or so analysts covering the company. An analyst like me would simply have to wait his turn. While I could live with this—to a degree—the gatekeeper added one more point: a consideration in granting analysts meetings with management of Goldman Sachs was the analyst’s standing, influence, and knowledge. “In other words,” the gatekeeper added, “we evaluate you.” Here I was again—an outsider, trying to gain access to a place where some people didn’t want me, solely so that I could do my job. It was like being back at the beginning of my first job search when Goldman sent me a letter effectively saying “Don’t call us, we’ll call you.” I thought Goldman’s position was ironic—didn’t I get any credit for my calls being accurate over the past decade? Wasn’t I right about the rally in bank stocks during the second half of the 1990s and right about the negative direction of the sector starting in 1999? Had I not risked my career by going negative on the entire industry when I thought it was warranted? Moreover, in the aftermath of the “global settlement” that Eliot Spitzer and the SEC had hammered out with banks, and as the ranks continued to thin, I was one of the analysts who had stayed away from those issues, who had put the needs of clients first and tried to do my job the right way. There were a couple of odd things about that settlement: It only punished the analysts (and the firms where they worked) for overly positive behavior. There wasn’t any punishment—and there still isn’t—for when companies try to retaliate against analysts who they think are overly negative. Companies can refuse to let you meet with management, ignore your questions during earnings calls, and more. At times the backlash can be more insidious and subtle. Sometimes, as I would soon learn, it can be something as small as a joke. To continue…
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