Dear readers
Welcome back to Kondegbily for the summary of the article: How catastrophic failure of the past can inform our financial future. This article was published on my website on 14th June 2022.
When we talk about bankruptcy, the firm that come up in most of people mind is lehman brothers. The collapse of lehman borthers is of obviously the biggest failure of firm in capitalism history. However in 1998 the trouble caused by long term capital management (LTCM) threatens world economic. To write this article I read mainly the business book when genius fall, more money than god and the report published by the president’s working group on financial market Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management. I also watch some relevant video like the hedge fund that almost broke the world released by the youtube channel real vision finance.
Before talking about the nightmarish adventure of LTCM, let’s take a quick look at the situation of our current world. My beloved readers, I write this post with the firm desire to spread joy and happiness. My heart is filled with the need to talk about delicious things like diced pineapple, beaches, or festivals during this summer season in Toronto. Unfortunately, the current state of our world is a serious headache for investors and the population as a whole. Global economics has been performing poorly since the outset of 2022, and the sources of concern are numerous. For today’s summary, I have three topics in mind: inflation, tightening, and the bear market.
Inflation is a concern of world economics, and this topic will be revisited many times over the year. Triggered by the supply chain disruption, commodities crisis, and tremendous amount of money given to households and firms as Covid relief, prices are surging rapidly around the world. These rising prices have pushed the central bank to act in order to curb the ravages of inflation.
We are therefore witnessing an exceptional change in monetary policy: a shift from quantitative easing to quantitative tightening. On June 1, the Bank of Canada hiked its key lending rate by 50 basis points and committed itself to act more aggressively to curb inflation. “Governing Council is prepared to act more forcefully if needed to meet its commitment to achieve the 2% inflation target,” said a statement from the bank. On June 15, 2022, The Fed increased interest rates by 75 basis points – the highest increase since 1994 – and Jerome Powell, the chairman of The Fed, said during his press conference: “Clearly, today’s 75 basis-point increase is an unusually large one and I do not expect moves of this size to be common.” These two facts are blamed for the recent slump in the stock market.
The beginning of 2022 was characterized by a bear market. Technically defined as a plunge of asset prices of 20% or more from a recent high, the stock market is losing value. The prices of all kinds of assets are declining, creating and spreading distress and panic among investors. Between January and June, S/P 500 plummeted by 20%. In this turbulent environment, cryptocurrency also experienced turmoil, with bitcoin down by 40% during the first 5 months of the year. However, this spectacular drop was attributed to world equity, mostly of tech stock. After beating records in terms of valuation, tech stock is now inflicting pain. From November 2021 to this May, Nasdaq 100 lost 23%, and the so-called FAANG (Facebook, Amazon, Apple, Netflix, and Google) has plummeted two trillion dollars in value since the start of 2022. Furthermore, tech companies are laying off employees around the world. According to Layoffs.fyi, more than 13,000 tech workers around the world have been laid off since the beginning of April. This chaos in the tech industry makes many analysts believe that we are on the verge of a dot-com bubble 2.0. If you are interested in this topic, I recommend reading a wonderful article written by Parmy Olson in Bloomberg, “Tech Stocks Are Entering an Age of Uncertainty.” In the face of the bear market, some investors may choose to stop investing. As a believer in capitalism despite its imperfections, I have faith in the power of market resilience. Tidjane Thiam, then-CEO of Credit Suisse, stated during his interview with Darius Rochebin: “Capitalism is a Darwinist system.” As a result, I prefer to see this crisis as an opportunity to buy assets at a cheaper price. It’s difficult to time the market, but why do we not expect prices to soar again like Amazon did (+13965) since 2002? I prefer to finish this section by alluding to a lesson of optimism by rapper Kanye West. As he said in Praise God: “Even if you are not ready for the day, it cannot always be night.”
Now let’s talk about the main topic of the article summary, How Catastrophic Failures of the Past Can Inform Our Financial Future. This article discusses the failure of Long-Term Capital Management – a hedge fund that swelled incredibly and became the star of Wall Street before its downfall. I could even use a title for this article like The Flop of Genius. If you have a major passion for sports like me, you’ve likely heard about the recent failure of the Brooklyn Nets. LTCM shares some similarities with that team. Kevin Durant broke my heart into 100 pieces by leaving my favorite player, Stephen Curry, and deciding to join two other big players: Kyrie Irving and James Harden. For many NBA analysts, that move was the beginning of a new era and a smashing time for the Nets. Unfortunately, in 2022, the outcome falls well below expectations. Like the Brooklyn Nets, the members of LTCM were extremely talented. In this excellent finance team, we had Johny Meriwether, roughly the best trader in the ‘90s, Robert C. Merton and Myron S. Scholes, both finance professors awarded a Nobel Prize of Economy in 1997 for their contribution related to the valuation of options, and David W. Mullins, an outstanding and brilliant mind who was Vice Chair of the US Federal Reserve during this time. In its best days, LTCM was exceptionally profitable. In 1996, it generated a 40% return net of fees and 2.1 billion in profit. In 1997, despite the challenging economic conditions, they achieved a 17% return. However, the storm from the Asian crisis and Russian debt turmoil sparked the firm’s collapse. On September 23, 1998, the Federal Reserve Bank of New York organized a bailout to prevent the breakdown of the financial system.
What can we learn from this article? We can see various concepts in play: convergence trading and the notion of efficient markets, hedge funds, and leverage. For this summary, we will focus on the last two concepts. According to the CFA (Charter Financial Analyst) Institute, hedge funds can be defined as pooled investment vehicles that invest in a wide variety of products, including derivatives, foreign exchange, and publicly traded securities. Generally, hedge fund investments are not available to the general public. Compared to mutual fund managers, hedge fund managers have on average a shorter career. Being a hedge fund manager is a very lucrative career, and the top hedge fund managers are wealthier than professional football players by far. In 2020, according to the Forbes 400, here is the wealth of some hedge fund superstars: Ray Dalio (16.9 billion), Ken Griffin (15 billion), and William Ackman (2.1 billion). However, hedge funds are risky and use various strategies to achieve phenomenal returns, including leverage. Leverage is a strategy that uses borrowed money in order to invest in assets or projects. A company’s capital structure requires two types of financing: equity and debt. When the company uses too much borrowed money in accordance with its industry, it is highly leveraged. Leverage is not a bad strategy in itself and can create tremendous returns for shareholders as long as it is sustainable. On the other hand, it is a risky strategy and magnifies any losses. In accounting, various tools can help to assess the level of company leverage, and LTCM was very highly leveraged. In this article, I distinguished between two types of leverage: accounting leverage and economic leverage. In accounting, we can translate those two words to “on-balance sheet” and “off-balance sheet.” In French, this is literally “operation du bilan” and “operation hors bilan.”
I couldn’t conclude this summary without first wishing “eid el kebir” to my Muslim brothers, and also happy birthday to myself. I hope to live as long as the Eiffel Tower lasts.
Best regards,
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