SAM ERS CHAPT
...GIVING THE GIFT OF KNOWLEDGE
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Table of Contents 02
The Devil’s Casino
No One Would Listen
History of Greed
How an Economy Grows and Why it Crashes
Alchemists of Loss
The Little Book of Economics
The Little Book that Still Beats the Market
The Invisible Hands
Don’t Count on It
The Great Reflation
Dear Mr. Buffett
Vicky Ward Extract: Chapter 1 - A Long, Hot Summer buy now
Harry Markopolos Extract: Chapter 1 - A Red Wagon in a Field of Snow buy now
David E.Y. Sarna Extract: Chapter 5 - The Perils of Greed buy now
Matthew Lynn Extract: Introduction - May Day in Athens buy now
Peter D. Schiff Extract: Chapter 1 - An Idea is Born buy now
Kevin Dowd and Martin Hutchinson Extract: Introduction buy now
Greg Ip Extract: Chapter 1 - The Secrets of Success buy now
Joel Greenblatt Extract: Chapter 2
Steven Drobny Extract: Chapter 4 - The House buy now
John C. Bogle Extract: Chapter 1
Ken Fisher Extract: Chapter 1 - Bonds are Safer than Stocks buy now
Lars Tvede Extract: Introduction - Information Technology buy now
Anthony Boeckh Extract: Chapter 5 - Money and the Great Reflation buy now
Janet Tavakoli Extract: Chapter 1 - An Unanswered Invitation
The Devil’s Casino Shortlisted for
The Devil’s Casino
Spear's Financial Book of the Year 2010
Friendship, Betrayal, and the High Stakes Games Played Inside Lehman Brothers Vicky Ward
978-0-470-54086-2 • Hardback • 288 pages March 2010 • £18.99 / €22.40 / $27.95
Chapter 1 A Long, Hot Summer I just remember the nights. George would come in from the office at what seemed like 4 a.m. every single night. I don’t know how he got through those months. I don’t know how any of them did. It was crazy. —Nancy Dorn Walker By nightfall on Saturday, June 7,2008, the Manhattan streets were still radiating heat, an unwelcome harbinger of a long, stifling summer. At the Skylight Studio, a sprawling private event space in SoHo, George Herbert Walker, a 39 year - old second cousin of then President George Walker Bush, and at the time head of Lehman’s Investment Management division, was celebrating his marriage to Nancy Dorn, 31, a pretty blonde hedge fund analyst from Texas. The couple— who had exchanged their vows at New York’s City Hall a few weeks earlier and had already celebrated with family down in Texas—ate Southern food, danced to the overwrought musical stylings of a suitably ironic wedding singer, and drank margaritas with 400 of their friends. It was, however, a celebration tempered by the first signs that Lehman Brothers was about to come crashing down. The newlyweds had planned for their party to be casual and low - key— cushions on the floor and a buffet. Dorn wore a strapless Missoni dress that was asymmetrical and calf length. Walker—tall, bespectacled, a “cuddly bear,” some friends said—rather typically and charmingly cannot recall what he wore that night. The last thing the couple wanted was to be perceived as grandiose. In fact, Walker had instructed their friend, party planner Bronson van Wyck, “Just make sure we don’t make it into Page Six,” the gossip page of the New York Post. The public outrage over the $3 million extravaganza hosted by Blackstone Group CEO Stephen A. Schwarzman for his 60th birthday on February 13, 2007, was still echoing throughout New York City. The star - studded, 500 - guest event held at the Park Avenue Armory, featuring performances by Rod Stewart (who was paid $1 million) and Patti LaBelle (who sang “Happy Birthday”), had been an ill - timed disaster of self - congratulation: Blackstone’s stock had fallen steadily ever after and was then teetering at $18 per share, nearly half of its value a year earlier. And now, all of Wall Street was suddenly standing on the edge of a precipice, and everyone—especially those in attendance at the Walkers’party— were acutely
aware of it. “We wanted people to come and go when they wanted to, and not force them to sit down for a formal dinner,” Dorn said. The band—a Neil Diamond cover band, Super Diamond— was chosen by Walker in order to keep the mood light. Just months earlier, on March 17, Bear Stearns had imploded, and was scooped up by JPMorgan Chase, which paid $2 per share (that was eventually elevated to $10 per share with the aid of a $29 billion government nonrecourse loan); the rescue operation had stunned the financial market. Worried eyes were now staring at the next domino in Wall Street’s Big Five: Lehman Brothers. Walker had moved to the bank only two years before from the larger, more capitalized (and therefore safer) Goldman Sachs. Since March, most of Lehman’s senior management had been working nights and weekends, furiously trying to shore up their balance sheets. That weekend, many of the guests at the Walkers’“second wedding” had come directly from the Lehman offices on 745 Seventh Avenue at 50th Street. Most, like David Goldfarb, Lehman’s global head of Strategic Partnerships, Principal Investing, and Risk, had met their wives at the office and had simply grabbed their jackets from the backs of their chairs before heading hurriedly, their minds elsewhere, out the door. Even Walker hadn’t been home much recently; on the day of the wedding party, Nancy Dorn had gone to a movie by herself. The June earnings were due in two days. As the new 41 - year - old CFO, Erin Callan, worked on them (she did not attend the party), her colleagues knew they’d be announcing Lehman’s first losses since spinning off from American Express— $2.8 billion. They were deeply concerned. “Everyone was stressed that night— we felt badly for George,” Goldfarb said. “We were more tired than downbeat. No one at that time had any inkling that we would go down. We just knew we had a lot of work to do.” Despite the tumult, nearly all the core senior management team of Lehman came to the party. Longtime chairman and CEO Dick Fuld was there with his wife of nearly thirty years, Kathy, 56, then the vice chair of the Museum of Modern Art. Sticking close to them were Joe Gregory, Lehman’s president, and his second wife, Niki, a beautiful Greek - born brunette. Then there was the urbane, silver - haired Tom Russo, Lehman’s chief legal officer. Famous for his charm and eloquence, he was nicknamed “the Mayor of Davos” because, as one colleague put it, “he arrives first and leaves last” at the annual financial powerhouse conference in Switzerland. Beneath his twinkling eyes is a steel core—after Lehman Brothers collapsed, in late September, Russo would offer his consolation to Lehman Europe by way of a terse telephone call, in which he told them: “You’re on your own.” “Never be fooled by Tom’s charm,” a colleague said. “He’s as tough as anyone when he wants to be.” The last member of Fuld’s inner circle in attendance that night was Scott Freidheim, whom Fuld looked upon almost as a son. Freidheim, then 41, is the son of former Booz Allen & Hamilton vice chairman and former CEO of Chiquita Brands International, Cyrus Freidheim. Scott was yanked out of Lehman’s investment banking unit in 1996 and appointed managing director, office of the chairman. He quickly rose to the top echelons of the organization, which earned him as many enemies as friends. Most of the executive committee was there: Hugh “Skip” McGee (the head of
The Devil’s Casino
investment banking), Herbert “Bart” McDade III (head of equities), and Ted Janulis (mortgages). Also present were Steven Berkenfeld (chairman of the investment banking committee) and John Cecil, the small, earnest former McKinsey director who had risen to become the CFO of Lehman in the late 1990s and who, though he had left Lehman in 2000, was still being paid as a consultant. Also gathered were a large number of senior executives of NeubergerBerman, Lehman’s asset management division, commonly referred to as its “crown jewel.” Months earlier Joe Gregory had taken Walker aside. “You know, you didn’t have to invite all these people,” he said. “Remember: These are just the people you work with. They are not your friends.” Gregory was the only person at Lehman who had been at the firm longer than Fuld. Their careers began in the early 1970s when Lehman was one of the leading advisory mergers and acquisitions (M & A) houses on Wall Street, before it became a bond and mortgage shop. Fuld and Gregory had fought in what became known as “the Great War” of 1983 and 1984, an epic battle for control of Lehman between their professional mentor, the bond trader Lewis “Lew” Glucksman, and Peter G. “Pete” Peterson, the former commerce secretary. A preening sophisticate who dominated luncheons with his prattle, Peterson was widely disliked by the relatively blue collar traders for his patrician demeanor. Glucksman and his traders won the Great War and ousted Peterson, chiefly because by the mid - 1980s the traders were making more money than the advisory bankers aligned with Peterson. But the fight cost the firm dearly. Top banking talent fled and revenues plummeted, making it vulnerable for a takeover by the newly merged entity of American Express Shearson in April 1984. Peterson hadn’t left without implanting a lethal sting. It was greatly in his financial interests to get Lehman sold. In fact, it was greatly in the interests of pretty much all the senior investment bankers to get it sold. This was precisely what happened, as detailed in a 1986 saga chronicled by Ken Auletta in Greed and Glory on Wall Street. Glucksman was offered a $15.6 million noncompete buyout fee (on 4,500 shares). He and most of the other partners took the money and ran. And Gregory and Fuld began their ascents into the ruling elite of the new Lehman Brothers. The firm was founded in 1850 by three cotton trader brothers— Henry, Emmanuel, and Mayer Lehman. The cotton business had evolved from trading and general merchandising into an exchange in lower Manhattan. With the post–Civil War expansion of trading in stocks and bonds, the firm prospered and expanded. The next great leap for Lehman Brothers occurred after World War II, under the reign of Bobbie Lehman, who had a Rolodex bursting with names like Whitney, Harriman, and most of the rest of New York’s ruling class. He decorated the walls of Lehman’s offices downtown at One William Street with works from his private art collection—paintings by Picasso and Cezanne, Botticelli and Rembrandt, El Greco and Matisse. He was a gentleman, and his great strength was that he knew how to unite the people who worked for him. Andrew G.C. Sage II, a former employee, told Ken Auletta, “Bobbie was not much of an investment banker. He wouldn’t know a preferred stock from livestock,
but he was a hell of a psychologist.” Under him, Lehman became the gentleman’s banking house. “The partners at Lehman were all men of stature,” Felix Rohatyn, the banker who kept New York City from the throes of bankruptcy in the 1970s, told Auletta. “They were principals. You dealt with them as owners of a great house. You felt that if there was any such thing as a business aristocracy, and at the same time a highly profitable venture, that was it.” The firm’s stellar reputation survived Bobbie’s death in 1969. Many of its M & A bankers in the 1970s and early 1980s are still famous, still the icons of their profession. Their ranks included Eric Gleacher, Stephen A. Schwarzman, Peter Solomon, J. Tomlinson “Tom” Hill, Robert Rubin, Roger Altman, and a young Steve Rattner; they all achieved great success—and wealth—after leaving Lehman Brothers. It was infighting—typical in the firm’s last half - century—that brought Lehman low enough to be bought by Shearson American Express in 1983. And through that strange marriage ( “Shearson taking over Lehman is like McDonald’s taking over’21,’” a Lehmanite told Bryan Burrough and John Helyar for their 1990 book, Barbarians at the Gate), Lehman stewed. And schemed. Its Lehman Commercial Paper Inc. (LCPI) unit grew to eclipse Shearson’s own department, and provided enough momentum for Lehman Brothers to finally spin out once again, its egos intact. As for Fuld and Gregory? It had taken immense grit, courage, and a warlike mentality to restore the burnish to the once golden brand. They had defied the naysayers who believed that a tiny bond shop would never survive the Mexican peso crisis of 1994; and they did the same again through the Russian crisis of 1998. They had weathered rumor, had survived scandal, and had even ousted their longtime colleague, T. Christopher Pettit, to preside over a fully fl edged global investment bank. Since Lehman, in their hands, had gone public and had grown from 8,500 employees to 28,000, the stock price had risen by a factor of 16. The partners were all rich. In 2007, Fuld was named CEO of the Year by Institutional Investor magazine in the Brokers and Asset Managers category. The bank was once again competitive, once again a respected force on Wall Street. They weren’t now going to let it go down just because of an asset and housing crisis. They had survived 9/11, when their three floors of offices in the World Trade Center had been destroyed and their headquarters in the nearby World Financial Center badly damaged. They’d been through far worse. And so, on this evening, for the sake of the well - liked George Walker, Lehman’s top management tried to have a good time, tried to forget about their troubles. They chatted, they danced, they drank. Gregory and Fuld slipped away early. This was not unusual— Fuld had never been much of a party guy. He was famous for showing up at in - house cocktail parties for ten minutes and then leaving to be with his family. “We’re going to be fine,” Fuld told a stranger who approached him just before he left the party. And if worse came to worst, he believed, the U.S. government wouldn’t let Lehman fail. We’re going to be fine.
No One Would Listen
No One Would Listen A True Financial Thriller Harry Markopolos
978-0-470-55373-2 • Hardback • 368 pages February 2010 • £18.99 / €22.40 / $27.95
Chapter 1 A Red Wagon in a Field of Snow On the morning of December 11, 2008, a New York real estate developer on a JetBlue flight from New York to Los Angeles was watching CNBC on the small seat - back television. A crawl across the bottom of the screen reported that Bernard Madoff, a legendary Wall Street figure and the former chairman of NASDAQ had been arrested for running the largest Ponzi scheme in history. The developer sat silently for several seconds, absorbing that news. No, that couldn’t be right, he thought, but the message streamed across the screen again. Turning to his wife, he said that he knew that she wasn’t going to believe what he was about to tell her, but apparently Bernie Madoff was a crook and the millions of dollars that they had invested with him were lost. He was right—she didn’t believe him. Instead, she waved off the thought. “That’s not possible,” she said, and returned to the magazine she was reading. The stunned developer stood up and walked to the rear of the plane, where the flight attendants had gathered in the galley. “Excuse me,” he said politely, “but I’m going to be leaving now. So would you please open the door for me? And don’t worry— I won’t need a parachute.” At about 5:15 that December afternoon, I was at the local dojo in my small New England town watching my five- year - old twin boys trying to master the basic movements of karate. It had been a gloomy day. Rain continued intermittently, and there was a storm in the air. I noticed there were several voice mails on my cell phone. That’s curious, I thought; I hadn’t felt it vibrate. I stepped into the foyer to retrieve the messages. The first one was from a good friend named Dave Henry, who was managing a considerable amount of money as chief investment officer of DKH Investments in Boston. “Harry,” his message said clearly, “Madoff is in federal custody for running a Ponzi scheme. He’s under arrest in New York. Call me.” My heart started racing. The second message was also from a close friend, Andre Mehta, a super - quant who is a managing director of alternative investments at Cambridge Associates, a consultant to pension plans and endowments. I could hear the excitement in Andre’s voice as he said, “You were right. The news is hitting. Madoff’s
under arrest. It looks like he was running a huge Ponzi scheme. It’s all over Bloomberg. Call me and I’ll read it to you. Congratulations.” I was staggered. For several years I’d been living under a death sentence, terrified that my pursuit of Madoff would put my family and me in jeopardy. Billions of dollars were at stake, and apparently some of that money belonged to the Russian mafia and the drug cartels— people who would kill to protect their investments. And I knew all about Peter Scannell, a Boston whistleblower who had been beaten nearly to death with a brick simply for complaining about a million dollar market - timing scam. So I wouldn’t start my car without first checking under the chassis and in the wheel wells. At night I walked away from shadows and I slept with a loaded gun nearby; and suddenly, instantly and unexpectedly, it was over. Finally, it was over. They’d gotten Madoff. I raised my fist high in the air and screamed to myself, “Yes!” My family was safe. Then I collapsed over a wooden railing. I had to grab hold of it to prevent myself from falling. I could barely breathe. In less time than the snap of my fingers I had gone from being supercharged with energy to being completely drained. The first thing I wanted to do was return those calls. I needed to know every detail. It was only when I tried to punch in the numbers that I discovered how badly my hand was shaking. I called Dave back and he told me that the media was reporting that Bernie Madoff had confessed to his two sons that his multibillion - dollar investment firm was a complete fraud. There were no investments, he had told them; there never had been. Instead, for more than two decades, he had been running the largest Ponzi scheme in history. His sons had immediately informed the Federal Bureau of Investigation (FBI), and agents had shown up at Madoff’s apartment early that morning and arrested him. They’d taken him out in handcuffs. It looked like many thousands of people had lost billions of dollars. It was exactly as I had warned the government of the United States approximately $ 55 billion earlier. And as I stood in the lobby of that dojo, my sense of relief was replaced by a new concern. The piles of documents I had in my possession would destroy reputations, end careers, and perhaps even bring down the entire Securities and Exchange Commission (SEC), the government’s Wall Street watchdog— unless, of course, the government got to those documents before I could get them published. I grabbed my kids and raced home. My name is Harry Markopolos. It’s Greek. I’m a Chartered Financial Analyst and Certified Fraud Examiner, which makes me a proud Greek geek. And this, then, is the complete story of how my team failed to stop the greatest financial crime in history, Bernie Madoff’s Ponzi scheme. For the previous nine years I had been working secretly with three highly motivated men who worked in various positions in the financial industry to bring the Bernie Madoff fraud to the attention of the SEC. We had invested countless hours and risked our lives, and had saved no one—although eventually, after Madoff’s collapse, we would succeed in exposing the SEC as one of this nation’s most incompetent financial
No One Would Listen
regulators. For example, it was well known that Madoff operated his legitimate broker - dealer business on the 18th and 19th floors of the Lipstick Building on New York’s East Side. But what was not generally known was that his money management company, the fraud, was located on the 17th floor of that building. Months after Madoff’s collapse, the FBI would reveal to my team that based on our 2005 submission providing evidence that Madoff was running a Ponzi scheme, the SEC finally launched an investigation— but that its crack investigative team during the two - year - long investigation “never even figured out there was a 17th floor.” I had provided all the evidence they needed to close down Madoff—and they couldn’t find an entire floor. Instead they issued three technical deficiency notices of minor violations to Madoff’s broker - dealer arm. Now, that really is setting a pretty low bar for other government agencies to beat. But sadly, all of this nation’s financial regulators—the Federal Reserve Bank, the Federal Deposit Insurance Corporation, the Office of the Comptroller of the Currency, and the Office of Thrift Supervision—are at best incompetent and at worst captive to the companies they are supposed to regulate. As I would later testify before Congress, “The SEC roars like a mouse and bites like a flea.” In retrospect, considering how much I have learned since then, and how much my team has learned, that probably was inaccurate: I was being too kind. Tens of thousands of lives have been changed forever because of the SEC’s failure. Countless people who relied on that agency for the promised protection have lost more than can ever be recovered. In some cases people lost everything they owned. And truthfully, the SEC didn’t even need to conduct an extensive investigation. My team had given them everything they needed. With the materials we submitted, it would have taken investigators no more than the time it took to ask Madoff three questions for his fraud to be discovered and his operation to be shut down. The magnitude of this Ponzi scheme is matched only by the willful blindness of the SEC to investigate Madoff. This was not my first fraud investigation. My first investigation, which had a much more satisfying conclusion, concerned stolen fish. At one time my dad and two uncles owned a chain of 12 Arthur Treacher’s Fish & Chips restaurants in Maryland and Delaware. Eventually I became the assistant controller, which was basically a glorified bookkeeper. Then I became the manager of four units in Baltimore County. If you own a chain of restaurants, you will learn more about retail theft than you care to know. We had one manager who was using the restaurant as a front for his major income activity, which was selling drugs out of the drive - through window. Customers would place their order with him and find something other than fish and chips in their bags. We had another manager we knew was stealing from the restaurant, but we couldn’t figure out how he was doing it. Finally my uncle parked across the highway in the International House of Pancakes parking lot and watched him through a pair of binoculars. He discovered that when the cashier took her break, this manager would literally bring in another cash register from his car, and for the next hour he would ring
up sales for himself. He had a nice business going; unfortunately, it was my family’s business. We had a limited number of family members; so to eliminate fraud we had to rely on professional management, using the most advanced computers available at that time, to manage inventory. We had formulas for the components that went into every order: the amount of fish, chicken, shrimp, and clams. Every portion was controlled by size. I learned accounting in those restaurants. We continually matched our inventory to our sales and in that way could determine where our shortfalls were. Our goal was 3 percent waste. We wanted some waste, and some leftovers, because at the end of the night if you don’t have waste it means you’ve given your customers cold fish or spoiled shrimp that should have been thrown out. Too little waste meant you were not providing a quality product; too much waste meant there was theft. When I discovered more than 5 percent waste in my district, I began examining the numbers. The numbers told me that something was fishy in one of our fish and chips stores. I appreciate mathematics, and I knew the answer was in front of me; I just had to be smart enough to find it. I enjoy watching the choreography of the numbers. There is a certain satisfaction I get from it. I wasn’t always that way; in seventh and eighth grades I struggled with math and needed a tutor to lead me through algebra. In high school I excelled in math and enjoyed it. I studied finance in college and had terrible calculus teachers. They were PhD’s who didn’t know how to teach. I couldn’t understand them, and I dropped the subject three times. I finally hired a PhD student in physics to tutor me, and eventually I was doing differential equations. I turned out to be a natural in math. More than a natural, in fact. I’m a quant, which is the slang term for a quantitative analyst. Basically, that means I speak the language of numbers. Numbers can tell an entire story. I can see the beauty, the humor, and sometimes the tragedy in the numbers. Neil Chelo, a member of my Madoff team and a close friend, describes quants as people who conceptualize things in the form of numbers. As he says, quants look at numbers and see associations that other people aren’t even aware exist, and then understand the meaning of those associations in a unique way. A lot of my friends are quants. Neil is a quant; he can be obsessive about balancing not only his monthly bank statements, but even his credit card bills— to the penny. Quants are nerds and proud of it. I look at numbers the way other people read books. For example, obviously computers are pretty darn fast doing math and calculating the value of derivatives, but even today there are certain calculations that are so math intensive that even a computer can choke on them. Occasionally a situation arises in which there is a second derivative, called gamma, which is the rate of change in the first derivative, delta. Don’t try to understand this calculation, unless you intend to trade options. You’ll never need to know how to do it and there is no test at the end. And you certainly won’t need to know it to understand
No One Would Listen
how Bernie Madoff successfully ran his worldwide Ponzi scheme for decades. Bernie’s fraud was much less sophisticated than that. But in those situations prices can move literally at an infinite rate. A computer can’t track it very quickly. I can. After working in the financial industry for several years I could calculate those prices faster than a computer. Generally there were a couple of times every year when I had to throw out the computer and look at the price of a stock or the market and calculate my own option prices in a few seconds. In one of those situations, my ability to do the calculations rapidly and correctly could salvage our investment or even allow us to make a lot of money. Actually, it was that same combination of ability and experience that enabled me to look at the returns of Bernie Madoff and know almost instantly that his claims were impossible. It was my ability to understand the numbers that allowed me to catch the thief in my fish and chips store. I started by inventorying every shift for a week or two, which allowed me to pinpoint those shifts on which the thefts were occurring. That allowed me to identify the suspects. Finally I determined that there was only one person working all those shifts. Once I knew who the thief was, I was careful not to catch him. He was putting food in a shopping bag and carrying it out to his car. If I had caught him doing it I would have had to fire him, which probably would have meant paying unemployment. The amount of money involved was too small for law enforcement to become involved, but significant for my business. So rather than firing him, I didn’t say a word. Over time I just cut back his hours until he was working only one shift a week— not enough to survive on—and he quit. Bernie Madoff was a much bigger fish, but oddly enough not much more difficult to catch. Actually, it was another fraud that first brought me into the financial industry. My father’s former banker, the man who got the family into fast food, was working as a registered representative, a salesman, at a firm called Yardley Financial Services. It was shut down after the CEO was caught selling fake London gold options. The former banker joined several other former Yardley employees and opened Makefield Securities. My dad bought a 25 percent interest in the firm, and I went to work there in 1987. I began by doing oil and gas partnership accounting, completing depreciation schedules, matching trade confirms—all relatively basic and often very boring work. I probably was underpaid for the work I was doing, but whenever you work for family you’re going to be underpaid. Look at Bernie Madoff’s two sons. Their father was running the most successful fraud in history and—at least according to Bernie— he wouldn’t let them participate. My first day as a licensed broker was October 19, 1987. I remember it well because that was the day the stock market crashed. Makefield was an over - the - counter market marker that traded between 12 and 25 stocks. We relied on Harris terminals—dumb terminals I called them because they did not automatically update prices. They simply provided the quote at the moment you
hit the stock ticker. But they showed who was bidding and asking on shares at different prices. I came in to work that morning ready to begin my career as a broker, and instead walked into chaos. We had only four phone lines coming in. They started ringing at 9 a.m. and never stopped. Not for a second. I knew that it was unusual, but I hadn’t been in the market long enough to understand it was unprecedented. I did know that it wasn’t good. We were one of the few companies buying that day, because we were short; we had been betting that the market would go down, and needed to cover our positions. For much of the time we didn’t even know where the market was— our computers couldn’t keep up with the price declines. The New York Stock Exchange tape was delayed about three hours, so at 1 o’clock in the afternoon we were still getting trades from 10 a.m. There wasn’t a moment of calm the entire day. Everybody in the office was shell - shocked. They were trading every step down. I had been trained, but I wasn’t ready to be thrown into the battle. I was so junior that they certainly weren’t going to trust me. I spent the day running errands and setting up trading calls so that our traders could handle their calls more efficiently. We knew the market was crashing, but we didn’t have enough information to understand how bad it was. The end of the day was the ugliest close anybody would ever want to see. We worked through much of the night processing trades, trying to get some understanding of where we were. The market had fallen almost 23 percent. So much for my first day as a licensed broker. What surprised me from the very beginning of my career was the level of corruption that was simply an accepted way of doing business. Bernie Madoff wasn’t a complete aberration; he was an extension of the cutthroat culture that was prevalent from the day I started. This is not an indictment of the whole industry. The great majority of people I’ve met in this industry are honest and ethical, but in a business where money is the scoreboard there is a certain level of ingrained dishonesty that is tolerated. I became disillusioned very quickly. I learned that the industry is based on predator - prey relationships. The equation is simple: If you don’t know who the predator is, then you are the prey. Frank Casey, who discovered Madoff for our team, referred to those elements on Wall Street that conduct their business for bottom l ine profits rather than serving their clients as “rip your face off financing.” I don’t know where my education went wrong, but my brother and I had been taught that there was no such thing as a minor lapse of ethics. Either you were honest or you were not. It was not possible to be partly honest. I learned that at Cathedral Prep in Erie, Pennsylvania. It was the kind of Catholic school that had a very strict rule that every teacher followed: Once a teacher knocked you down he had to stop beating you. I was one of the better - behaved students and was knocked out cold only once. At the beginning of the year we had to turn in two bars of soap to use in the showers after gym. I brought two bars of Pet’um Dog Soap, which leaves your coat shiny, clean, and tick - free. It had a nice drawing of a Scottish terrier
No One Would Listen
on the wrapper, which I showed to my classmates. That was my mistake. The teacher called us individually to drop our soap in a box at the front of the room. When my name was called, the rest of the class started laughing loudly. The teacher looked in the box and found my Pet’ums. “Come here, Meathead,” he commanded. He grabbed a thick textbook and beat me with it until I went down. He followed the rules! When I got a beating like that I couldn’t go home and tell my parents, because my father would then give me another beating for causing a problem in school. A prank I did get away with was infesting the school with fruit flies. In 10th - grade biology class we were breeding fruit flies for a series of experiments. I managed to sneak a vial home and secretly bred two complete cycles, so I had tens of thousands of fruit flies in a five- gallon jar. I explained to my mother that I was breeding them for a special science project. One morning I convinced her to bring me to school early. I slipped into the school through an open door by the cafeteria and released them all. It took them three days to infest the entire building, which had to be fumigated over the weekend. More often, though, I got caught. Detention was held on Saturday mornings, when our job was to clean the school. I was a regular in detention. My parents never knew, though; I managed to convince my mother that I was in a special honors program that met on Saturday mornings. She would brag to her friends that her son Harry was so smart he was invited to attend honors classes on Saturdays! At Cathedral Prep the difference between right and wrong was demonstrated to me on a daily basis. I learned there that actions had consequences. When I began working in the financial industry I learned very quickly that dishonest actions also had consequences— often you ended up making a lot more money. The most valuable commodity in the financial industry is information. Manipulating the market in any way that gives an individual access to information not available to other people on an equal basis is illegal. In early 1988 I was promoted to over - the - counter trader. I was making a market in about 18 NASDAQ stocks. One of the companies with which I traded regularly was Madoff Securities. That was the first time I had ever heard the name. All I knew was that it was a large and well - respected company at the other end of the phone. Madoff was a market maker—the middleman between buyers and sellers of stocks—and if you were dealing in over - the - counter stocks, eventually you had to do business with Madoff. It was soon after I started trading that I encountered massive violations taking place on an hourly basis. This was not true at Madoff specifically; in fact, I don’t remember a single incident in which its brokers were dishonest. But I had just learned all the regulations, and I saw them broken every day, every hour; and everybody knew about it and nobody seemed to care. The regulations were quite clear. The sellers in a deal have 90 seconds to report a trade. By not reporting it they were allowing the price to stay at levels different from those that would have resulted if the trading volume had been reported. Basically, it meant they were trading on inside information, which
David E. Y. Sarna
is a felony. It causes a lack of the transparency that is necessary to maintain fair and orderly markets. This happened in my trades every day. It was an accepted way of doing business, although I couldn’t accept it. I would report it regularly to the district office of the National Association of Securities Dealers (NASD) in Philadelphia, and they never did a thing about it. My younger brother had similar experiences. At one point he was hired by a respected brokerage firm in New Jersey to run its trading desk. On his first morning there he walked into the office and discovered that the Bloomberg terminals that supposedly had been ordered hadn’t arrived. Then he found out that the traders didn’t have their Series 7 licenses, meaning they weren’t allowed to trade. And then he learned that the CEO had some Regulation 144 private placement stock, which legally is not allowed to be sold. But the CEO had inside information that bad news was coming and he wanted to sell the stock. My brother explained to the CEO, “You can’t sell this stock. It’s a felony.” The CEO assured him he understood. My brother went out to lunch with the Bloomberg rep to try to get the terminals installed that he needed to start trading. By the time he returned to the office, the unlicensed traders had illegally sold the private placement stock based on insider information. My brother had walked into a perfect Wall Street storm. He called me in a panic. “What do I do?” I said, “These are felonies. The first thing to do is write your resignation letter. The second thing you do is get copies of all the trade tickets; get all the evidence you can on your way out the door. And the third thing you do is go home and type up everything and send it to the NASD.” That’s exactly what he did. The NASD did absolutely nothing. These were clear felonies and the NASD didn’t even respond to his complaint. When I started at Makefield in 1987, the industry was just beginning to become computerized, so most of the business was still done on the phone. I would spend all day with a phone hanging from my ear. I spoke with many of the same people every day and often got to know them well—even though I never met them in person. Among the people I most enjoyed speaking with was a client named Greg Hryb, who was with Kidder Peabody’s asset management arm, Webster Capital. Greg was nice enough to take time during those calls to teach me the business. When he started his own asset management firm, Darien Capital Management, in June 1988, he hired me as an assistant portfolio manager and an asset manager trainee. I moved to Darien, Connecticut, that August, and it was there that my education really began. ... chapter continues
History of Greed
History of Greed Financial Fraud from Tulip Mania to Bernie Madoff David E. Y. Sarna
978-0-470-60180-8 • Hardback • 398 pages September 2010 • £19.99 / €24.00 / $29.95
Chapter 5 The Perils of Greed IT’S ALL FOR THE EASY MONEY Many of today’s securities frauds go one step beyond the frauds that we briefly discussed in the preceding chapter. After all, fraudsters have had nearly 400 years to polish their skills. By turning paper into stock certificates or debentures that they print and then give to themselves and their friends, who turn them into money, stock operators are fulfilling the dream that had eluded man for over 2,500 years. Ever since the ancient Mesopotamians, Egyptians, Persians, Indians, Japanese, Koreans, Chinese, and classical Greeks and Romans first tried, unsuccessfully, to turn worthless base metal into gold (efforts that continued until well into the nineteenth century), people have tried to turn nothing into something. Now, this feat of alchemy is accomplished every day by entrepreneurs and promoters as well as by investment bankers. It’s done legally or not, as the case may be. And very often, there are no bright lines to distinguish one from the other. In the previous chapter, we’ve noted that securities fraud has a long history. In this chapter, we look at the huge penalties meted out to fraudsters, and consider why, notwithstanding all the lessons of history, we still see so much fraud.
The Lure and the Risks The lure of easy money is great. So are the risks. Turning an unlimited supply of worthless paper into money can create theoretically infinite wealth, but the risks can be equally impressive. According to the Source-book of Criminal Justice Statistics,2 sentences of incarceration were imposed in 62.5 percent of the fraud cases where the sentencing guidelines were applied (and they nearly always are). In financial crimes, the monetary amount of the fraud is almost always the major component in determining the length of the sentence. One financial fraudster, Sholam Weiss, 3 absconded and was sentenced in absentia to 845 years, in addition to restitution, fines, and penalties of $ 133,900,000. He was captured and incarcerated. His projected release date is November 23, 2754, and in the meantime he is inmate 32610 - 054 in United States Penitentiary–Canaan, where he is rumored to be dying of cancer. You can check on his progress, if you like, by going to www.bop.gov. Click on “Locate Inmate” and then enter his inmate number. Another fraudster, Norman Schmidt, was sentenced to 330 years of prison for taking “tens of millions of dollars from hundreds of investors,” and using the money for personal gain. His scheduled release date is September 12, 2291.
David E. Y. Sarna
By way of comparison, the punishment for murder can be as little as 10 years in some jurisdictions. 4 For innocent but greedy investors, who buy and sell shares in the market, or who buy into “too good to be true” schemes but are unconnected in any way, the risks are usually limited to the amount of their investment (unless they are illegally short selling). This means that they may lose all their hard - earned cash and be left holding worthless paper. If they were leveraged (borrowed money to make the investment) they may end up in debt, or even bankrupt. For those who gave Bernard L. Madoff Investment Securities, LLC their money to invest, the worthless paper caused them to suffer enormous losses, up to $ 7.5 billion for some funds and up to $ 545 million for trusting individual investors, in what added up to the largest financial scam in history. More than a few retirees needed to go back to work in order to put bread on their tables. Many lost their homes. But for the crooked entrepreneurs, and for all of their service providers (including, as we will see, the lawyers), the risks can be even greater, causing them not only the loss of their accumulated wealth but their liberty as well— and for a long time. While Sholam Weiss’s 845 - year sentence and Norman Schmidt’s 330 - year sentence 5 are exceptionally long, many others are increasingly sent away for a very long time for nonviolent, white - collar crimes. In October 2009, Richard Monroe Harkless, 65, was sentenced by United States District Judge Virginia A. Phillips in federal court to 100 years in prison. 6 He was the mastermind of a California - based Ponzi scheme that collected well over $ 60 million from hundreds of investors—and caused more than $ 39 million in losses. Others I write about in this book received sentences of up to 150 years of imprisonment. There are other pitfalls to fraud beyond incarceration. Sometimes even a small misstep can kill the entrepreneur’s company and trash the market value of the company’s stock, in addition to potentially landing a company’s executives in jail to serve sentences of 10 to 20 years or more, as well as saddling them with huge liabilities for fines and restitution, which means that investors who lost money must be made whole. For example, in the case of Computer Associates, executives accused of accounting fraud that infl ated the stock price (a tale discussed in Chapter 31 ) were ordered to pay restitution of nearly $ 800 million, 7 many times more than they personally benefited from the fraud.
Martha Stewart and Dr. Samuel D. Waksal Sometimes, people can go to jail for breaking the securities laws even when the company itself has real value. Martha Stewart allegedly told her broker, Merrill Lynch’s Peter Bacanovic, to sell about $ 228,000 worth of the stock of ImClone Systems at $ 60 back on December 27, 2001, just ahead of news that ImClone’s cancer drug, Erbitux, would not be approved by the Food and Drug Administration (FDA). She ended up being indicted, going to trial, and being found guilty by a jury on all four counts charging her with obstructing justice and lying to investigators about her well - timed stock sale. She famously was sent to jail. Stewart received a split sentence of six months in jail and six months of house arrest. She also was barred from ever serving as an officer or director of a public company (including her eponymous one). The fellow who tipped her, ImClone’s then CEO, Dr. Samuel D. Waksal, was released from prison in February 2009 after having served about five years of his seven - year sentence in federal prison camps (he got time off for successfully completing a drug treatment program as well as the standard allowance for good behavior of about 15 percent). The former ImClone Systems chief executive received his sentence of 87 months in prison and a $ 3 million fine after being charged for securities fraud, bank
fraud, obstruction of justice, and perjury related to his attempts to sell stock, as well as scheming to avoid paying sales tax on art he purchased, by having it supposedly delivered out of state when in fact it wasn’t. The irony here is that the FDA ultimately did approve Erbitux, and it has saved many lives. Indeed, had Waksal and Stewart just waited a few years, they could have sold the stock legally at an even higher price. In early 2008, ImClone’s partner, Bristol - Myers Squibb, made a bid for all of the 83.4 percent of ImClone’s stock that it did not already own, which kicked off a bidding war. Its offer of $ 60 a share was topped by Eli Lilly & Company, and ImClone was ultimately sold to Lilly for $ 70 a share, for a total consideration of over $ 6.5 billion.
Why Take the Risk? So, given the inherent risks such as we have just seen—to the entrepreneur, broker, investor, trader, or any other player— why would anyone in his right mind (or hers, for that matter, but overwhelmingly stock fraud is perpetrated by males, except for the public relations folks, who are generally female) want to tread in such treacherous waters? The answer, in one word, is greed. Or, in two words: easy money. Everyone playing the stock game—no matter what they may say—is in it for easy money. The entrepreneur hopes to raise money from the public at a better valuation than what he can get raising it privately. He also secretly hopes—in the future, so he says— to cash in some of his chips by selling his stock into the market (usually, though, he means in the very near future, just as soon as he can). The investors are looking for huge gains on their money (threebaggers or fourbaggers, they call them— that is, to sell their stock for three or four times what they paid for it), and just as soon as possible. The brokers are looking for spreads, commissions, and fees that are several times what they can charge for executing orders for large - cap, boring stocks like IBM or Microsoft, where commissions run to just a few pennies per share. Ditto the market makers and traders. Promoters and service providers (who try to get paid in stock) look to dump the stock into the market just as soon as they can, and charge fees far in excess of what they might earn offering similar services to others in a conventional cash fee - for - service transaction. While companies of all sizes have been involved with stock fraud, and there have been some well - publicized frauds in large - cap stocks with a market capitalization in the billions (Enron being the poster child), most garden - variety stock fraud takes place in stocks with low prices and smaller market capitalizations, as these are the most easily manipulated.
It’s Not Blackjack Blackjack is a unique game of chance, in which the odds that favor the house (at least in some casinos) can be as small as 0.02 percent (under the Lisboa Rules in Macau, for example10); in most other games of chance, the odds strongly favor the house. In the small stock game, most of the participants are on the house’s side and only the retail investors are the players; the odds overwhelmingly favor the house. And to help nature along even more, the dice are often loaded and the cards marked. However, just as gamblers are drawn to casinos or to lotteries by the lure of winning the jackpot, so too are investors inexorably drawn—like moths to a fl ame—to invest in nanocap, microcap, and small - cap stocks in hopes of securing quick and enormous returns.
Bust Greece, the Euro and the Sovereign Debt Crisis Matthew Lynn
978-0-470-97611-1 • Hardback • 288 pages December 2010 • £18.99 / €22.80 / $32.50
Introduction Mayday in Athens It was a long time since the Hammer & Sickle, the Marxist symbol of the unity of workers and peasants, had been flown anywhere in Europe with anything approaching pride. But on May 4th, 2010, as the protests in Greece over the austerity package imposed on the country by the European Union and the International Monetary Fund gathered force, members of the Greek Communist Party stormed the Acropolis, and draped a huge banner across it famous old stones. The slogan “Peoples of Europe Rise Up” was etched into the banner, and, next to the words, in stark, blood-red graphics, the crossed implements that were formally adopted as the official flag of the Soviet Union all the way back in 1924. The Acropolis is the most potent symbol of Greek culture; indeed, it is one of the foundation stones of Western civilisation, a monument that reminds all of us of the common intellectual and cultural heritage we all share. Over the next twentyfour hours, across all the news networks, the protestors’ flag was broadcast as a backdrop as reporters filed reports on the riots rampaging through Athens. There could be no better way of illustrating what was happening, both on the streets and in the financial markets. On one level, ordinary Greeks were venting their anger and frustration over an economy that appeared to have gone off the rails as suddenly and violently as a train accelerating into a crash. On another, a wider conflict was being played out. The riots were about far more than just a few budget cuts in one smallish country far from the centre of the world economy. They were about whether a whole economic and political system created over three generations was sustainable. Or whether, groaning under a mountain of debts, and a mess of ill-thought through dreams and aspirations, it was about to collapse under the weight of its own contradictions. It was no exaggeration to argue that the post-war economic system established in Europe was breaking apart in front of people’s eyes. And the Hammer & Sickle drove that point home with the kind of unrelenting clarity that would have bought a smile to the corpse of the man who approved the design, Vladimir Lenin. Early May, 2010, in Athens was to prove an extraordinary few days. Violent,
brutal and passionate, on the streets of the Greek capital, all the fault lines and conflicts within the global economy were about to be played out in vivid Technicolor. The drama had been brewing for the past two years. In the wake of the credit crunch, following the collapse of the American investment bank Lehman Brothers, the financial markets had frozen. There was a sudden and terrifying collapse in world trade: in response, governments everywhere had massively increased their budget deficits in an attempt to steady economies that looked to be on the verge of tipping into a replay of the Great Depression of the 1930s. But as 2009 turned into 2010, and as the fears of another depression eased, the markets started to worry about something else. The cure was starting to look even worse than the disease. And the build-up of sovereign debts, and whether those debts could ever possibly get repaid, was suddenly the issue everyone was worrying about. There were a dozen different countries the bond dealers could have picked on. But it happened to be Greece. Over the course of the past few weeks, the country’s Prime Minister George Papandreou had been taught a painful lesson in the harsh realities of global finance. When the money runs out, so do your options. The capital markets were no longer interested in buying Greek bonds. Their neighbours and allies in the euro area showed little interest in helping out either. The country’s debts were proving quite literally impossible to finance. Already, the Greeks had been forced to appeal for outside help. Now the European Union and the International Monetary Fund had landed in Athens with the promise of a rescue package. But the price they would demand would be a heavy one. Cuts on a brutal and massive scale, an end to the easy money culture that had taken root in Greece over the past decade, and a shocking assault on the living standards of ordinary people. That was the price that would have to be paid, and it was no longer negotiable. As May 1st, dawned, it was already clear that this was to be pivotal weekend in Greek history. The nation that had been the birthplace of modern democracy, which had indeed created the word itself, did not have a great track record of implementing the ideals to which it had been the cradle. Between 1946 and 1949 it had been the scene of a vicious civil war between rival armies backed by the forces of left and right. The country was left in ruins. It struggled to re-build itself, and managed to miss out on the post-war reconstruction of Europe. In 1967, a group of reactionary, socially conservative military leaders staged a coup, creating a buffoonish, at times ridiculous ‘Regime of the Colonels’ that lasted until 1974. This was a country with a long history of settling its divisions with riots and bloodshed. It had happened plenty of times in the past. And now it looked to be happening again. Mayday has always been a crucial date in the European calendar. The International Workers Day, it is the traditional moment for trade unions and leftwing political parties to mobilise their forces and challenge the capitalist order. It is, as well, the month of revolution. The convulsions that shook much of Europe in 1968 started in that month. Perhaps the start of spring turns people’s minds to the possibility of creating society afresh. Whatever the truth of that, officials from the International Monetary Fund and the European Union could have hardly chosen a worse moment to descend on the Greek capital demanding cuts. The trouble started on the Saturday night, May 1st. As Labor Day rallies
gathered to march through the city, scuffles broke out with riot police armed with shields and batons. Nineteen people were arrested. The former President of the Greek Parliament, Apostolos Kaklamanis, was targeted by demonstrators, and both missiles and abuse were hurled towards him, before the police managed to extricate the surrounded politician and get him away safely to hospital. On the Sunday night, there were signs of more trouble brewing when a bomb exploded outside a branch of the British bank HSBC in central Athens. A small, homemade device, put together by enthusiastic amateurs from gas canisters and petrol, it wasn’t powerful enough to do much more than damage the front of the building. It was, however, a warning of worse to come over the next few days. Meanwhile, far away in Brussels, the Luxembourg Prime Minister Jean-Claude Juncker, a veteran of European Union negotiations, and the serving President of the euro group, which represented the interests of the nations sharing the single currency, had called an emergency meeting of euro-zone’s finance ministers for 5pm Athens time on the Sunday evening. Their task would be to endorse whatever deal the so-called ‘troika’, the group of European Union, European Central Bank, and IMF officials, had managed to hammer out with the Greek government over the course of the weekend. Against the backdrop of simmering violence, a deal was finally welded into shape. The euro-zone finance ministers agreed a $146 billion package that would enable the Greek government to limp through the next few months. In return, the Greek government agreed to push through 30 billion euros of budget cuts, amounting to 13% of GDP. Of the bail-out package, 10 billion euros would be set aside for helping out the country’s battered banking system. “I want to tell Greeks very honestly that we have a big trial ahead of us,” Prime Minister Papandreou told his nation in a televised address on the Sunday evening after the deal was announced. “I have done and will do everything not to let the country go bankrupt,” Ordinary Greeks would, he continued, have to accept “great sacrifices” to avoid “catastrophe.” A solution to the crisis? That was far too much to hope for. To keep her own electors at home happy, the German Chancellor Angela Merkel had played up the extent to which her government had toughed up the conditions attached to the loan. “This is an ambitious program that contains tough savings measures and on the other hand seeks to improve the efficiency of the Greek economy,” Merkel insisted at a press conference in Bonn after the deal was agreed. “Three months ago it would have been unthinkable that Greece would accept such tough conditions.” For the Greeks, the idea of a German Chancellor imposing painful austerity on their country was more than many could tolerate. This was, after all, a country that had suffered terribly under German occupation during World War II. Three hundred thousand people had died of starvation in Athens during the winter of 1941-42 as the Nazi occupying regime requisitioned food and fuel to send back to the Third Reich. And in towns such as Kalavryta, German troops executed the entire adult male population, leaving only 13 male survivors and children in reprisals for attacks by the Greek resistance. Too many Greeks had been raised on stories of German brutality for Merkel’s language to be anything other than provocative.
There was little sign that the Greeks were willing to accept their fate, at least not without violent, bitter protest. Giorgos Delastik is a popular columnist in the country, writing for To Ethnos, a mass market daily controlled by the Bobolas family of industrialists. “Today, people across the country woke up to a palpable atmosphere of tension in the wake of the government’s announcement of a fresh package of austerity measures including major wages cuts, which will prompt a significant decline in living standards,” he wrote in an incendiary column published on May 3rd. “Civil servants and pensioners will be worst affected, but private sector workers will also lose out. Perhaps the most galling aspect of this latest development is the fact that Prime Minister George Papandreou announced the austerity package under orders from the foreign powers that have now assumed control of our country: the International Monetary Fund and the European Union.” He warned his readers that Greece faced a bleak future of unparalleled austerity. “There is no denying the utter disregard for social progress in these austerity measures, which are worse than anything that Greece has seen in more than a century… The GDP of our country is set to fall by a record 4% in 2009, the most dramatic decline in 50 years - a slump only exceeded by a 6.4% drop in 1974 prompted by the joint effect the oil crisis and the invasion of northern Cyprus by the Turkish army, which followed the fall of the military junta. And worse still, they will have no positive impact on Greece’s public debt, which is set to increase from 115% in 2009 to 140% in 2014.” That was just one small snapshot of the mood right across Greece. As the emergency rescue package was unveiled, the civil service union called an immediate general strike. Greeks are used to strikes, and they are used to farleft communist and anarchist groups stirring up trouble. But this was different. Ordinary people were willing to march out onto the streets themselves, protesting at what they believed was an unfair and unjust package imposed on them by outsiders. It was on May 5th, as the scale of the pain about to be inflicted on the Greek people became clear, that the violence turned raw and ugly. The crowds chose their spots well, gathering in places which were, for most ordinary Greeks, filled with the symbolism of past conflicts. The first demonstrators flocked to Sintagma Square. With the Parliament building directly behind it, the square is a popular meeting place, and a hub for the Athens Metro. The English translation of its name is Constitution Square, and it acquired its name after the constitution that Greece’s King Otto was forced to grant his people in 1843 after a popular and military uprising (Otto was born Prince Otto Friedrich Ludwig of Bavaria, another reminder of the unhappy history of German meddling in Greek affairs). Throughout modern Greek history, the Square has been the arena for voicing protest and anger against the reigning powers. Other protestors gathered around Athens Polytechnic, the site of a student uprising against the military dictatorship in 1973: at least a dozen people were killed in that year, and many more were injured in violent clashes that eventually turned out to be the catalyst for the downfall of the military junta. Now, once again, the Polytechnic students were out on the streets, and the Communist Party organizers were finding a willing audience for their recruiters. It was not hard to imagine the IMF-EU junta, as some of the protestors already referred to it, might
go the same way the colonels of an earlier generation. As the day progressed, the mood started to turn uglier. Protestors, aware that the world’s media had descended upon Athens, and that their actions would be broadcast around the world, attempted to storm Parliament, ready to take the building by force if necessary. Many no doubt had learned the story of the Lenin’s assault on the Winter Palace in October 1917, a grand, theatrical coup that set the stage for the Bolshevik revolution. Capture the right building at the right moment, and you can take possession of an entire country. The riot police stood firm, however. Demonstrators rushing up the steps of the building chanted “thieves”, their voices carrying on the breeze to the politicians inside. With batons, shields, muscle and tear gas, the police lines repulsed wave after wave of attacks. Paving stones were ripped up, and improvised petrol bombs were hurled towards them in a brutal assault of flame and concrete, but the police stood resolute. The protestors threw up barricades, and set cars alight. One building was incinerated, and the fire fighters only managed to pull four people to safety at the last moment before they died in the flames. On Stadiou Avenue, a road leading up towards the Square, protestors firebombed the Marfin Bank. Twenty people were working inside that day. As the flames took hold, most of them managed to escape. But three of the staff tried to make their way up to the roof to avoid suffocation. Their way was blocked, and as the flames kept rising higher and higher, it was too late for the fire fighters to do anything for them. All three died in the blaze. The riots had claimed their first casualties. As news spread around the city of the deaths, an angry mob started to gather around the burned out building. When the owner of the bank arrived on the scene, he was accused of forcing his workers to stay at their posts, despite the general strike called by the trade unions. More protests were rising up around the country. In Salonika, 50,000 people marched through the streets destroying dozens of banks and shops in Greece’s second largest city. Over many hours demonstrators fought running battles with the police. Anarchists occupied the city’s labour centre. In Patras, around 20,000 protesters were joined by farmers driving tractors and garbage truckers on their vehicles, as flaming barricades were erected along the central streets of the city. There were fierce clashes between protestors and the police. In Ioannina, the protesters attacked banks and shops, prompting the police to respond with tear gas, whilst in Corfu, protesters occupied the County Headquarters. The Administrative Headquarters of Naxos and the City Hall of Naoussa all came under attack. Although the riots and demonstrations eventually fizzled out, for a moment the anger of the country appeared revolutionary in its potency. As the debris was cleared up, Greece awoke the next morning asking itself tough questions. “Can a society self-destruct?” asked the Greek daily newspaper Kathemerini, posing the question in big, bold capital letters. “Of course it can, and it is certain that this will happen if we continue this way – when the state and society allow some nihilist hooligans to burn the city and murder three working citizens.” It was a good point, and one that could well be posed more widely. After all, it wasn’t just Greece that was being put to the test as the rioters rampaged across the capital, and through the streets of all Greece’s major cities. It was the euro, a currency still only just over a decade old. And it was the European Union, the
foundation of peace and prosperity across the continent for the past half century. The euro was created by an economic elite convinced they were creating a better more harmonious and more efficient Europe. But now it was being defended with tear gas and truncheons. That was certainly not the way it was meant to be. As the burnt out cars were cleared away, it was obvious to anyone that Greece was bust. It faced a generation of grinding austerity, political turmoil and resentful poverty. But the euro was broken as well, and with it the idea of the EU, or at least one centralising version of it. On Mayday in Athens, the edifice had cracked. That, as we shall discover over the rest of this book, had been a long time coming. Arrogance and hubris had caught out a generation of political leaders that had pushed too hard and too fast for political and monetary union. But broken it was. And, as we shall also discover, it will be impossible to put it together again. As the rioting stopped, the Hammer & Sickle wasn’t flying over Europe again. A day after it was put up, the banner draped across the Acropolis urging the people of Europe to rise up had been removed. Tourists could once again wander amid the ancient stones. But a kind of revolution had taken place. The euro no longer looked like the future of anything. Sovereign debt was dominating discussion in the world markets. And that was a transformation - and one that was to ready to dominate the continent, and indeed the global economy, for much of the coming decade. Please note: This excerpt is from an advance uncorrected proof and is subject to change. All information must be checked against final book
Also Available In Too Deep BP and the Drilling Race That Took it Down 9780470950906 • Hbk • Dec 2010 • £18.99 / €22.40 / $27.95
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Peter D. Schiff
How an Economy Grows and Why It Crashes buy now Peter D. Schiff 978-0-470-52670-5 • Hardback • 256 pages May 2010 • £13.99 / €16.00 / $19.95
Chapter 1 An Idea is Born Once upon a time there were three men— Able, Baker, and Charlie—who lived alone on an island. Far from a tropical paradise, the island was a rough place with no luxuries. In particular, food options were extremely limited. The menu consisted of just one item: fish. Fortunately, the island was surrounded by an abundant population of strangely homogeneous fish, any one of which was large enough to feed one human being for one day. However, this was an isolated place where none of mankind’s many advancements in fish-catching technology had arrived. The best these guys could do was jump in and grab the slimy buggers by hand. Using this inefficient technique, each could catch one fish per day, which was just enough to survive to the next day. This activity amounted to the sum total of their island economy. Wake, fish, eat, sleep. Not much of a life, but hey, it beats the alternative. And so, in this super-simple, sushibased island society there are…. No savings! No credit! No investment! Everything that is produced is consumed! There is nothing saved for a rainy day, and there is nothing left to lend.
How an Economy Grows and Why It Crashes
Although our island dwellers lived in a primitive society, it didn’t mean that they were stupid or lacked ambition. Like all humans, Able, Baker, and Charlie wanted to improve their living standards. But in order to do this, they had to be able to catch more than one fish apiece per day, which was the minimum they needed to survive. Unfortunately, given the limitations of their bare hands and the agility of fish, the three were stuck at subsistence level. One night, looking up into the star-studded sky, Able began pondering the meaning of his life…. “Is this all there is? There must be more to life than this.” You see, Able wanted to do something besides fishing by hand. He’d love to make some better, more fashion-forward palm-leaf clothing, he wanted a place to shelter himself from monsoons, and ultimately, of course, he wanted to direct feature films. But with his daily toil so devoted to fishing, how could these dreams ever come true? His mental wheels started turning… and suddenly an idea for a fish catcher was born…a device that could vastly expand the reach of the human hand while severely reducing a fish’s ability to escape after the initial grab. With such a contraption, perhaps more fish could be caught in less time! With his newfound time, perhaps he could start to make better clothes, build a shelter, and put the finishing touches on his screenplay. As the device took shape in his mind, the orchestral music began to swell, and suddenly he conceived of a future free from daily fish drudgery. He decided to call his device a “net,” and he set about finding materials to build one. The next day, Baker and Charlie noticed that Able wasn’t fishing. Instead, he was standing in the sand, making string out of palm bark. “What gives?” asked Baker. “Are you on a diet or something? If you keep sitting there tying those strings, you’re gonna go hungry.” Able explained, “I have been inspired to create a device that will unlock oceans of fishing possibilities. When I’m finished, I’ll spend less time fishing, and I’ll never go hungry again.”
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Charlie rolled his eyes and wondered if his friend had finally lost his mind. “This is madness, I tell you… madness. When it doesn’t work, don’t come crying for a piece of my fish. Just because I’m sane doesn’t mean I’m gonna pay for your crazy.” Undeterred, Able continued weaving.
✔ REALITY CHECK In this simple task, Able is demonstrating a basic economic principle that can lead to an improvement in living standards: He is underconsuming and he is taking risk! Underconsumption: In order to build his net, Able is unable to fi sh that day. He has to forgo the income (the fish) that he would have otherwise caught and eaten.It’s not that Able lacks the demand for fish. In fact, he loves fish and he will go hungry if he doesn’t get one that day. Able has no more or less demand for fi sh than his two friends. But he is choosing to defer that consumption in order to potentially consume more in the future. Risktaking: Able is also taking risk because he has no idea that his device will actually work, or allow him to catch enough fi sh to compensate for his sacrifice. In the end, he might just have a bunch of string and an empty stomach. If his idea fails, he can expect no compensation from Baker and Charlie, who did, after all, try to warn him of his folly. In economic terms, capital is a piece of equipment that is built and used not for its own sake, but for building or making something else that is wanted. Able doesn’t want the net. He wants the fish. The net can, maybe, get him more fish. Therefore, the net, a piece of capital, is valuable. By day’s end Able had completed his net! He had created capital through his self-sacrifice! That night, while Baker and Charlie slept with full stomachs, Able dealt with hunger pangs while images of luscious fish danced in his head. However, his pain was more than overcome by his hope that he had done the right thing and that a bright, fish-filled future awaited. The next day, Baker and Charlie made much sport of Able’s invention.
How an Economy Grows and Why It Crashes
“Hey, that’s quite a nice- looking hat,” said Baker. “A little hot for tennis, don’t ya think?” added Charlie. “Laugh it up, boys,” responded Able, “but let’s see who’s laughing when I’m up to my armpits in fish guts.” As Able charged into the surf, the ridicule kept coming as he awkwardly handled his strange new device. After a few minutes he got the hang of it and in no time snagged a doozy. Baker and Charlie stopped laughing. When, in just another hour, Able landed his second fish of the day, the boys were in awe. After all, it generally took them all day to get just one fish! From this one simple act, the island’s economy was about to change in a very big way. Able had just increased his productivity, and that was a good thing for everybody. For the moment, Able pondered his sudden boon. “Since I can provide two days of food with only one day of fishing, I can use every other day to do something else. The possibilities are endless!”
✔ REALITY CHECK By doubling his productivity Able is now able to produce more than he needs to consume. From gains in productivity all other economic benefits flow. Before Able rolled the dice to build his net, the island had no store of savings. His willingness to take a chance and go hungry led to the island’s first piece of capital equipment, which in turn produced savings (for the sake of this story we will assume that fish do not spoil). This spare production is the lifeblood of a healthy economy.
TAKEAWAY For all species, except our own, economics really boils down to day-to-day survival. Given the competition for scarce food, the harshness of the elements, the danger of predators, the vulnerability to disease, and the relative rarity of innovation, bare-bones survival (with some time left over for reproduction) is about all animals can attain. We would be in the same boat (as we were in the not-toodistant past) if not for two things: our big brains and our dexterous hands. Using the two together, we have been able to build tools and machines that magnify our ability to get more out of our environment. Economist Thomas Woods likes to challenge his students with a simple thought experiment: What kind of economy would we have if all machines and tools disappeared? Cars, tractors, iron smelters, shovels, wheelbarrows, saws, hammers, spears, everything. What if they all went poof and all that we consumed
Peter D. Schiff
had to be hunted, gathered, grown, and made, WITH OUR BARE HANDS? Without question, life would be rough. Imagine how hard it would be to eat if we had to bring down game with our teeth, fists, and fingernails. Large game would be out of the question. Rabbits would be within our power to subdue… but you would have to catch them first. What if vegetables had to be planted and picked by hand, and what if we didn’t even have sacks in which to carry the harvest? Imagine if we had to make clothes and furniture without factories… without even scissors or nails? Despite our intelligence, we would be no better off, economically at least, than chimps and orangutans. Tools change everything and create the possibility of an economy. Spears help us bring down game, shovels help us plant crops, and nets help us catch fish. These devices magnify the efficacy of our labor. The more we can make, the more we can consume, and the more prosperous our lives become. The simplest definition of economy is the effort to maximize the availability of limited resources (and just about every resource is limited) to meet as many human demands as possible. Tools, capital, and innovation are the keys to this equation. Keeping this in mind, it is easy to see what makes economies grow: finding better ways of producing more stuff that humans want. This doesn’t change…no matter how big an economy eventually gets.
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Alchemists of Loss
Alchemists of Loss
How modern finance and government intervention crashed the financial system Kevin Dowd & Martin Hutchinson
978-0-470-68915-8 • Hardback • 432 pages May 2010 • £16.99 / €20.40 / $27.50
Introduction Towards the end of his General Theory of Employment, Interest and Money, published in 1936, John Maynard Keynes wrote that: “… the ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influences, are usually the slaves of some defunct economist. Madmen in authority, who hear voices in the air, are distilling their frenzy from some academic scribbler of a few years back. I am sure that the power of vested interests is vastly exaggerated compared with the gradual encroachment of ideas.”1 In this book we suggest that the key to understanding the recent financial crisis is to appreciate the impact of two belief systems, at first sight unconnected. Both of these belief systems originated from economic theories propounded by “defunct economists.” The first of these is Modern Finance. At its broadest level, Modern Finance consists of a set of attitudes and practices, perhaps best understood by comparing it to what went before. In the past, finance emphasized old-fashioned values: the importance of trust, integrity and saving; the need to build long-term relationships and invest for the long term; modest remuneration for practitioners and a focus on the interests of their clients; and tight governance and a sense of harmonized interests and mutual benefit. All of these dovetailed together into a coherent whole. Modern Finance emphasizes the opposite: a focus on marketing and sales, form over substance, and never mind the client; an obsession with the shortterm and the next bonus; a preference for speculation and trading over long-term investment; stratospheric remuneration levels for practitioners, paid for through exploitation of clients and taxpayers, or “rent seeking”; the erosion of the old governance mechanisms and out-of-control conflicts of interest. Underpinning much of Modern Finance is a vast intellectual corpus, the formidable mathematical “Modern Financial Theory.” This includes Modern Portfolio Theory developed in the 1950s; the Efficient Market Hypothesis and the Capital Asset Pricing Model developed in the 1960s; the weird and wonderful universe of financial
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derivatives pricing models, including notably the Black-Scholes-Merton equation for valuing options, developed in the early 1970s, and its many derivatives; and financial risk management or, more accurately, the modern quantitative theory of financial risk management, which emerged in the 1990s. Modern Financial Theory soon became widely accepted; those who questioned it were, for the most part, drummed out of the finance profession. It became even more respectable with the award, to date, of no fewer than seven Economics Nobels, ample proof of its scientific respectability. Modern Finance was big on promises. We were assured that it would provide us with the ever-expanding benefits of “financial innovation” and sophisticated new financial “services,” and not just at the level of the corporation, but trickling down to the retail level, benefiting individual savers and investors in their everyday lives. The evidence for this was, allegedly, the much greater range of choice of financial services available and the expanding size of the financial services sector as a percentage of GDP. At the same time, improvements in financial risk management meant that we could sleep easily in our beds, knowing our hard-earned money was safe in the hands of financial institutions working on our behalf. Or so we were led to believe. Yet, intellectually impressive as it is, most of this theoretical edifice was based on a deeply flawed understanding of the way the world actually works. Like medieval alchemy, it was an elegant and internally consistent intellectual structure based on flawed assumptions. One of these was that stock price movements obey a Gaussian distribution. While the Gaussian distribution is the best-known distribution, it is only one of many, and has the special property that its “tails” are very thin – i.e. that events from outside the norm are truly rare, never-in-the-history-of-the-universe rare. History tells us that’s not right; markets surprise us quite often. Among some of the other common but manifestly indefensible claims of Modern Finance are that: • modern “free markets” ensure that financial innovation is a good thing, which benefits consumers and makes the financial system more stable; • risks are foreseeable and, incredibly, that you can assess risks using a risk measure, the Value-at-Risk or VaR, that gives you no idea of what might happen if a bad event actually occurs; • highly complex models based on unrealistic assumptions give us reliable means of valuing complicated positions and of assessing the risks they entail; • high leverage (or borrowing) doesn’t matter and is in any case tax-efficient; and • the regulatory system or the government will protect you if some “bad apple” in the financial services industry rips you off, as happens all too often. The invention and dissemination of Modern Financial Theory is a startling example of the ability to achieve fame and fortune through the propagation of error that becomes generally accepted. In this, it is eerily reminiscent of the work of the Soviet biologist Trofim Denisovich Lysenko, a man of modest education whose
Alchemists of Loss
career began when he claimed to be able to fertilize fields without using fertilizer. Instead of being dismissed as so much fertilizer themselves, Lysenko’s claims were highly convenient to the authorities in the Soviet Union, and he was elevated to a position of great power and influence. He went on to espouse a theory, “Lysenkoism,” that flatly contradicted the emerging science of genetics and was raised to the level of a virtual scientific state religion. Those who opposed his theo ries were persecuted, often harshly. Lysenko’s theories of agricultural alchemy in the end proved highly damaging and indeed embarrassing to Soviet science, and Lysenko himself died in disgrace. Of course, the analogy is not perfect: proponents of Modern Financial Theory did not rely on Stalin to promote their ideas and silence their opponents, nor did they rely on the prison camps. Instead, their critics were sidelined and had great difficulty getting their work published in top journals, so ending up teaching in the academic “gulag” of less influential, lower-tier schools. But what the two systems share in common is a demonstrably false ideology raised to a dominant position where it inflicted massive damage, and an illusion of “scientific” respectability combined with a very unscientific unwillingness to listen to criticism. For its part, the financial services industry eagerly adopted Modern Financial Theory, not because it was “true” in any meaningful sense (as if anyone in the industry really cared!) but because the theory served the interests of key industry groups. After the investment debacles of 1966–74, investment managers wanted a scientific-seeming basis to persuade clients to entrust their money to them. The options and derivatives markets, growing up after 1973, wanted a mechanism to value complicated positions so that traders could make money on them. Securities designers wanted mechanisms by which their extremely profitable derivatives-based wrinkles could be managed internally and sold to the public. Housing securitizers wanted a theory that reassured investors and rating agencies about the risks of large packages of home mortgages, allowing those packages to get favorable credit ratings. Back-office types and proprietary traders wanted models that would provide plausibly high values for the illiquid securities they had bought, allowing them to be marked upwards in financial statements and provide new profits and bonus potential. Most of all, Wall Street wanted a paradigm that would disguise naked rent seeking as the normal and benign workings of a free market. With this level of potential support, it’s not surprising that Modern Financial Theory was readily adopted by Wall Street and became dominant there, even though crises as early as 1987 demonstrated that it was hugely flawed. It didn’t hurt that, in parts of the business, the universal adoption of Modern Finance techniques tended to validate them, as options prices arbitraged themselves towards their Black-Scholes-Merton value, for example. After 1995, the loosening of monetary conditions for a time created an apparently eternal “Great Moderation” bull market environment in which Modern Finance techniques appeared to work well, but then broke down completely when they were really needed. Nevertheless, for those with open eyes, it has been apparent for some time that Modern Financial Theory wasn’t delivering what was promised on its behalf. The industry was benefiting, to be sure: its remuneration skyrocketed, and perhaps that had something to do with its expanding share of GDP. But what about everyone else?
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What exactly were these new financial services that were benefiting us all? More credit than we could afford to repay? Subprime mortgages? Unwelcome cold calls at dinner time from our bank pestering us to buy expensive “products” we didn’t want? Or, at the corporate level, credit derivatives perhaps? And if risk management was working so well, why were there so many risk management disasters over the last two decades? Something was going wrong. For a long time the problems were explained away or swept under the rug, and critics were dismissed as coming from the fringe: if you held your nose and didn’t look too hard at what was going wrong, you could perhaps still just about persuade yourself that it really was working. Occasional problems were, after all, only to be expected. But there eventually came a point where denial was no longer an option: as institution after institution suffered unimaginably unlikely losses in 2007 and 2008 and much of the banking system simply collapsed, the edifice of Modern Financial Theory (and especially Modern Financial Risk Management) collapsed with it. And, to any flat-earther who denies what is self-evident to everyone else, we would ask: if the events of 2007–08 do not constitute a failure of Modern Financial Theory, then what exactly would? Yet, even after this debacle, Modern Financial Theory remains in daily use throughout Wall Street. Its models are still used to manage investments, value derivatives, price risk, and generate additional profits, just as if the crash had never happened. Needless to say, this refusal to recognize reality is deeply unhealthy, although the costs will probably be borne yet again by taxpayers and the global economy in general rather than by Wall Street’s denizens themselves. A new paradigm is urgently needed. The second belief system that led to financial disaster is one which celebrates the benefits of state intervention into the economy. Of course, there are many such belief systems, but the one most directly relevant when seeking to understand the current financial crisis is Keynesian economics. The “defunct economist,” in this case, is Keynes himself. Keynesian economics came to dominate economic thinking in the 1930s, as people tried to come to terms with the calamity of the Great Depression. It maintained that the free market economy was inherently unstable, and that the solution to this instability was for the government to manage the macro economy: to apply stimulus when the economy was going down, and put on the brakes when it was booming excessively. In his General Theory, Keynes explicitly put himself in the dubious tradition of the monetary cranks, the “funny money” merchants of old, who had been dismissed before then. He sneered at the Gladstonian notion that the government should manage its finances like a household and instead offered a macroeconomics founded on paradox – in particular, the “paradox of thrift,” a notorious idea infamously espoused by Bernard Mandeville in his Fable of the Bees: or, Private Vices, Publick Benefits (1714) that caused great offence when it was first suggested and was aptly described later as a cynical system of morality made attractive by ingenious paradoxes. The gist of it was that we can somehow spend ourselves rich.
Alchemists of Loss
Keynes not only resurrected the idea and made it “respectable,” but enthroned it as the centerpiece of his new theory of macroeconomics. Keynes liberated us from old-fashioned notions about the need for the government to manage its finances responsibly, inadvertently perhaps also paving the way for the more recent belief, widespread before the current crisis, that we as individuals didn’t need to be responsible for our own finances either. Keynesianism ruled the roost for a generation or more. In practice, Keynesian policies almost always boiled down to more stimulus, typically greater government spending and/or expansionary monetary policy. The result was inflation, low at first, but by the late 1960s a major problem. Keynesianism never really came to terms with this problem, and its most significant attempt to do so – the treacherous Phillips curve, interpreted by Keynesians as a trade-off between inflation and unemployment – was refuted by Milton Friedman in his famous presidential address to the American Economics Association in 1967. In the long term, no such trade-off existed. Yet policymakers were reluctant to embrace Friedman’s position that bringing inflation down required tight monetary policy – lower monetary growth and higher short-term interest rates – which was likely to produce short-term recession as a side effect. Policymakers were hooked on “stimulus.” In any case, if inflation ever did get out of hand, they could always apply brute force or wage and price controls to contain it, and they ignored the warnings of Friedman and his monetarist followers that controls wouldn’t work either. Keynesian economics reached the apogee of its influence after World War II in both the United States and Britain, then ran into serious trouble in both countries after 1970. After the 1970s’ Keynesian-driven stagflation, a move towards much tighter money eventually worked. Inflation was brought down and seemed to be conquered for good. Yet slowly, quietly, Keynesianism made its comeback. Most economists and policymakers had never entirely given up on the idea that policy should have some element of “lean against the wind,” even if they acknowledged that “old” Keynesianism had gone too far. Moreover, as the memories of past inflation horrors began to dim, the Federal Reserve in particular slowly began to squander the inflation credibility it had earned with such difficulty and cost in the Paul Volcker years of tight money in the late 1970s and early 1980s. In the meantime, Volcker had been replaced by Alan Greenspan,who began in the mid-1990s to pursue the easy-money policy demanded by politicians and the stock market. For over a decade the Fed pushed interest rates down, and its ‘accommodating’ – that is to say, expansionary – monetary policy fueled a series of ever more damaging boom-bust cycles in asset markets, the worst (so far) of which culminated in the outbreak of crisis in the late summer of 2007. More ominously, the policy response to the most acute crisis since the Great Depression was massive stimulus – deficit spending on an unprecedented scale; even more accommodating monetary policy, with interest rates pushed down to zero; and massive taxpayer bailouts of financial institutions and of the bankers who had led them to ruin. Keynesianism was now back with a vengeance. Thus, in
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another one of those Keynesian paradoxes, the Keynesian medicine that had helped fuel the crisis was now, in huge doses, the only solution to it. The irony was lost on most policymakers. One of the few exceptions who didn’t lose his mind in the panic was the social democrat German finance minister, Peer Steinbrück. In December 2008, he expressed the bewilderment of many when he observed how “The same people who would never touch deficit spending are now tossing around billions [and, indeed, much more]. The switch from decades of supply-side politics all the way to a crass Keynesianism is breathtaking. When I ask about the origins of the crisis, economists I respect tell me it is the credit-financed growth of recent years and decades. Isn’t this the same mistake everyone is suddenly making again …?” Indeed it is. Both these ideologies, Modern Financial Theory and Keynesian economics, have proven themselves vulnerable to the revenge of the gods of the Copybook Headings, in the words of Rudyard Kipling’s poem. Kipling wrote it in 1919, at a time of sadness and disillusionment after losing a son in World War I. Its central theme is that whatever temporary beliefs we may acquire through market fluctuations or fashionable collectivist nostrums, eventually the old eternal truths of the children’s copybook return to punish us for having departed from them: “ Then the Gods of the Market tumbled, and their smooth-tongued wizards withdrew And the hearts of the meanest were humbled and began to believe it was true That All is not Gold that Glitters and Two and Two make Four And the Gods of the Copybook Headings limped up to explain it once more.” Kipling was an instinctive economist; this verse of the poem describes exactly how the wizards of the tech boom and the housing boom withdrew at the peak of the market, when the gods of the Copybook Headings reawakened and took their revenge. Traditional truths about the market that had been thought outdated and irrelevant were then revealed to have been in control all along. Copybook Headings whose gods have already come back to haunt us include the following, out of many others: “Speculation always ends in tears.” This is the oldest Copybook Heading of all, and we have all known about this since the foolish Tulip Mania in Holland in 1636–37, when at one point 12 acres of prime farmland was allegedly offered for a single tulip bulb – needless to say, a painful crash followed. A recurring feature of speculative manias is how, as the market peaks, those involved reassure themselves that some new paradigm is now in control that guarantees that, this time, the laws of economics no longer hold and the market can only go up and up. We saw this at the peak of the tech bubble when “new economy” proponents assured us that internet stocks obeyed a different set of rules, free of the constraints of old economics. The central premise of Pets.com, that money could be made by express shipping catfood around the US, was so risible that a moment’s reality therapy should have
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exposed it, but there was no reality in that market. We saw it again in 2006–07, when believers in the Great Moderation fallacy assured us that the vagaries of the business cycle had finally been conquered, shortly before a very immoderate crisis broke loose. The god of this Copybook Heading is particularly powerful and vengeful, with a long memory. “Whoever makes a loan has responsibility if it goes wrong afterwards.” One of the most important gods of traditional banking, this one was widely flouted in the securitization markets, in which loan originators were able to escape responsibility for poor credit decisions. The result was an orgy of poor housing lending, involving not simply poor credit decisions but outright fraud, connived in by loan originators who collected their fees and passed the fraudulent paper on to Wall Street and international investors. In this disaster, Wall Street was self-deluded, drunk with excessive money supply, aided and abetted by mortgage brokers whose ethics would have made used-car salesmen blush. “Don’t take risks that you don’t understand.” Flouted openly in most bubbles, this god was drugged during this one by perverted science, most egregiously, by “Value-at-Risk” risk management methods, which controlled risk just fine provided that the markets involved were not in fact particularly risky. “The maximum safe leverage is 10 to 1 for banks and 15 to 1 for brokers dealing in liquid instruments.” This Copybook Heading was widely ignored, most openly by investment banks operating at leverage ratios of over 30 to 1 by the end of 2007, the sin made worse by banks hiding their risks by pushing assets off their balance sheet by use of “structured investment vehicles” funded by commercial paper that was apt to become illiquid when most needed. This god’s revenge is traditionally very painful and is proving so again. “Investments should be recorded in the books at the lower of cost or market value until they are sold.” This time around the accounting profession adopted “mark-to-market” accounting, which allowed investments to be “marked up” on rises in value, with mark-up earnings reported and bonuses paid even when the investments had not been sold. Wall Street is now bleating about “mark-to-market” because it requires mark-downs of investments that have fallen in value; the real reason why it should be dropped is its enabling of spurious mark-ups, of which the Street took full advantage. Mark-to-market is highly pro-cyclical and provides counterproductive incentives to fallible and greedy bankers. But as this Copybook Heading god is rather young and junior, it is not yet clear how severe his revenge will be. “Don’t inflate broad money much faster then real GDP.” This very mild version of the Sound Money Copybook Heading seeks to ensure stable prices and suppress asset bubbles. It was followed by Paul Volcker and by Alan Greenspan in his first seven years in office, then abandoned in early 1995, since when money supply has soared ahead of real GDP. Its abandonment resulted in series of asset bubbles, the more dangerous of which was that in housing because of the debt involved. Its god is something of a Rip Van Winkle, having allowed 12 years of misbehavior whilst he slept soundly from 1995 to 2007, but is exceptionally powerful and malignant when roused, as we discovered in 2008, but may need to learn again.
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“Save for a rainy day.” One of the oldest and most venerable Copybook Headings, this articulates the notion that long-term prosperity requires that we restrain our impulse to spend everything today, and be especially careful about living on credit. Keynes and his followers took particular delight in teasing its god with their arguments that prosperity required spending rather than saving. This god is famously slow to anger, but his revenge is devastating when it comes: his specialty is a disappearing act, when all that credit-fuelled prosperity suddenly vanishes and those who defy him discover to their dismay that they are thrown out on their ears, stark naked, like Adam and Eve expelled from the Garden of Eden. As well as the above gods, whose revenge has already become partly or fully apparent, recent events have flouted further Copybook Headings that will in due course no doubt produce further retribution: “Allow capital to flow to its most productive uses.” This Heading is always flouted during bubbles, when capital is allocated to innumerable unproductive dotcoms or ugly undesirable McMansions. It is sometimes also flouted during downturns, when the government rescues failing industries, devoting capital to the dying and unproductive. Examples abound, notably in Britain in the 1960s and 1970s and in France in the 1980s and 1990s. In the present crisis, there is not just the $700 billion debt bailout, but the $400 billion rescue of Fannie Mae and Freddie Mac, the $50 billion rescue of the automobile industry, and the clearly impending bailouts of overseas governments and various states and municipalities in the US to be considered. In downturns, capital is especially scarce; hence flouting this Copybook Heading during a downturn produces a much nastier revenge by its god, killing off far more new and productive investments than it would in a boom and slowing longterm economic growth to a crawl. “Keep the fiscal deficit to a level that prevents the public debt/GDP ratio from rising.” This, originally propounded by Gordon Brown, when UK Chancellor of the Exchequer and before his recent apostasy, for which he will certainly be called to account, is the wimpiest possible version of the Copybook Heading warning against budget deficits. The stricter and more substantial versions of Gladstone’s time mandated low levels of government debt and prohibited deficits altogether. The Brownian version is the bare minimum, and even that is defied now more than ever before, both in the short term through $1 trillion plus deficits from recession and bailouts and in the long term through the actuarial problems in Social Security and Medicare. The revenge of this god is exquisitely cruel; he turns the country into Argentina. We can speculate why the last decade has seen such a record level of Copybook Heading flouting. Maybe the Baby Boom generation, who have been in charge, were affected so badly by the permissive theories of Dr. Spock and the “flower-power” 1960s that rejecting conventional wisdom in the form of the Copybook Headings became second nature to them. But be that as it may, the gods are clearly not happy and, as the Chinese might say, there are interesting times ahead. In the remainder of this book, we will begin with history, move on to financial analysis, show how the theory intersected the reality, add the element of monetary policy, and demonstrate how the result was market chaos and meltdown. Having anatomized the disaster, we will suggest some solutions, theoretical, institutional,
Alchemists of Loss
and practical, as well as examining the financial services business’s likely future. The next two chapters are historical. Chapter 2 looks at the traditional financial system, in London and New York, and discusses why it worked, in particular what mechanisms it had to ensure its long-term continuance and the financial system’s overall stability. Chapter 3 anatomizes previous market meltdowns, drawing lessons as appropriate that throw light on recent events and on our current situation. Current difficulties have their reflections in past crises, and anatomizing a broad range of such crises is the best way to analyze the present. Useful past history is not limited to the Great Depression. Part Two is the analytical core of the book. It begins (Chapter 4) by setting out the principles of Modern Financial Theory, along with a light-hearted gallery of the financial alchemists involved, seven Nobel prizes and all. It then (Chapter 5) examines the assumption flaws underlying the theories, why they were unrealistic, and why their lack of realism caused the theories themselves to be hopelessly fallible when applied in practice. Finally (Chapter 6), this section examines the theory of risk management, that new science, whose principles were derived from Modern Financial Theory, which gave practitioners and regulators alike a spurious sense that all was rationally controlled. Since the theories underlying risk management techniques were themselves flawed, risk management likewise broke down. Indeed, commonly practiced modern risk management turned out to be a perfect paradigm of error, focusing risk managers’ attention away from the periods during which major risks arose, and failing utterly when it was most needed. Part Three examines the interaction of theory and practice, how modern financial theory migrated to Wall Street, and why it was given vastly more attention and resources than is granted to most professorial maunderings. The first chapter (7) details changes in the business environment from the 1960s that both accompanied the introduction of Modern Finance and made the financial services business especially receptive to it. Chapter 8 details the process by which sector after sector of Wall Street found elements of modern theory exceedingly useful, whether as sales techniques, as spuriously precise valuation methodologies, or as generators of new opportunities to make remarkable profits producing “products” that had little or no social value or were just downright dangerous. Chapter 9 looks at the other side of the coin – how the adoption of Modern Financial Theory modified Wall Street itself. It looks at how the incentives of Wall Street interacted with the techniques of Modern Finance and captive regulators to produce a system that enlarged risk rather than controlling it, and led to unprecedented levels of rent seeking and crony capitalism. Chapter 10 then takes a closer look at the litany of financial disasters that have occurred in Wall Street’s wake. Part Four looks at how policy, captured by Wall Street during these years, interacted with the financial markets to make matters worse. Chapter 11 looks at monetary policy, and how it metamorphosed in the last three decades, and how the long period of excessive monetary expansion since the mid-1990s fuelled a series of boom-bust cycles, so creating the perfect environment for Wall Street’s excesses. Chapter 12 looks at how the regulatory system not only failed, but actively contributed to these excesses.
Kevin Dowd & Martin Hutchinson
Part Five, Chapters 13 and 14 looks at the events of 2007–09, the bursting of the bubbles and the market, and the public reactions to that bursting. Chapter 13 also suggests alternative steps that could have been taken at various points during the crisis, which might well have mitigated the losses for taxpayers and would certainly have reduced the crisis’ overall costs to the global economy. In the official responses to crisis, remnants of belief in the Modern Finance chimera mingled with anti-Wall Street populism, but there were very few practicable suggestions of how we might move towards a financial system that would actually work. In Chapter 14 we outline the nightmare scenario that will unfold if no substantial reform steps are taken. Finally, in Part Six we turn to possible solutions. Chapters 15 and 16 return to first principles and discuss how financial alchemy might be turned into reality-based chemistry, the first chapter dealing with quantitative risk management methods, and the other with the needed institutional changes for the finance industry. Chapter 17 suggests some policy reforms to provide a legal and monetary framework within which the finance industry especially and the economy generally can be returned to health; underpinning this is the need to rein in rampant cronyism and restore the moral authority of the capitalist system. The last chapter offers some final thoughts on what we might learn from the dreadful experiences of recent years. This book details how a misguided alchemy-like corpus of Modern Financial Theory combined with a wishful-thinking Keynesian mindset, ever present greed, and inept monetary and regulatory policy to produce a “perfect storm” of financial meltdown. Global prosperity, endangered in any case by the inexorable rise in population and the not unreasonable demands of the new billions for Western living standards, mandates that we learn deeply and permanently how to avoid a similar comedy of errors in the future.
Also Available The New Empire of Debt The Rise and Fall of an Epic Financial Bubble, 2nd Edition 9780470483268 • Hbk • Aug 2009 • £18.99 / €22.40 / $27.95
Financial Reckoning Day Fallout Surviving Today’s Global Depression, 2nd Edition 9780470483275 • Hbk • Aug 2009 • £18.99 / €22.40 / $27.95
The Little Book of Economics
The Little Book of Economics
How the Economy Works in the Real World Greg Ip 978-0-470-62166-0 • Hardback • 272 pages September 2010 • £13.99 / €16.00 / $19.95
Chapter 1 The Secrets of Success How People, Capital, and Ideas Make Countries Rich POP QUIZ: The year is 1990. Which of the following countries has the brighter future? The first country leads all major economies in growth. Its companies have taken commanding market shares in electronics, cars, and steel, and are set to dominate banking. Its government and business leaders are paragons of long term strategic thinking. Budget and trade surpluses have left the country rich with cash. The second country is on the brink of recession, its companies are deeply in debt or being acquired. Its managers are obsessed with short - term profits while its politicians seem incapable of mustering a coherent industrial strategy. You’ve probably figured out that the first country is Japan and the second is the United States. And if the evidence before you persuaded you to put your money on Japan, you would have been in great company. “Japan has created a kind of automatic wealth machine, perhaps the first since King Midas,” Clyde Prestowitz, a prominent pundit, wrote in 1989, while the United States was a “colony - in - the - making.” Kenneth Courtis, one of the foremost experts on Japan’s economy, predicted that in a decade’s time it would approach the U.S. economy’s size in dollar terms. Investors were just as bullish; at the start of the decade Japan’s stock market was worth 50 percent more than that of the United States. Persuasive though it was, the bullish case for Japan, as fate would have it, turned out completely wrong. The next decade turned expectations upside down. Japan’s economic growth screeched to a halt, averaging just 1 percent from 1991 to 2000. Meanwhile, the United States shook off its early 1990s lethargy and its economy was booming by the decade’s end. In 2000, Japan’s economy was only half as big as the U.S. economy. The Nikkei finished down 50 percent, while U.S. stocks rose more than 300 percent. What explains Japan’s reversal of fortune and its decade long economic malaise? Simply put, economic growth needs both healthy demand and supply. As is well known, Japan’s demand for goods and services suffered when overinflated stocks
and real estate collapsed, saddling companies and banks with bad debts that they had to work off. At the same time, though less well known, deep - seated forces chipped away at Japan’s ability to supply goods and services. The supply problem is critical because in the long run economic growth hinges on a country’s productive potential, which in turn rests on three things: 1. Population 2. Capital (i.e., investment) 3. Ideas Population is the source of future workers. Because of a low birth rate, an aging population and virtually nonexistent immigration, Japan’s working - age population began shrinking in the 1990s. A smaller workforce limits how much an economy can produce. Capital and ideas are essential for making those workers productive. In the decades after World War II, Japan invested heavily in its human and economic capital. It educated its people and equipped them with cutting - edge technology adapted from the most advanced Western economies in an effort to catch up. By the 1990s, though, it had largely caught up. Once it had reached the frontier of technology, pushing that frontier outwards would mean letting old industries die so that capital and workers could move to new ones. Japan’s leaders resisted the bankruptcies and layoffs necessary for that to happen. As a result, the next wave of technological progress, based on the Internet, took root in the United States, whose economic lead over Japan grew sharply over the course of the 1990s.
A Recipe for Economic Growth Numerous factors determine a country’s success and whether its companies are good investments. Inflation and interest rates, consumer spending, and business confidence are important in the short run. In the long run, though, a country becomes rich or stagnates depending on whether it has the right mix of people, capital, and ideas. Get these fundamentals right, and the short - run gyrations seldom matter. Until the eighteenth century, economic growth was so slight it was almost impossible to distinguish the average Englishman ’s standard of living from his parents’. Between 1945 and 2007 the United States economy went through 10 recessions yet still grew enough to end up six times larger with the average American three times richer. We’ve taken growth for granted for so long that we’ve forgotten that stagnation could ever be the norm. Yet, it once was. Until the eighteenth century, economic growth was so slight it was almost impossible to distinguish the average Englishman’s standard of living from his parents’. Starting in the eighteenth century, this changed. The Industrial Revolution brought about a massive reorganization of production in England in the mid - 1700s and later in Western Europe and North America. Since then, steady growth — the kind that the average person notices — has been the norm. According to economic historian Angus Maddison, the average European was four times richer in 1952 than in 1820 and the average American was eight times richer.
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In the pre - industrial era, China was the world’s largest economy. Its modest standard of living was on a par with that of Europe and the United States. But China then stagnated under the pressure of rebellion, invasion, and a hidebound bureaucracy that was hostile to private enterprise. The average Chinese was poorer in 1952 than in 1820. So why do some countries grow and some stagnate? In a nutshell, growth rests on two building blocks: population and productivity. Population determines how many workers a country will have. Productivity, or output per worker, determines how much each worker earns. The total output a country can produce given its labor force and its productivity is called potential output, and the rate at which that capacity grows over time is potential growth. So if the labor force grows 1 percent a year and its productivity by 1.5 percent, then potential growth is 2.5 percent. Thus, an economy grows.
Take a Growing Population Let’s recap. An economy needs workers in order to grow. And, usually, the higher the population, the higher the number of potential workers. Population growth depends on a number of factors including the number of women of child - bearing age, the number of babies each woman has (the fertility rate), how long people live, and migration. In poor countries, many children die young so mothers have more babies. As countries get richer and fewer children die, fertility rates drop and, eventually, so does population growth. As women have fewer children, more of them go to work. This demographic dividend delivers a one - time kick to economic growth. For example, it was a major contributor to East Asia’s growth from the 1960s onward and to China’s growth after the introduction of its one - child policy. But a country only gets to cash in its demographic dividend once. Eventually, as population growth slows, it ages and each worker must support a growing number of retirees. If fertility drops much below 2.1 babies per woman, the population will shrink unless it is offset by higher immigration. For this reason, a demographic cloud hangs over China. It may be “the first country to grow old before it grows rich,” say population experts Richard Jackson and Neil Howe. Its fertility rate is below two and its working - age population will start to decline around 2015.
Add Capital A country is not rich, though, just because it has a lot of people — just look at Nigeria, which has 32 times as many people as Ireland but an economy of roughly equal size. The reason for this population/economic size disparity is that the average Nigerian is much less productive than the average Irishman. For a country to be rich — that is, for its average citizen to enjoy a high standard of living — it must depend on productivity, which is the ability to make more, better stuff out of the capital, labor, and land it already has. Productivity itself depends on two factors: capital and ideas. You can raise productivity by equipping workers with more capital, which means investing in land, buildings, or equipment. Give a farmer more land and a bigger tractor or pave a highway to get his crops to market, and he’ll grow more food at a
lower cost. Capital is not free, though. A dollar invested for tomorrow is a dollar not available to spend on the pleasures of life today. Thus, investment requires saving. The more a society saves, whether it’s corporations or households (governments could save but are more likely to do the opposite), the more capital it accumulates. Capital, though, will only take a country so far. Just as your second cup of coffee will do less to wake you up than your first, each additional dollar invested provides a smaller boost to production. A farmer’s second tractor will help his productivity far less than his first. This is the law of diminishing returns.
Season with Ideas How do you overturn the law of diminishing returns? With ideas. In 1989, Greg LeMond put bars on the front of his bicycle that enabled him to ride in a more aerodynamic position. This simple idea sliced seconds off his time, allowing him to beat Laurent Fignon and win the Tour de France. New ideas transform economic production the same way. By combining the capital and labor we already have in a different way, we can produce different or better products at a lower cost. “Economic growth springs from better recipes, not just from more cooking,” says Paul Romer, a Stanford University economist. For example, DuPont’s discovery of nylon in the 1930s transformed textile production. These man - made fibers could be spun at far higher speeds and required far fewer steps than cotton or wool. Combined with faster looms, textile productivity has soared, and clothes have gotten cheaper and better. The productive power of ideas is nothing short of miraculous. Investing in more buildings and machines costs money. But a new idea, if it’s not protected by patent or copyright, can be reproduced endlessly for free. The productive power of ideas is nothing short of miraculous. Investing in more buildings and machines costs money. But a new idea, if it’s not protected by patent or copyright, can be reproduced endlessly for free. Just as other cyclists quickly copied Greg LeMond’s aerobars, companies catch up to their competitors by copying their ideas. Although this can be frustrating for the person who came up with the idea, it’s great for the rest of us as we benefit from the improvements made with the existing idea. Here are a few examples: • New Business Processes. Some of the most powerful ideas involve rearranging how a company runs itself. In 1776, in the first chapter of The Wealth of Nations, Adam Smith marveled how an English factory divides pin making into 18 different tasks. Smith calculated that one worker, who could by himself make one pin a day, could now make 4,000. “The division of labor occasions, in every art, a proportionable increase in the productive powers of labor,” he wrote. Two centuries later Wal - Mart revolutionized retailing by using big box stores, bar codes, wireless scanning guns, and exchanging electronic information with its suppliers to track and move goods more efficiently while scheduling cashiers better to reduce slack time. As competitors like Target and Sears copied Wal - Mart, customers of all three benefited from lower prices and more selection, a McKinsey study found. New Products. Netscape’s Navigator was the first commercially successful browser but was soon supplanted by Microsoft’s Internet Explorer, which is now under siege by Mozilla Firefox, Apple Safari, and Google Chrome. Browsers keep getting
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better but consumers still pay the same price, zero. Drugs provide another example. According to Robin Arnold of IMS Health, Eli Lilly’s introduction of the antidepressant Prozac in 1986 inspired competitors to develop similar drugs like Zoloft and Celexa, providing alternatives for patients who didn’t respond well to Prozac. It’s not just companies that thrive by imitating their competitors. Entire countries can turbo - charge their development by strategically copying the ideas and tech nologies that other countries already use. For example, Japanese steelmakers didn’t invent the basic oxygen furnace; they adapted it from a Swiss professor who had devised it in the 1940s. They thus leapfrogged U.S. steelmakers who were using less efficient open hearth furnaces. Their mainframe computer makers benefited from a government edict that IBM make its patents available as a condition of doing business there. More recently, China’s adaptation of existing ideas from other countries has resulted in significant economic growth. Since 1978, it has moved workers from unproductive farms and state - owned companies to more productive privately owned factories that used machinery bought or copied from foreign companies, expertise acquired from foreign universities or joint venture partners, and intellectual property adapted and occasionally stolen from foreign creators. Still, once a country has copied all the ideas it can, future growth depends on waiting for new ideas or developing its own. Inevitably, a country at the technological frontier grows more slowly than one catching up to the frontier. As we learned earlier in this chapter, that’s just what happened to Japan.
Nurturing Growth Getting the ingredients right is essential to economic growth, but so is the environment that the government creates in order to foster its development. Like the temperature on the oven, the wrong setting can ruin the recipe. So, what do governments do that matters most? • Human Capital. It’s no use equipping workers with the most advanced equipment in the world if they can’t read the instructions. Education and training, both forms of human capital, are essential to productivity. Korea went from third world status to the ranks of the industrialized nations in a generation in part by rigorously educating all its children. Its high school graduation rates now exceed those of the United States. • Rule of Law. Economic growth needs investors to know that if they invest today, they get to keep the rewards years later. That requires transparent laws, impartial courts, and the right to property. The United States’ army of lawyers sue at the drop of a hat and wrap every transaction in legalese, but in a maddening way that signifies its respect for laws. Small government is better than big government, but size is less important than quality. For example, Sweden’s government spends more than half of gross domestic product (GDP) while Mexico’s spends only a quarter of its GDP. But Swedish govern ment is efficient and honest while Mexico’s is inefficient and rife with corruption. That’s one reason Sweden is rich and Mexico is poor. Does government have to be democratic for growth? There’s no firm rule. The authoritarian governments of China, Korea, and Chile ran smart policies that produced strong growth early in their development. Conversely, sometimes democratic
governments are pressured by voters to expropriate private property, run up unsupportable debts, or shelter politically favored groups at everyone else’s expense. But dictators have done all those things and worse, bringing on social unrest that ruins the investment climate. Democracy provides essential feedback to government just as free markets do to companies, and elections are generally less disruptive than civil wars. • Letting Markets Work. Entrepreneurs and workers get rich coming up with new, cheaper ways to make things. In the process, they drive someone else out of business. Joseph Schumpeter, the Austrian - born Harvard economist, called this “creative destruction.” Governments squelch creative destruction by forbidding new companies from entering a market, granting monopolies, restricting imports or foreign investment, or making it hard for companies to lay off workers. A financial system that would rather lend to government - owned companies than small entrepreneurs also holds back growth.
Into the Weeds Now that we’ve established what a country needs to grow, how do we measure that growth? The global gold standard is the GDP, which is the value of all the products and services a country produces in a year. GDP can be measured in two ways: Expenditure - Based GDP. Total of all the money spent on stuff. Income - Based GDP. Total of all the money earned producing stuff. Expenditure - based GDP includes spending by consumers— on such items as houses, bread, and visits to the doctor — and by government — on such items as schools and soldiers. It also includes spending by businesses, but only on investment - related expenses — such as a bakery’s new oven or building. GDP excludes business spending on inputs (e.g., ingredients and parts) that show up in what consumers buy. For example, a bakery’s purchase of flour is included in what the consumer spends on bread. To add that to GDP would be counting it twice. Exports are also included in expenditure - based GDP because this represents what foreigners spend on things made in the United States. Imports are subtracted from GDP to exclude what Americans spend on things made in other countries. Expenditure - based GDP is measured in nominal and real dollars. Nominal dollars represent the actual value of activity. Real dollars remove the effects of inflation. Suppose sales of bread rise 5 percent. If the price per loaf rose 2 percent, then real spending on bread (i.e., the number of loaves sold) rose 3 percent. That’s real GDP and it’s the usual way of measuring economic growth. However, you can’t spend real GDP — wages and profits are earned in nominal dollars so nominal GDP is a better way to measure the size of the economy. The second method, income - based GDP, includes the wages, benefits, and bonuses earned by workers and managers; the profits earned by companies and their shareholders; the interest earned by lenders; and the rent earned by landlords. In theory, the expenditure - based GDP and income based GDP sums should be equal, because one person’s spending is another person’s income. In practice, however, GDP is so large and difficult to measure with precision that it would be a miracle if calculating it two ways produced the same number.
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When the U.S. Commerce Department’s Bureau of Economic Analysis calculates GDP, 75 percent of its initial estimate is based on surveys of actual activity like retail sales and construction. For the rest it gets creative. For example, it checks out the weather to estimate utility output or dog registrations to estimate spending at veterinarians’ offices. It sounds goofy, but it lines up pretty well with the hard data that eventually replaces it.
Will the United States Become the Next Japan? As the United States struggles out of its eleventh, and worst, recession since World War II, a nagging worry hangs over it: Does it face a long period of stagnation as Japan did in the 1990s? The pessimist could marshall a lot of evidence to answer yes. He’d contrast the technology bubble of the 1990s, which left the United States with broadband Internet and business - to- business web sites, with the real estate bubble of the late - 2000s that did nothing for productivity and left behind trillions of dollars of bad property loans that are making it harder for the businesses of tomorrow to get money. The pessimist would go on to note that Americans’faith in free markets has been shaken and government has grown. New regulators are cropping up and old ones are getting more intrusive. Finally, he’d point out that the labor force is growing more slowly and employment is no higher than a decade ago. Anti - immigrant sentiment could turn off the tap of young foreign workers while our schools, despite recent improvement, are global underperformers. The optimist would reply that the United States still has the building blocks of growth. Its population growth and fertility rate remain among the highest in the industrial world and far higher than China’s. Americans are jaded about finance but still like free enterprise. In April 2009, at the depths of the worst recession and bear market in memory, the Pew Research Center found that 90 percent of the people in this country said they admired people who get rich by working hard. The optimist would go on to note that for all the rhetoric to the contrary, U.S. leaders still believe in free enterprise, as well. Within two years of taking stakes in nine major banks, the Treasury had sold all but one. True, the federal government propped up General Motors; but to get the money GM had to go through bankruptcy and shear off 30 percent of its U.S. workforce. By contrast, France gave money to Peugeot and Renault only after they promised to preserve French jobs. Optimists would also point out that the United States’legal and democratic traditions have survived intact. Populist anger at bankers is at a fever pitch. Yet in the first major criminal trial stemming from the mortgage meltdown, jurors acquitted two traders for Bear Stearns, because, one said, “We just didn’t have enough to convict them.” If the financial system can flush the bad debt left from the property bubble, then investment should resume and with it, productivity growth of perhaps 1.5 percent to 2 percent per year. Add that to labor force growth of 0.75 percent and you get long - term growth of 2.25 percent to 2.75 percent per year. The United States may no longer be a glamorous growth stock; but it’s still a blue chip.
The Little Book that Still Beats the Market
Joel Greenblatt 978-0-470-62415-9 • Hardback • 208 pages September 2010 • £13.99 / €16.00 / $19.95
Chapter Two Actually, just getting started is a big deal. It takes a great amount of discipline to save any money. After all, no matter how much money you earn or receive from others, it’s simply much easier and more immediately rewarding to find something to spend it on. When I was young, I decided that all my money should go to Johnson Smith. Of course, I’d love to tell you that Johnson Smith was an orphan who just needed a little help. I’d love to tell you that the money given to Johnson Smith helped change his life. I’d love to tell you that, but it wouldn’t be completely accurate. You see, Johnson Smith was a company. Not just any company, either. It was a company that sold whoopee cushions, itching powder, and imitation dog vomit through the mail. I mean, I didn’t completely throw away all my money. I did buy some educational stuff, too. Once, the guys at Johnson Smith were able to sell me a weather balloon that was 10 feet tall and 30 feet around. I’m not sure what a giant balloon had to do with the weather, but it sounded educational, sort of. Anyway, after my brother and I finally figured out how to blow it up by somehow reversing the airflow on the vacuum cleaner, we ran into a big problem. The 10-foot balloon was quite a bit larger than our front door. Using a complicated formula that not even Einstein could fully comprehend, we decided that if we turned our backs and pushed really hard, the giant balloon could be squeezed out without bursting the balloon or damaging the door (and besides, our mother wasn’t home yet). And it worked, except we forgot one thing. It seems that the air outside was colder than the air inside our house. That meant that we had filled our balloon with warm air. And since, as everyone except apparently me and my brother knew, hot air rises, the balloon started to float away. The two of us were left chasing a giant balloon down the street for about half a mile before it finally popped on a tree. Luckily, I learned a valuable lesson from the whole experience. Although I don’t exactly remember what that was, I’m pretty sure it had something to do with the importance of saving money for things that you might want or need in the future rather than wasting money buying giant weather balloons that you get to chase down the block for all of three or four minutes. But for our purposes, let’s assume that we can all agree that it is important to save money for the future. Let’s also assume that you have been able to resist the many temptations of the Johnson Smith people and the thousands of other places calling out for your money; that you (or your parents) have been able to provide for all
The Little Book that Still Beats the Market
of the necessities of life, including food, clothing, and shelter; and that by being careful about how much you spend, you have somehow been able to put aside at least a small amount of money. Your challenge is to put that money—let’s say $1,000— someplace where it can grow to be even more money. Sounds simple enough. Sure, you can just put it under your mattress or in your piggy bank, but when you come to get it, even years later, you’ll still be left with the same $1,000 you put there in the first place. It won’t grow at all. In fact, if the prices of the things you were going to buy with that money go up during the time your money was just sitting there (and therefore your $1,000 will buy less stuff than it used to), your money will actually be worth less than it was worth the day you put it away. In short, the mattress plan kind of stinks. Plan B has got to be better. And it is. Just take that $1,000 over to the bank. Not only will the bank agree to hold your money, they’ll pay you for the privilege. Each year, you’ll collect interest from the bank, and in most cases, the longer you agree to let them hold your money, the higher the interest rate you’ll get. If you agree to keep your $1,000 with the bank for five years, you might collect something like 5 percent in interest payments per year. So the first year you collect $50 in interest on your $1,000 original deposit, and now you will have $1,050 in the bank at the beginning of year 2. In year 2, you collect another 5 percent interest on the new, higher total of $1,050, or $52.50 in interest, and so on through year 5. After five years, your $1,000 will grow into $1,276. Not bad, and certainly a lot better than the mattress plan. Which brings us to Plan C. This plan is known as “who needs the bank?” There’s an easy way to just skip the bank altogether and lend to businesses or to a group of individuals yourself. Often businesses borrow money directly by selling bonds. The corner bakery won’t usually sell these, but larger (multimillion-dollar) companies, such as McDonald’s, do it all the time. If you purchase a $1,000 bond from a large company, for example, that company might agree to pay you 8 percent each year and pay back your original $1,000 after 10 years. That clearly beats the crummy 5 percent the bank was willing to pay you. There’s one little problem, though: If you buy a bond from one of these companies and something goes wrong with its business, you may never get your interest or your money back. That’s why riskier companies—say, Bob’s House of Flapjacks and Pickles—usually have to pay higher interest rates than more solid, established ones. That’s why a company’s bonds have to pay more than the bank. People need to make more money on their bond to make up for the risk that they may not receive the promised interest rate or their original money back. Of course, if you’re not comfortable taking any risk of losing your $1,000, the U.S. government sells bonds, too. While there is nothing completely riskless in this world, lending money to the U.S. government is the closest any of us will ever get. If you are willing to lend the U.S. government your money for 10 years, the government might, for example, agree to pay you something like 6 percent per year (if you lend for shorter periods of time—say, five years—the rate will usually be lower, maybe 4 or 5 percent). For our purposes, the bond we’ll be looking at most is the U.S. government bond that matures (pays off the original loan) after 10 years. We’ll be looking at that one because 10 years is a long time. We’ll want to compare how much we can earn from a safe bet like a U.S. government bond with our other long-term investment choices.
So if the annual interest rate on the 10-year government bond is 6 percent, that essentially means that people who are willing to lend their money out for 10 years, but are unwilling to take any risk of losing their original investment or of not receiving the promised interest rate, can still expect to receive 6 percent each year on their money. In other words, for people willing to lock their money up for 10 years, the “no risk” rate of return is 6 percent per year. It’s important to understand what that means. It means that if anyone asks you to loan them money or to invest with them over the long term, they better expect to pay you more than 6 percent a year. Why? Because you can get 6 percent a year without taking any risk. All you have to do is lend money to the U.S. government, and they’ll guarantee that you receive your 6 percent each and every year, along with all of your money back after 10 years. If Jason wants money for a share of his gum business, that investment better earn you more than 6 percent per year, or no way should you do it! If Jason wants to borrow money over the long term, same deal. He better expect to pay you a lot more than 6 percent. After all, you can get 6 percent risk free by lending to the U.S. government! And that’s it. There are only a few things you need to remember from this chapter:
Quick Summary 1. You can stick your money under the mattress. (But that plan kind of stinks.) 2. You can put your money in the bank or buy bonds from the U.S. government. You will be guaranteed an interest rate and your money back with no risk.* 3. You can buy bonds sold by companies or other groups. You will be promised higher interest rates than you could get by putting your money in the bank or by buying government bonds—but you could lose some or all of your money, so you better get paid enough for taking the risk. 4. You can do something else with your money. (We’ll talk about what in the next chapter.) And I almost forgot, 5. Hot air rises. Hey, I did learn something from that balloon after all. Thanks, Johnson Smith. *Bank deposits up to $100,000 are guaranteed by an agency of the U.S. government. You must hold your bank deposit or your bond until it matures (possibly 5 or 10 years, depending upon what you buy) to guarantee no loss of your original investment. I’m going to make your life even simpler. As I write this, the 10-year U.S. government bond rate is substantially lower than 6 percent. However, whenever the long-term government bond is paying less than 6 percent, we will still assume the rate is 6 percent. In other words, our other investment alternatives will, at a minimum, still have to beat 6 percent, no matter how low long-term U.S. government bond interest rates go. The big picture is that we want to make sure we earn a lot more from our other investments than we could earn without taking any risk. Obviously, if long-term U.S. government bond rates rose to 7 percent or higher, we would use 7 percent or that higher number. Now that’s really it.
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The Invisible Hands Hedge Funds Off the Record Rethinking Real Money Steven Drobny
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Chapter 4 The House I headed off the beaten path of financial capitals to Stockholm to meet a fixed income specialist and pioneer in Swedish financial markets. On a gorgeous, late summer day, we strolled around town, discussing the credit crisis, China, pension funds, and a myriad of things that had taken place over the previous 18 months. This manager builds a diverse portfolio of small bets, all reasonably independent of each other, where on average he feels he has a slight edge. This process led him to once present his fund to his investors as a casino, although he was quick to note he was the house, not the gambler. After all, as Steve Wynn once said: “The only way to win in a casino is to own one.” Overlooking the marina, we ate roe and fresh fish, as my mind raced to keep abreast of “The House’s” thought process, a rare combination of rapid-fire connections, pragmatic wisdom, and deep analysis. Where trading often conjures images of taking outsized bets and winning, over time his game is won through superior portfolio construction. Later, in his office, we dug more deeply into some of the systemic issues that continue to plague the world economy and certain challenges that real money managers face within that environment. He thinks real money managers should use their inherent strengths and more effectively manage their endemic weaknesses, adopting innovative portfolio management techniques to address the uncertain road ahead. How did you get into this business? I started off in the business doing market making and then prop trading within the fixed income division at a bank. After that it seemed rather natural to take the next step to start a hedge fund. As a young kid I liked to play poker, bridge, and other games. While these games no longer excite me, I now get a similar high taking risk in the markets, especially from the analysis behind the risk taking. Markets are an intense, intellectual game with real consequences and, when properly done, with real 49
The Invisible Hands
benefits both for the risk takers and society. I find markets fascinating, particularly the macro elements because of the interplay between the international economy and geopolitics. I love forming an idea of what is happening in the world and in markets, identifying the best risk/reward, thinking about how to strip out all the unnecessary risk, how to protect against other risks, and how to construct a portfolio. Then you put on trades based on this analysis and see the result. I love the feedback of being right or wrong. How does the feedback of being right or wrong affect you? It annoys me when I’m wrong—I get upset with myself when I feel that I’m making mistakes. It is important to clarify that losing money and making mistakes are not the same thing. Likewise, making money and doing the right things are also not necessarily the same. I can have a period during which I’m making really nice money, yet feel that I screwed up because I didn’t read the markets well. Perhaps I had been looking for a different scenario to play out, or I did not have the optimal positions, or my position sizing or hedging could have been better. Similarly, I could be losing money, yet be very happy with myself because something unexpected happened and I had on some protection which worked really well, limiting my losses. Or perhaps I readjusted my views, positions, and hedges in such a way that I had very small losses and stand ready to take advantage of new opportunities to make a lot of money going forward. My market timing has never been good so I avoid short-term trading and do not try to time strategies. This probably saves some agony and regret, which can be important for your focus. The importance of psychology—your own psychology and that of other market participants—is underestimated by most institutional investors. And it is much more difficult to understand your own psychology than the markets’ psychology. It takes a much longer time to truly understand how you work, how you function psychologically in various environments, and how you manage this psychology and your risk as you monitor the markets. You can only learn this over time. At what point in your career did you know you had skill? Does one ever know? I would say that 10 years ago, a really good or a really bad run affected me more psychologically than it does today. I still get annoyed when I feel that I do not understand what is going on in the markets, or when I feel that I am making mistakes. But I don’t get too annoyed by losing money. Many years ago, I was making markets in Swedish government bonds for a bank. Because the Swedish government bond market was new at the time, I had read all the books I could find on the subject, and had gone to the U.S. to sit with primary dealers to learn more about bond trading. I thought I had a fairly good idea of what was going on. I had made a lot of money as a market maker and prop trader before that so I was fairly confident in my abilities. Then, within the Swedish bond market, I introduced a standardized forward
market where originally I was the sole market maker. Clients or other banks could trade with me and I kept the balance of the exposure, which I could translate through the repo market, also newly created. I could hedge whatever I wanted, and at one point saw an opportunity to short the Swedish government bond market on an absolute basis, something that had probably never been done beforeâ€”the tools had not been available. People had been underweight duration against the benchmark before, but I actually went outright short at one stage and made money on the trade. I thought I was really smart because I had made money in all types of markets, even with newly created instruments. Many heard about our bank making money in an environment of rising rates; the president of the bank called down to the trading floor to congratulate me, and I was starting to believe that I was really smart. Of course, I increased the short position just when rates started to turn and quickly lost the bulk of what I had previously made. I went from thinking that I was able to walk on water to thinking maybe I am not very good at this after all. After such a humiliating experience where I saw my risk capital cut significantly, I promised myself that I would never put myself in such a situation again. I slowly began to develop an understanding for what risk taking was really all about, using my love for the markets to test concepts such as sizing, risk, and so on. I was forced to accept the fact that markets are a very psychological game as well as a risk management game. Traders have to be able to handle risk, not only that which is inherently in the market, but also that which is specific to their portfolio and their circumstances. I have been trying to improve on this ever since, and I have been at it for 25 years now. If you were asked to run one of the Swedish AP pension funds as part of your social welfare duty, how would you go about it? The AP funds are a bit special, but if I were running a typical public pension fund, I would start by trying to identify my natural advantages and disadvantages, some of which are obvious, others less so. The most obvious advantages of a pension fund are its balance sheet and its credit worthiness. Pension funds have a very long-term investment horizon and a great deal of liquidity, although I am not sure they fully appreciate it. There are very few pension funds that take full advantage of their liquidity position. The most obvious disadvantage, however, is that a pension fund is highly constrained in its investment universe, making it far less flexible than a hedge fund. Pensions are subject to explicit external constraints by regulators, as well as more implicit constraints if they manage to a benchmark, which most do. These constraints often lead pension boards to impose strict guidelines for portfolio construction, exacerbating the problem. Further, although pension boards can have investment proÂfessionals, they can also be populated by people outside the investment business further handicapping them in terms of knowledge and experÂ tise. There are also certain ancillary constraints in the realm of political risk or
The Invisible Hands
public relations that tend to complicate matters further. Finally, their rather stiff governing structure usually makes them slow-moving players in the markets, which can be a disadvantage. The quality of investment talent within a pension fund is also likely to be a disadvantage. Usually talent flows to areas where it gets the best pay and the most interesting challenges. I imagine that due to competition from hedge funds, banks, and other asset managers, it is very difficult to retain top talent at a public pension fund. While this is certainly not true 100 percent of the time, as there are some very good people in the long-only community, on average the best talent will tend to flow to better paying and less constrained environments. As an analogy, you would not expect a really talented football player to stay on his local team in a midsized town that no one has heard of. If someone has worldclass talent, he will likely end up playing professional football in a Champions League club, which pays much more and has much greater exposure. All players want to reach their full potential, and will generally go where they can get not only the best coaches and facilities, but also be able to play with and against others of their caliber. The same applies to the investment community. If someone really has an outstanding talent that distinguishes him, whether that be intellect, mathematical aptitude, a talent for reading market psychology, or a mixture of other factors, this person will probably migrate to where he gets the best reward for his effort, where he will be able to play amongst the best and thus get even better, and where he is the least constrained. So the weaknesses in the real money world are structural. How would you go about maximizing the strengths, such as the strong balance sheet and credit worthiness that you mentioned? The most obvious way is to get paid for pockets of illiquidity in the market, and the easiest way of doing that is by investing in safe but less liquid securities. This is one way of being what Myron Scholes calls a liquidity provider to the market, something difficult to be if you are a leveraged player with redemptions, like a hedge fund. A liquidity provider should ideally have long-term money, say for the next 20 or 30 years, maybe forever. This is an underutilized resource among most pension funds, who often think that being fully invested means they have 100 percent of their assets allocated and thus no more liquidity. But you can get additional liquidity from repo’ing bonds, selling equities and simultaneously buying them back forward, shifting into instruments with cheap embedded leverage, and many other creative ways. You can pick up very safe extra return just by repo’ing special securities and lending equities that are in demand, and this also provides liquidity to the market. If you do it the right way with the right counterparties and with the correct haircuts, it’s risk-free income. If I were managing a real money portfolio, I would try to pick up extra return
from activities where I provide some kind of risk-free liquidity from both shortand long-term usage of my balance sheet. The market is willing to pay for this service, and it will probably be even more willing to do so going forward as bank balance sheets remain constrained. The long-term real money players should be the ultimate private sector providers of liquidity to the system. They should take advantage of getting paid for liquidity much more systematically than they do today. They are leaving the easy money on the table. To sum it up, I would not try to outguess the market in the short-or mediumterm; I would outsource that to others who have a better institutional setup. I would, however, use the strength of my balance sheet to pick up extra return. And over multiyear horizons, I would strive to be overweight cheap asset classes and underweight expensive ones, a strategy where a long-term horizon and a common sense approach is useful. But I am glad I do not have to do it for real. I am sure it is much easier sitting on the outside having a view on how it should be done. Isn’t levering up a portfolio with illiquid assets what caused so much trouble for investors in 2008, especially in the endowment and pension world? I am not saying that you should go into illiquids of all types. Rather, I am primarily talking about risk-free illiquidity, or very low-risk illiquidity. Of course, illiquid risky assets are a totally different ballgame. An interesting new example of what I am talking about is high-yielding government guaranteed bonds issued by financial institutions on the back of the credit crisis. The yields are high because the instruments are less liquid, but they are government guaranteed. Another example is government bonds that have recently been trading above LIBOR (see box). Buying a long-term government bond issued by a credit worthy country above LIBOR is essentially a very-long-term arbitrage. To capture the profits over the investment horizon, you need to be able to withstand mark-to-market losses along the way. Real money players who have a long-term time horizon are best suited to do these types of trades. These are excellent risk-reward trades, and everyone with a long-term time horizon should have these types of trades in their portfolio.
LIBOR The London Inter Bank Offer Rate is an interest rate at which banks can borrow funds, in marketable size, from other banks in the London interbank market. The LIBOR is fixed on a daily basis by the British Bankers’ Association. The LIBOR is derived from a filtered average of the world’s most creditworthy banks’ interbank deposit rates for larger loans with maturities between overnight and one full year. The LIBOR is the world’s most widely used benchmark for shortterm interest rates. It’s important because it is the rate at which the world’s most preferred borrowers are able to borrow money. It is also the rate upon which rates for less preferred borrowers are based. For example, a multinational corporation with a very good credit rating may be able to borrow money for one year at LIBOR
The Invisible Hands
plus a small spread. Countries that rely on the LIBOR for a reference rate include the United States, Canada, Switzerland and the United Kingdom. Source: Forbes Investopedia. What are your thoughts on diversification, which didn’t provide much safety in 2008? I am a great fan of diversification. It is one of the few free lunches that we have in the markets. But I would certainly not argue in favor of diversifying a very large percentage of the portfolio in private equity, real estate, and other similar illiquid investments. This is a fairly dangerous strategy, and I am not so sure you get paid much, if anything, for the illiquidity component you take on. These vehicles largely pay out traditional risk premia that can be found in the public markets through much simpler, more liquid instruments. Many investors do not use diversification efficiently. There are pension funds that have 80 or 90 percent of their assets invested in equities, arguing that in the long term, this will result in higher returns compared to a more traditional portfolio. This cannot be a smart way of constructing a portfolio. Diversification into more asset classes, perhaps using instruments with embedded leverage, can produce the same or even higher returns with less risk. If you are talking about diversification in the endowment model sense, we may have just witnessed a version of what [George] Soros calls “reflexivity,” whereby people’s behavior affects both the real economy and the markets through a feedback loop (see box). If everyone is looking for the same type of diversification for the same reasons using the same instruments, less diversification would automatically result when you need it most. Five or 10 years ago, it was reasonably important to know how crowded your trades were. Recently it has been absolutely essential. During 2008, knowing how others were positioned in your trades was a matter of life or death. Determining whether you were alone in a trade or if it was crowded made all the difference in the world.
Reflexivity The concept of reflexivity is very simple. In situations that have thinking participants, there is a two-way interaction between the participants’ thinking and the situation in which they participate. On the one hand, participants seek to understand reality; on the other, they seek to bring about a desired outcome. The two functions work in the opposite directions: in the cognitive function reality is the given; in the participating function, the participants’ understanding is the constant. The two functions can interfere with each other by rendering what is supposed to be given, contingent. I call the interference between the two functions “reflexivity.” I envision reflexivity as a feedback loop between the participants’ understanding and the situation in which they participate, and I contend that the concept of reflexivity is crucial to understanding situations that have thinking participants. Reflexivity renders the participants’ understanding imperfect and ensures that
their actions will have unintended consequences. Source: George Soros, Alchemy of Finance. What else do most institutional investors get wrong? All of us are less mentally disciplined than we should be. It is amazing how much time we can spend hoping an investment pans out, rather than looking at all sides of the argument—analyzing the downside, all the risks, and valuing it relative to other types of investments. It is also crucial to reappraise a situation as the fundamentals or the prices change. It is easy to just fall in love with a trade, believing it is going to make a lot of money, or more dangerously, underestimating how much it can lose. It is a typical human mistake of which we are all guilty at times. Most investors look at relatively few factors or variables, and even on the more sophisticated end of the spectrum, I am sometimes struck by the reasoning they employ on risk. Some of them even equate risk and volatility. Volatility is a useful concept in most situations, but risk is something much more complex. Many investors rely on basic rules of thumb rather than reasoning and analysis built on sound financial theory. Many assumptions are made without any regard to whether they have any logical backing or not. A good example would be the assumption that equities always generate good long-term returns, regardless of the price at which you buy them. This is total baloney. But people tend to believe cliches and stories rather than logic and science. For example, many people think the expected return of an asset is determined by its risk. That is getting it the wrong way around. The right way to look at it is: The expected return is a function of the risk premium of the asset at a given price. This is different than saying return is a function of risk, unless you are na¬ıve enough to think that all markets are perfectly priced all the time. A risky asset priced with a small risk premium is just a bad investment. For example, buying equities listed on Nasdaq in 1999 was not a good idea. These shares certainly had high risk but were not priced to compensate for that. Rather, they were priced for a low future return. We had a repeat of that in credit markets in 2007, when people could not get enough of risky bonds that were clearly priced for very poor long-term returns. Saying that equities or other risky assets will always deliver high returns in the long term is just incorrect. Price matters. Valuation matters. Knowing basic financial theory and its limitations can help avoid sloppy thinking. But you don’t necessarily need to be an expert on all of this stuff, and I am most certainly not an expert. I do, however, believe I have a good grasp of the logic that forms the building blocks of how financial instruments are priced and how the macro environment affects financial markets. Long-term winners in financial markets use common sense. Less blind faith in models and a more common-sense approach would have helped many players during the past few years.
The Invisible Hands
Should institutional investors use outside advisors to help plug their knowledge gap? In theory, yes, but not all consultants and rating institutions are up to their jobs. They are simply not experts in the subjects in which they claim expertise. Some of them do not have a clue what they are doing, yet they still peddle advice to pension fund boards and institutions that, in many cases, know even less than they do. That is a recipe for disaster, and that is exactly what happened recently in credit markets. First the rating agencies declared that a leveraged CDO was triple-A rated, that Iceland was triple-A rated, that a host of stuff was higher quality than it really was, and frankly a child should have known better. But the agencies peddled these opinions to the boards of institutions, which, in turn, happily bought them and promptly lost a lot of money. It’s unbelievable, really. The following is an amusing story about sloppy thinking and bad assumptions. I heard about a pension fund that bought a chunk of inflation-protected government bonds, locking in a real return of 2 percent for the next 30 years. However, in their asset and liability model, they simultaneously assumed that these were going to deliver a 4 percent real return since this was the return these bonds had delivered historically. What happened to common sense? ... chapter continues
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John C. Bogle
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Chapter 1 Don’t Count On It! The Perils of Numeracy Mysterious, seemingly random, events shape our lives, and it is no exaggeration to say that without Princeton University, Vanguard never would have come into existence. And had it not, it seems altogether possible that no one else would have invented it. I’m not saying that our existence matters, for in the grand scheme of human events Vanguard would not even be a footnote. But our contributions to the world of finance—not only our unique mutual structure, but the index mutual fund, the three-tier bond fund, our simple investment philosophy, and our over-weening focus on low costs—have in fact made a difference to investors. And it all began when I took my first nervous steps on the Princeton campus back in September 1947. My introduction to economics came in my sophomore year when I opened the first edition of Paul Samuelson’s Economics: An Introductory Analysis. A year later, as an Economics major, I was considering a topic for my senior thesis, and stumbled upon an article in Fortune magazine on the “tiny but contentious” mutual fund industry. Intrigued, I immediately decided it would be the topic of my thesis. The thesis, in turn, proved the key to my graduation with high honors, which in turn led to a job offer from Walter L. Morgan, Class of 1920, an industry pioneer and founder of Wellington Fund in 1928. Now one of 100-plus mutual funds under the Vanguard aegis, that classic balanced fund has continued to flourish to this day, the largest balanced fund in the world. In that ancient era, Economics was heavily conceptual and traditional. Our study included both the elements of economic theory and the worldly philosophers from the 18th century on—Adam Smith, John Stuart Mill, John Maynard Keynes, and the like. Quantitative analysis was, by today’s standards, conspicuous by its absence. (My recollection is that Calculus was not even a department prerequisite.) I don’t know whether to credit—or blame—the electronic calculator for inaugurating the sea change in the study of how economies and markets work, but with the coming of the personal computer and the onset of the Information Age, today numeracy is in the saddle and rides economics. If you can’t count it, it
Don’t Count on It!
seems, it doesn’t matter. I disagree, and align myself with Albert Einstein’s view: “Not everything that counts can be counted, and not everything that can be counted counts.” Indeed, as you’ll hear again in another quotation I’ll cite at the conclusion, “to presume that what cannot be measured is not very important is blindness.” But before I get to the pitfalls of measurement, to say nothing of trying to measure the immeasurable—things like human character, ethical values, and the heart and soul that play a profound role in all economic activity—I will address the fallacies of some of the measurements we use, and, in keeping with this theme of this forum, the pitfalls they create for economists, financiers, and investors. My thesis is that today, in our society, in economics, and in finance, we place too much trust in numbers. Numbers are not reality. At best, they’re a pale reflection of reality. At worst, they’re a gross distortion of the truths we seek to measure. So first, I’ll show that we rely too heavily on historic economic and market data. Second, I’ll discuss how our optimistic bias leads us to misinterpret the data and give them credence that they rarely merit. Third, to make matters worse, we worship hard numbers and accept (or did accept!) the momentary precision of stock prices rather than the eternal vagueness of intrinsic corporate value as the talisman of investment reality. Fourth, by failing to avoid these pitfalls of the numeric economy, we have in fact undermined the real economy. Finally, I conclude that our best defenses against numerical illusions of certainty are the immeasurable, but nonetheless invaluable, qualities of perspective, experience, common sense, and judgment.
Peril #1. Attributing Certitude to History The notion that common stocks were acceptable as investments—rather than merely speculative instruments—can be said to have begun in 1925 with Edgar Lawrence Smith’s Common Stocks as Long-Term Investments. Its most recent incarnation came in 1994, in Jeremy Siegel’s Stocks for the Long Run. Both books unabashedly state the case for equities and, arguably, both helped fuel the great bull markets that ensued. Both, of course, were then followed by great bear markets. Both books, too, were replete with data, but the seemingly infinite data presented in the Siegel tome, a product of this age of computer-driven numeracy, puts its predecessor to shame. But it’s not the panoply of information imparted in Stocks for the Long Run that troubles me. Who can be against knowledge? After all, as the quotation goes, “knowledge is power.” My concern is too many of us make the implicit assumption that stock market history repeats itself when we know, deep down, that the only certainty about the equity returns that lie ahead is their very uncertainty. We simply do not know what the future holds, and we must accept the self-evident fact that historic stock market returns have absolutely nothing in common with actuarial tables. John Maynard Keynes identified this pitfall in a way that makes it obvious: “It is dangerous to apply to the future inductive arguments based on past experience. (That’s the bad news) unless one can distinguish the broad reasons for what it was” (that’s the good news). For there are just two broad reasons that explain equity returns, and it takes only elementary addition and subtraction to see how
John C. Bogle
they shape investment experience. The too-often ignored reality is that stock returns are shaped by (1) economics and (2) emotions.
Economics and Emotions By economics, I mean investment return (what Keynes called enterprise2), the initial dividend yield on stocks plus the subsequent earnings growth. By emotions, I mean speculative return (Keynes’ speculation), the return generated by changes in the valuation or discount rate that investors place on that investment return. This valuation is simply measured by the earnings yield on stocks (or its reciprocal, the price-earnings ratio). For example, if stocks begin a decade with a dividend yield of 4 percent and experience earnings growth of 5 percent, the investment return would be 9 percent. If the price-earnings ratio rises from 15 times to 20 times, that 33 percent increase would translate into an additional speculative return of about 3 percent per year. Simply add the two returns together: Total return on stocks: 12 percent. So when we analyze the experience of the Great Bull Market of the 1980s and 1990s, we discern that in each of these remarkably similar decades for stock returns, dividend yields contributed about 4 percent to the return, the earnings growth about 6 percent (for a 10 percent investment return), and the average annual increase in the price/earnings ratio was a remarkable and unprecedented 7 percent. Result: Annual stock returns of 17 percent were at the highest levels, for the longest period, in the entire 200-year history of the U.S. stock market.
The Pension “Experts” Who, you may wonder, would be so foolish as to project future returns at past historical rates? Surely many individuals, even those expert in investing, do exactly that. Even sophisticated corporate financial officers and their pension consultants follow the same course. Indeed, a typical corporate annual report expressly states “our asset return assumption is derived from a detailed study conducted by our actuaries and our asset management group, and is based on long-term historical returns.” Astonishingly, but naturally, this policy leads corporations to raise their future expectations with each increase in past returns. At the outset of the bull market in the early 1980s, for example, major corporations assumed a future return on pension assets of 7 percent. By the end of 2000, just before the great bear market took hold, most firms had sharply raised their assumptions, some to 10 percent or even more. Since pension portfolios are balanced between equities and bonds, they had implicitly raised the expected annual return on the stocks in the portfolio to as much as 15 percent. Don’t count on it! As the new decade began on January 1, 2000, two things should have been obvious: First, with dividend yields having tumbled to 1 percent, even if that earlier 6 percent earnings growth were to continue (no mean challenge!), the investment return in the subsequent ten years would be not 10 percent, but 7 percent. Second, speculative returns cannot rise forever. (Now he tells us!) And if price-earnings ratios, then at 31 times, had simply followed their seemingly-universal pattern of reversion to the mean of 15 times, the total investment return over the coming decade would be reduced by seven percentage points per year. As the year 2000 began, then, reasonable expectations suggested that annual stock returns
Don’t Count on It!
might just be zero over the coming decade.3 3 Update: As it turned out, the annual return on stocks for the 1999-2009 decade came to -0.2 percent. If at the start of 2000 we were persuaded by history that the then-long-term annual return on stocks of 11.3 percent would continue, all would be well in the stock market. But if we listened to Keynes and simply thought about the broad reasons behind those prior returns on stock—investment vs. speculation—we pretty much knew what was going to happen: The bubble created by all of those emotions—optimism, exuberance, greed, all wrapped in the excitement of the turn of the millennium, the fantastic promise of the Information Age, and the “New Economy”—had to burst. While rational expectations can tell us what will happen, however, they can never tell us when. But the day of reckoning came within three months, and in late March 2000 the bear market began. Clearly, investors would have been wise to set their expectations for future returns on the basis of current conditions, rather than fall into the trap of looking to the history of total stock market returns to set their course. Is it wise, or even reasonable, to rely on the stock market to deliver in the future the returns it has delivered in the past? Don’t count on it!
Peril #2. The Bias Toward Optimism The peril of relying on stock market history rather than current circumstances to make investment policy decisions is apt to be costly. But that is hardly the only problem. Equally harmful is our bias toward optimism. The fact is that the stock market returns I’ve just presented are themselves an illusion. Whether investors are appraising the past or looking to the future, they are wearing rose-colored glasses. For by focusing on theoretical market returns rather than actual investor returns, we grossly overstate the returns that equity investing can provide. First, of course, we usually do our counting in nominal dollars rather than real dollars—a difference that, compounded over time, creates a staggering dichotomy. Over the past 50 years, the return on stocks has averaged 11.3 percent per year, so $1,000 dollars invested in stocks at the outset would today have a value of $212,000. But the 4.2 percent inflation rate for that era reduced the return to 7.1 percent and the value to just $31,000 in real terms—truly a staggering reduction. Then we compound the problem by in effect assuming that somewhere, somehow, investors as a group actually earn the returns the stock market provides. Nothing could be further from the truth. They don’t because they can’t. The reality inevitably always falls short of the illusion. Yes, if the stock market annual return is 10 percent, investors as a group obviously enjoy a gross return of 10 percent. But their net return is reduced by the costs of our system of financial intermediation—brokerage commissions, management fees, administrative expenses—and by the taxes on income and capital gains. A reasonable assumption is that intermediation costs come to at least 2 percent per year, and for taxable investment accounts, taxes could easily take another 2 percent. Result: In a 10 percent market, the net return of investors would be no more than 8 percent before taxes, and 6 percent after taxes. Reality: Such costs would consume 40 percent of the market’s nominal return. But
John C. Bogle
there’s more. Costs and taxes are taken out each year in nominal dollars, but final values reflect real, spendable dollars. In an environment of 3 percent annual inflation, a nominal stock return of 10 percent would be reduced to a real return of just 7 percent. When intermediation costs and taxes of 4 percent are deducted, the investor’s real return tumbles to 3 percent per year. Costs and taxes have consumed, not 40 percent, but 57 percent of the market’s real return. Taken over the long-term, this bias toward optimism—presenting theoretical returns that are far higher than those available in the real world—creates staggering differences. Remember that $31,000 real 50-year return on a $1,000 investment? Well, when we take out assumed investment expenses of 2 percent, the final value drops to $11,600. And if we assume as little as 2 percent for taxes for taxable accounts, that initial $1,000 investment is worth, not that illusory nominal $212,000 we saw a few moments ago—the amazing productive power of compounding returns—but just $4,300 in real, after-cost terms—the amazing destructive power of compounding costs. Some 98 percent of what we thought we would have has vanished into thin air. Will you earn the market’s return? Don’t count on it!
Escaping Costs and Taxes It goes without saying that few Wall Street stockbrokers, financial advisers, or mutual funds present this kind of real-world comparison. (In fairness, Stocks for the Long Run does show historic returns on both a real and nominal basis, although it ignores costs and taxes.) We not only pander to, but reinforce, the optimistic bias of investors. Yet while there’s no escaping inflation, it is easily possible to reduce both investment costs and taxes almost to the vanishing point. With only the will to do so, equity investors can count on (virtually) matching the market’s gross return: Owning the stock market through a low-cost, low-turnover index fund—the ultimate strategy for earning nearly 100 percent rather than 60 percent of the market’s nominal annual return. You can count on it! The bias toward optimism also permeates the world of commerce. Businessmen consistently place the most optimistic possible face on their firms’ prospects for growth . . . and are usually proven wrong. With the earnings guidance from the corporations they cover, Wall Street security analysts have, over that past two decades, regularly estimated average future five-year earnings growth. On average, the projections were for growth at an annual rate of 11½ percent. But as a group, these firms met their earnings targets in only three of the 20 five-year periods that followed. And the actual earnings growth of these corporations has averaged only about one-half of the original projection—just 6 percent. But how could we be surprised by this gap between guidance and delivery? The fact is that the aggregate profits of our corporations are closely linked, indeed almost in lock step, with the growth of our economy. It’s been a rare year when after-tax corporate profits accounted for less than 4 percent of U.S. gross domestic product, and they rarely account for much more than 8 percent. Indeed since 1929, after-tax profits have grown at 5.6 percent annually, actually lagging the 6.6 percent growth rate of the GDP. In a dog-eat-dog capitalistic economy where the competition is vigorous and largely unfettered and where the consumer
Don’t Count on It!
is king—more than ever in this Information Age—how could the profits of corporate America possibly grow faster than our GDP? Don’t count on it!
Earnings: Reported, Operating, Pro Forma, or Restated Our optimistic bias has also led to another serious weakness. In a trend that has attracted too little notice, we’ve changed the very definition of earnings. While reported earnings had been the, well, standard since Standard & Poor’s first began to collect the data all those years ago, in recent years the standard has changed to operating earnings. Operating earnings, essentially, are reported earnings bereft of all those messy charges like capital write-offs, often the result of unwise investments and mergers of earlier years. They’re considered “non-recurring,” though for corporations as a group they recur with remarkable consistency. During the past twenty years, operating earnings of the companies in the S&P Index totaled $567. After paying $229 in dividends, there should have been $338 remaining to reinvest in the business. But largely a result of the huge “nonrecurring” write-offs of the era, cumulative reported earnings came to just $507. So in fact there was just $278 to invest—20 percent less—mostly because of those bad business decisions. But it is reported earnings, rather than operating earnings, that reflect the ultimate reality of corporate achievement. Pro forma earnings—that ghastly formulation that makes new use (or abuse) of a once-respectable term—that report corporate results net of unpleasant developments, is simply a further step in the wrong direction. What is more, even auditor-certified earnings have come under doubt, as the number of corporate earnings restatements has soared. During the past four years, 632 corporations have restated their earnings, nearly five times the 139 restatements in the comparable period a decade earlier. Do you believe that corporate financial reporting is punctilious? Don’t count on it!
“Creative” Accounting Loose accounting standards have made it possible to create, out of thin air, what passes for earnings. One popular method is making an acquisition and then taking giant charges described as “non-recurring,” only to be reversed in later years when needed to bolster sagging operating results. But the breakdown in our accounting standards goes far beyond that: Cavalierly classifying large items as “immaterial;” hyping the assumed future returns of pension plans; counting as sales those made to customers who borrowed the money from the seller to make the purchases; making special deals to force out extra sales at quarter’s end; and so on. If you can’t merge your way into meeting the numbers, in effect, just change the numbers. But what we loosely describe as creative accounting is only a small step removed from dishonest accounting. Can a company make it work forever? Don’t count on it! That said, I suppose it does little harm to calculate the stock market’s priceearnings ratio on the basis of anticipated operating earnings. The net result of using the higher (albeit less realistic) number is to make price-earnings ratios appear more reasonable; i.e., to make stocks seem cheaper. By doing so, the present p/e ratio for the S&P 500 Index (based on 2002 estimates) comes to a
John C. Bogle
perhaps mildly-reassuring 18 times based on operating earnings, rather than a far more concerning 25 times based on reported earnings. But our financial intermediation system has far too much optimism embedded in it to promulgate the higher p/e number. Nonetheless, it is folly to rely on the higher earnings figure (and resultant lower p/e) without recognizing the reality that in the long run corporate value is determined, not only by the results of the firm’s current operations, but by the entire amalgam of investment decisions and mergers and combinations it has made. And they don’t usually work. A recent BusinessWeek study of the $4 trillion of mergers that took place amid the mania of the late bubble indicated that fully 61 percent of them destroyed shareholder wealth. It’s high time to recognize the fallacy that these investment decisions, largely driven to improve the numbers, actually improve the business. Don’t count on it!
Peril #3. The Worship of Hard Numbers Our financial market system is a vital part of the process of investing, and of the task of raising the capital to fund the nation’s economic growth. We require active, liquid markets and ask of them neither more nor less than to provide liquidity for stocks in return for the promise of future cash flows. In this way, investors are enabled to realize the present value of a future stream of income at any time. But in return for that advantage comes the disadvantage of the momentby-moment valuation of corporate shares. We demand hard numbers to measure investment accomplishments. And we want them now! Markets being what they are, of course, we get them. But the consequences are not necessarily good. Keynes saw this relationship clearly, noting that “the organization of the capital markets required for the holders of quoted equities requires much more nerve, patience, and fortitude than for the holders of wealth in other forms . . . some (investors) will buy without a tremor unmarketable investments which, if they had (continuous) quotations available, would turn their hair gray.” Translation: It’s easier on the psyche to own investments that don’t often trade. This wisdom has been often repeated. It is what Benjamin Graham meant when he warned about the hazard faced by investors when “Mr. Market” comes by every day and offers to buy your stocks at the current price. Heeding the importuning of Mr. Market allows the emotions of the moment take precedence over the economics of the long term, as transitory shifts in prices get the investor thinking about the wrong things. As this wise investor pointed out, “in the short-run, the stock market is a voting machine; in the long-run it is a weighing machine.”
Momentary Precision vs. Eternal Imprecision Yet the Information Age that is part of this generation’s lot in life has led us to the belief that the momentary precision reflected in the price of a stock is more important than the eternal imprecision in measuring the intrinsic value of a corporation. Put another way, investors seem to be perfectly happy to take the risk of being precisely wrong rather than roughly right. This triumph of perception over reality was reflected—and magnified!—in the recent bubble. The painful stock market decline that we are now enduring simply represents the return to reality.
Don’t Count on It!
Is the price of a stock truly a consistent and reliable measure of the value of the corporation? Don’t count on it! Among the principal beneficiaries of the focus on stock prices were corporate chief executives. Holding huge numbers of stock options, they were eager to “make their numbers,” by fair means or foul, or something in between. As the numbers materialized, their stock prices soared, and they sold their shares at the moment their options vested, as we know now, often in “cashless” transactions with bridge loans provided by the company. But unlike all other compensation, compensation from fixed-price options was not considered a corporate expense. Such options came to be considered as “free,” although, to avoid dilution, most corporations simply bought compensatory shares of stock (at prices far above the option prices) in the public market. It is not only that shares acquired through options were sold by executives almost as soon as they were exercised, nor that they were unencumbered by a capital charge nor indexed to the level of stock prices, that makes such options fundamentally flawed. It is that compensation based on raising the price of the stock rather than enhancing the value of the corporation flies in the face of common sense. Do stock options link the interests of management with the interests of longterm shareholders? Don’t count on it!
Ignorant Individuals Lead Expert Professionals . . . into Trouble Years ago, Keynes worried about the implications for our society when “the conventional valuation of stocks is established (by) the mass psychology of a large number of ignorant individuals.” The result, he suggested would lead to violent changes in prices, a trend intensified as even expert professionals, who, one might have supposed, would correct these vagaries, follow the mass psychology, and try to foresee changes in the public valuation. As a result, he described the stock market as, “a battle of wits to anticipate the basis of conventional values a few months hence rather than the prospective yield of an investment over a long term of years.” A half-century ago, I cited those words in my senior thesis—and had the temerity to disagree. Portfolio managers in a far larger mutual fund industry, I suggested, would “supply the market with a demand for securities that is steady, sophisticated, enlightened, and analytic, a demand that is based essentially on the (intrinsic) performance of a corporation rather than the public appraisal of the value of a share, that is, its price.” Well, 50 years later, it is fair to say that the worldly-wise Keynes has won, and that the callowly-idealistic Bogle has lost. And the contest wasn’t even close! Has the move of institutions from the wisdom of long-term investment to the folly of short-term speculation enhanced their performance? Don’t Count on it!
Economics Trumps Emotion—Finally In those ancient days when I wrote my thesis, investment committees (that’s how the fund management game was then largely played) turned over their fund portfolios at about 15 percent per year. Today, portfolio managers (that’s how the game is now played) turn over their fund portfolios at an annual rate exceeding 110 percent—for the average stock in the average fund, an average holding period of just eleven months. Using Keynes’ formulation, “enterprise” (call it investment fundamentals) has become “a mere bubble on a whirlpool of speculation.” It is the triumph of emotions over economics.
John C. Bogle But it is an irrefutable fact that in the long run it is economics that triumphs over emotion. Since 1872, the average annual real stock market return (after inflation but before intermediation costs) has been 6.5 percent. The real investment return generated by dividends and earnings growth has come to 6.6 percent. Yes, speculative return slashed investment return by more than one-half during the 1970s and then tripled(!) it during the 1980s and 1990s. But measured today, after this year’s staggering drop in stock prices, speculative return, with a net negative annual return of -0.1 percent during the entire 130-year period, on balance neither contributed to, nor materially detracted from, investment return. Is it wise to rely on future market returns to be enhanced by a healthy dollop of speculative return? Don’t count on it! The fact is that when perception—interim stock prices—vastly departs from reality—intrinsic corporate values—the gap can only be reconciled in favor of reality. It is simply impossible to raise reality to perception in any short timeframe; the tough and demanding task of building corporate value in a competitive world is a long-term proposition. Nonetheless, when stock prices lost touch with corporate values in the recent bubble too many market participants seemed to anticipate that values would soon rise to justify prices. Investors learned, too late, the lesson: Don’t count on it! ... chapter continues
Also from John C. Bogle Enough True Measures of Money, Business, and Life 9780470524237 • Pbk • Jun 2010 • £9.99 / €12.00 / $14.95
The Little Book of Common Sense Investing The Only Way to Guarantee Your Fair Share of Stock Market Returns 9780470102107 • Hbk • Mar 2007 • £12.99 / €17.40 / $19.95
Common Sense on Mutual Funds Updated 10th Anniversary Edition 9780470138137 • Hbk • Jan 2010 • £19.99 / €24.00 / $29.95
Debunkery Learn It, Do It, and Profit from it -Seeing Through Wall Street’s Money-Killing Myths Ken Fisher
978-0-470-28535-0 • Hardback • 256 pages November 2010 • £18.99 / €22.40 / $27.95
Chapter 1 Bonds Are Safer Than Stocks Bonds just feel safe. The very name even implies safety — as in, “My word is my bond.” Far too many investors with long - term growth goals load up on bonds, presuming they’re safer than scary stocks. But are they? Depends largely on how you define “safe.” Does “safe” mean a high probability of lower long - term returns with less near- term volatility? Or is “safe” increasing the probability your portfolio grows enough to satisfy your long - term growth and/or cash flow needs? If you need a certain amount of growth to maintain your lifestyle in retirement, you might not feel so “safe” when you discover having too little volatility risk for too many years later means you must subsequently dial back your lifestyle. And you may not feel “safe” when you must explain that to your spouse — particularly if in that future there is any huge inflation spurt (always possible).
Bonds Can Be Negative, Too Yes, stocks can be pretty darn volatile and scary — near term. But people forget: Bonds do sometimes lose value in the near term too. In 2009, bonds not only suffered relative to stocks (world stocks were up 30 percent) but also absolutely — 10 - year US Treasuries fell 9.5 percent. Not what you’d expect from über- safety. Still, stocks can and do fall much more — in 2008, world stocks were down 40.7 percent! But remember, these are all short - term returns. Stocks are generally riskier short - term because the expectation is they’ll have better returns long - term. And they have! (See Bunk 2 for more on stocks’ long - term superiority.) Overwhelmingly, if you’ve got a long time to invest (and most investors do — see Bunk 3 on how investors usually underestimate their time horizon to their detriment), stocks are typically a better bet. And if you need portfolio growth and can give stocks a bit of time, they have even been the safer bet! It’s all about time horizons.
Given Just a Bit of Time Buying stocks with money you need to pay the rent over the next year is
always foolish. But the truth is: Given a bit of time, historically stocks have bigger and, surprisingly, more uniformly positive returns than bonds. Figure 1.1 shows three - year rolling real returns (adjusting for inflation) of 10 - year Treasuries. Note: There are plenty of down periods — in some cases many of them right in a row. You aren’t protected from down periods with Treasuries.
40% 30% 20% 10% 0% 10% 20%
3-Year Trailing Annualized Real Return
Now compare that to Figure 1.2 , which shows the same thing but for the S & P 500. (I use US stocks here because they have longer, better data, and we can measure this over a longer period — but the story is generally the same using world stocks.) You actually have fewer negative three - year periods historically. Yes, the negative periods can be bigger, but the positive periods are more numerous and simply huger. Stock returns blow away bond returns, with fewer negative three - year periods!
Figure 1.1 US 10-Year Treasuries (Three-Year Rolling Real Returns)— ”Safer” Than Stocks?
40% 30% 20% 10% 0% 10% 20%
3-Year Trailing Annualized Real Return
Source: Global Financial Data, Inc., USA 10-year Government Bond Total Return Index from 12/31/1925 to 12/31/2009.
Figure 1.2 US Stocks (Three-Year Rolling Real Returns)—Compare to Bonds Source: Global Financial Data, Inc., S&P 500 total return from 12/31/1925 to 12/31/2009.
Inflation’s Bite Folks also forget about inflation. If, over your long - term investment time horizon, we have a period (or two) of materially increasing inflation, two things can happen at once. First, long - term interest rates typically rise as inflation does. Bond yields and price have an inverse relationship — so when rates rise, the price and value of your long - term bonds fall proportionally. Second, and as surely, your bonds get paid back in cheaper, inflated dollars — double whammy! With the amount of recent global money creation (as I write this in 2010) and the huge global deficits, it would be foolish indeed not to consider this a material possible risk. During such inflationary periods, stocks have tended to have lower returns relative to history but positive returns nonetheless (with short - term volatility, of course) — yet returns that generally have beaten inflation and maintained real purchasing power, and then some. I’m frequently accused of being a perma-bull. I’m not — I’ve gotten bearish three times in my career thus far and I wrote about it publicly then. (For a history thereof and my other views over the long - term past, see Aaron Anderson’s The Making of a Market Guru: Forbes Presents 25 Years of Ken Fisher, John Wiley & Sons, 2010.)
BONDS ARE SAFER THAN STOCKS But I do have a bias to being bullish if I can’t find any decent reasons to be bearish. Why? Look at those graphs! Capital markets are super complex. No one person or group of people can understand all the intricate inter- workings of the massive global market. As such, there are no certainties in investing, only probabilities. And history says you should want to be bullish way more than bearish. Bears can’t get that. They see the big down periods for stocks and say, “Eek!” But for some reason, they just can’t see the plain truth: Stocks are more consistently positive than bonds historically — given just a bit of time. Therefore, over the longer term, they have been less risky. Stocks are safer than bonds? Sure looks that way.
Also from Ken Fisher
How to Smell a Rat The Five Signs of Financial Fraud 9780470631966 • Pbk • Oct 2010 £11.99 / €13.60 / $16.95
The Only Three Questions That Count Investing by Knowing What Others Don't 9780470292679 • Pbk • Oct 2008 £11.99 / €13.60 / $16.95
The Ten Roads to Riches The Ways the Wealthy Got There (And How You Can Too!) 9780470481554 • Pbk • Nov 2009 £11.99 / €13.60 / $16.95
100 Minds That Made the Market 9780470139516 • Pbk • Sep 2007 £13.99 / €15.00 / $19.95
Supertrends Winning Investment Strategies for the Coming Decades Lars Tvede
978-0-470-71014-2 • Hardback • 472 pages April 2010 • £24.99 / €30.00 / $40.00
Introduction Information technology If you have normal eyesight, then it is possible to see a single human hair. A hair is about 50mm or 50,000nm wide (50,000 billionths of a meter). This is about five times the size that a human eye can resolve (the smallest we can see is 0.01 mm). Let me give an example to put that into perspective. San Francisco Bay is 20km across at its widest part. Or, if you stand in Copenhagen in Denmark and look across the sound to Sweden, the widest part is approximately the same. Now, let’s magnify everything 400 million times. If we do that, then the width of a hair becomes the distance across San Francisco Bay, or between Copenhagen and the shores of Sweden. In this world, the smallest object visible to a human being would be a fifth of that,or 4km wide. I know it’s weird to imagine a hair that is 20km wide,but please try for a moment, because it leads us to something extraordinary. In this reference frame, a nanometer would be 0.4 m, and a typical bacteria cell would be around 10m in diameter. As we stand a safe distance from this 10m long bacteria,we would be able to see a number of hydrogen atoms connected to other atoms. Each of these hydrogen atoms would be approximately 4cm in diameter, so roughly the size of large pebbles. An electron would be something in the region of 0.00000000000001 cm, and a quark would be around 0.000000000000004 cm, so even in this absurdly magnified world, you wouldn’t be able to see either. On that scale, what would a really compact computer chip look like? Here is a clue: In 1959, the Nobel Prize Winner Richard P. Feynman presented his views on the amount of data that could be compressed into a chip in the future. He said that if it was possible to build a computer where the physical representation of each bit was only 100 atoms, or 10 nm, it would be possible to store the full text of all the books that had ever been written (at the time 24 million books) in one computer chip of 100,000 X 100,000 nm or 1 X 10-8 m2 in each direction. So, in our magnified world, what he talked about was representing 1bit-a ‘‘1’’ or a ‘‘0’’-within a space the size of 100 large pebbles,or 4m. But again, what would a computer chip look like in our reference frame? If the distance between Denmark and Sweden (20 km) was the widthofa hair (50,000nm),
Feynman’s entire chip would be 40km in each direction or twice the distance I mentioned earlier across San Francisco Bay. In the real world, it would be twice the width of a hair. A tiny grain, really. So, what he described was 24 million books within a speck of dust. If all of these books were printed on paper they would weigh something like 800,000 tons. If you were able to lay them end to end, they would cover the distance between London and New York. Of course, Feynman just hypothesized about it in 1959. We shall later see how realistic he was. In order to do what Feynman described, you need to use an invention called a transistor. In fact, you would need an absolutely astronomical amount of very small transistors. Transistors are, in my opinion, one of the two greatest inventions in the history of mankind-the other one is the wheel. There exist a special case of wheels which we call cogwheels. If you take a complicated, mechanical watch and wind it up, there will be an incredible number of small and bigger cogwheels interacting with each other to convert the simple, mechanical energy from your process of winding up the watch to complex information. Perhaps it shows dates, hours, minutes, seconds, time zones, Moon phases, and more. All of it from simple rules upon more simple rules, expressed in the relative sizes and connections of all those cogwheels. The minute cogwheel turns 60 times, which makes the hour cogwheel turn once. The hour cogwheel turns 24 times, which makes the day change. Stuff like that. Now, if you write software, you also have simple rules. One of the most common is called an ‘‘if ... then ... else’’ statement. To explain what that means, let’s say that you drive your automobile towards a stoplight: If the light is green, then continue, else stop. A transistor is a physical device that expresses this simple rule. It was first patented in Canada in 1925, and any attempts to make computers before that (and there had been some) had actually been based on cogwheels, just like in watches. With the transistor you could replace one of our two greatest inventions with the other. Amazingly, after mankind had made this invention, over the next 22 years, no one used it for anything meaningful. In fact, virtually no one had ever heard about it. It wasn’t until 1947 that the first technical breakthrough for the transistor came, as engineers at Bell Labs found that you could make a transistor by applying electric current to a crystal of germanium. Without power, the crystal was a very bad electric conductor, but with it, electricity could easily flow through. Germanium could, in this way, become an on/off switch to control current flow through the device: If power field is on, then it’s conductive, else it’s not. One of the most common applications for the use of the transistor is as an amplifier. For instance, hearing aids use transistors as such, by letting the sound that is captured by a tiny microphone drive the control current (or ‘‘base’’) and then use a battery to let a stronger power pass through the transistor and drive a tiny loudspeaker.
Because germanium can conduct, if it has current applied to its base (and can’t without it), it is called a ‘‘semiconductor’’, as in ‘‘sometimes-
Transistor schematic drawing. The basic principle of operation is that the current passing through the device, from the ‘‘collector’’ to the ‘‘emitter’’, is controlled by a much smaller control current at what is called the ‘‘base’’. It’s a bit more complicated than a wheel, but not much. Actually, a wheel with ball bearings seems in principle more complex thana transistor. Source:Marcus Nebeling, Fiber Network Engineering Co.
The transistor as an amplifier. Small variations in the input signal control larger fluctuations in a more powerful current. Source: Marcus Nebeling, Fiber Network Engineering Co.
but-not-always’’ conductor. If you interconnect many transistors with each other, you will have an array of switches that will support a myriad of functions. In a way this is similar to a watch, where numerous cogwheels create a whole lot of complication. However, there is one huge difference. The transistors in a computer chip operate extremely fast, capable of turning on and off several billion times a second. One reason for this incredible speed is that electric signals move very fast (not the actual electrons, because they move rather slowly, but the electric field).
Actually, the fields move at close to the speed of light, which is equal to travelling 7.5 times around Earth at the Equator. Not per day, hour, or minute, but per second. The first transistors were big, but they soon got smaller, and the germanium was eventually exchanged with silicon and other materials, which like germanium could work as semiconductors, if you treated them with small impurities such as arsenic, phosphorus, antimony, boron, gallium, or aluminum (a process known as ‘‘doping’’). This was a great idea, because silicon was cheaper and easier to work with than germanium. Next idea: Make the transistors so small that many of them could sit on a little chip the size of a fingernail. Shortly after that innovation was conceived and shown to actually work, some engineers started making calculations for how it would function if you simply zoomed everything down in scale; smaller units, less power, etc.—everything. Perhaps to their surprise they found that it should work just fine, and that it would be much faster on top. Given an identical layout, it wouldn’t even create more heat per surface unit, since the necessary power decreased because of lower-capacitance interconnects. So, they began downscaling everything, and once they had made the chips smaller they made them smaller still, and so on. To produce these chips you take a so-called ‘‘wafer’’, which is made of nearly defect-free, single-crystalline silicone. This clean material is then cut with a diamond-edged metal to get a completely smooth surface. Next follows a whole series of processes, where one of the most important is addition of socalled ‘‘photoresist’’ fluid. After this has been applied, you put a template over the wafer, which has a pattern similar to what you want for electric current flows and transistors within the chip. This is in a way similar to putting a template on a surface before you paintspray a logo onto it, for instance. However, the ‘‘paint-spray’’ in chip production is actually neither paint, nor spray—it is light. So, you paint-spray the wafer (the photoresist on it) with a complex pattern of light, which creates chemical reactions. These patterns are thereby burned onto the wafer, while the rest of the photoresist can be washed away. The resulting product is called an integrated circuit. In order to save time and money, production is done simultaneously for many circuits— one wafer contains numerous integrated circuit patterns, which you at the end cut out as ‘‘dice’’ before finally attaching external wiring and other stuff on them. Finally, before selling them, you test each, and the percentage that have no errors are called ‘‘yield’’, whereas the rest are wasted. I have previously mentioned Moore’s Law, which states that the number of transistors that can be placed inexpensively on a chip (or integrated circuit) doubles approximately every two years. That law is evidently not one, like Newton’s laws, that will last forever. However, when Gordon Moore first described it in a paper in 1965, he tracked it back to 1959, and almost 50 years later it is still working, which is quite amazing. Indeed, the observation has been so captivating that it actually became partially self-fulfilling—it became such a mantra in the industry that, since your competitor kept up with Moore’s Law, you better do a bit better than that. In the 1970s there were periods where capacity actually doubled every 12 months.
How could they keep doing it? There were many drivers of this relentless progress. The sizes of the wafers were increased, for instance, and everything in the chips went to smaller and smaller geometries, while different means to better utilize space were devised. Furthermore, parts of the circuits were made with several different layers superimposed on top of each other. By 2000, chips typically contained more than 50 different chemical elements, all of which played a vital role in improving speed and reliability. Another method to improve the ability to manufacture smaller and smaller geometries was to shift to light with shorter and shorter wavelengths, since light with a long wavelength eventually couldn’t create patterns that were fine enough. This in turn created huge challenges for the creation of new variations of photoresist that would work at these shorter wavelengths; a task that has been so complex that chemists basically needed to start working on such a project 10 years ahead of the time before the given wavelength was taken into production. After all, the photoresist had not only to be sensitive to the specific wavelengths of light applied, it also had to provide high contrast and sharp edges. Furthermore, it also needed to be able to stick to the wafer and not get removed during the washing processes. The challenges didn’t end there. The engineers had to develop optics that were more exact than those used in the Hubble Space Telescope, with lasers that could create the shorter and shorter wavelengths needed. There was also the problem of avoiding so-called tunneling, where electrons spontaneously jump between transistors or wires when they are extremely close to each other. To this purpose they developed isolation material, which could be applied in spaces that were only a few atoms wide. To use the earlier analogy, if a hair was 20km wide, then you would need to efficiently isolate spaces that were perhaps about a 0.5m wide, and you would have to do this for millions of such spaces without a single error or omission anywhere. There was also the issue of clock rate. Let’s say that you want to do a series of calculations. So, you send in electrical signals and consequently electric field changes rush around close to 300.000km per second, and within an instant it’s all done. Then what? Then you want to make the next series of calculations, which may build on the results from the previous ones. So, you send new impulses in. How, by the way? You use crystals that have a given inherent frequency, like when you let your hand glide over the wet edge of a crystal wineglass, and it starts to emit a tone. When a computer chip is started, a circuit around the crystal applies a random noise to it, which will inevitably include the natural vibration frequency of the crystal. This will now start to oscillate, and that movement amplifies electric signals coming out of the crystal. The interval between these impulses is called the ‘‘clock rate’’. The first commercial PC,the Altair 8800 usedan Intel 8080CPU with a clock rate of 2 million cycles per second (2MHz). By 1995 we had reached rates of 100 million, and around five years later we broke the billion-per-second barrier. By 2010 the norm is that a chip does over 3 billion (3GHz). To get there has not been easy. After each clock pulse, the connections in the transistors need time to settle to their new state. If the next clock pulse comes before that, you get corrupted signals. Also, when running so fast, data processing creates more heat, which could damage the integrated circuit.
Since heat generation is such a serious issue—it has been one of the key areas where Moore’s Law is challenged—the chip designers have not been able to accommodate the current heat loads in these faster chips; consequently, they have needed to go to having multiple cores to address thermal loading. As long as Moore’s Law works, it means that the increase in computer capacity in the next two years, whenever you read this, will be as large as the overall increase since the world’s first real computer was launched in 1943. So, let’s say its 2010 and the law will uphold until 2012. This means that performance growth over those two years will equal performance growth in all the previous 67 years. For how long will the law function? The experts don’t know, because they can only see as far as their current ideas reach into the future, but as at 2010 most say that they see fairly clearly that they can keep it going until 2020 or even 2025. Can it work after that? Maybe, maybe not, they will typically say. ‘‘We don’t know what will be invented before it’s invented.’’ One thing we do know, however: If the logic gates in integrated circuits are smaller than 5 nm, the electrons may leap over, even if the ‘‘door’’ is closed (This minimum distance by the way is half the minimum distance that Feynman assumed in his article in 1959!). Since we saw that a nanometer equals the width of 10 hydrogen atoms, the distance of approximately 50 hydrogen atoms is about the smallest unit that an electron in a chip cannot spontaneously and unintentionally conquer. So, that is exactly where we will go with the current concept of computer chips. Imagine again that we are down in the insanely magnified world that I described earlier, where a hair was 20 km wide. It’s 2020 and we are looking at a computer chip. There will perhaps be 15 to 20 billion transistors on it, and the smallest gates in it are now down to only five hydrogen atoms wide, meaning just 20 cm. It contains 625 cores and the clock frequency is 73 GHz which means that 73,000 million times per second it sends electromagnetic pulses racing through the maze of interconnected transistors at a speed of almost 120,000 billion km per second (when the dimensions are amplified, the speed is too). That’s roughly where we are headed with the current concept of integrated circuits. However, there are already strong indications of what may happen after we reach that final level of compression around 2020. I could imagine that 3D design could keep Moore’s Law going for another decade or two after 2020, so perhaps until between 2030 and 2040.
Prototypeof IBM3D water-cooled chip. The photo showsa complete viewofa singleinterlayer, 3D, cooling prototype before assembly. The active cooling area, the structured area in the center of the prototype, measures 1X 1cm, has a height of 100 mm, and contains up to 10,0000 vertical interconnections. Photo:Charlotte Bolliger. Image courtesy of IBM Research_Zˇrich.
I mentioned earlier the wheel as one of the world’s two greatest innovations. If you have an automobile and a bicycle, you own six wheels right there, but there are also small wheels in modern drawers, under office chairs and numerous other places. If we add the cogwheels you own, we probably get to at least hundreds and more likely thousands. After all, they are embedded in your automobile and bicycle, as well as in watches, electric and mechanical engines, etc.
Schematic of IBM 3D water-cooled chip. The image shows the interlayer water-cooling technique in which the cooling structures are integrated directly into the chip stack. Using a special assembly technique, developed by IBM researchers in cooperation with the Fraunhofer Institute IZM, the layers canbe connected in a high-precision and robust way that allows water to be pumped through the 3D stack embedded in a cooling container. Water (20°C) is pumped in at one side, flows through the individual layers of the stack, and exits at the other side. Courtesy:IBM Research-Zˇrich.
But then take transistors. The production of transistors in 2010 will come close to 10,000,000,000,000,000,000, which means somewhere between 10 to 100 times bigger than the global population of ants. We will also produce more transistors than grains of rice every year. In fact, annual transistor production by 2010 is so high that if we distributed it evenly among all people in the world, they would probably get around 1.4 billion transistors each. If you were a family of four
you would get 6 billion. If you are a geek, your personal allotment for this year would probably be closer to 100 billion of these things. Mankind is simply pro ducing a vastly higher number of these transistors than we do of any other product component, and we keep doubling the production every 18 months. By 2020 a standard computer should be about 30 times as powerful as in 2010, and if Moore’s Law holds up until 2030, it will be around 1,000 times as powerful. But transistor production will grow much faster, because whereas each chip will contain more transistors, each household and factory will have more chips. However, when you buy a computer or a smartphone, it’s evidently not transistors you want, but the data handling and what that can do. Data-processing capacity is normally calculated in so-called ‘‘MIPS’’ (i.e., ‘‘million instructions per second’’). In 1972, IBM developed its ‘‘system/ 370 model 158-3’’, which had a capacity of 1 MIPS and people were flabbergasted. One million instructions per second! One million! And IBM even promised that it wouldn’t end there. So, many began to ask themselves what you actually could do with one or several MIPS capacity. The American robot specialist Hans Movarec has described it in terms of what a robot with that capacity in its brain would do, which is fairly easy to relate to: One MIPS, for instance, will be enough for a robot to point out or follow something very simple (e.g., a white line or a coloured spot). This was the capacity of an IBM mainframe in 1972. Let’s multiply by 10. A capacity of 10 MIPS equals findingor following graytone objects such as a smartbomb might do. (In 1987, Motorola launched a chip with this capacity. During the first Gulf War in 1990^ 1991, we saw the precision of smartbombs.) Next step: With 100 MIPS, an automobile can slowly find its way through a natural terrain. This could, for instance, be done with Intel Pentium Pro, which was launched in 1996. Four years later we reached 1,000 MIPS, enough to guide mobile utility robots through unfamiliar surroundings. We multiply by 10 again. With 10,000 MIPS, the vision becomes threedimensional and the robot can find and grab objects. By 2005 we had come this far, and in 2008 Intel launched the Intel Core i7 Extreme 965EE with 76,000 MIPS. The target everyone now have their eyes on is 100,000,000 MIPS capacity, because that is what the human brain is believed to have. The rate of growth we have seen and expect to continue to see makes innovation of new applications evolve at amazing speeds. Let me give an example: Try to take an iPod or iPhone annum 2010 in your hand and take a good look at it. It is fantastic, but a thing like that was completely impossible to make when the IT bubble burst in 2000. And yet, in 2010, 10 years later, many hundred million of these devices are in daily use. The increase in computer performance is not only about MIPS, but also about, memory, data storage, bandwidth, and, for portable devices, battery life. Bell Labs announced in the spring of 2009 a new world speed record for fiber-optic transport. By transmitting 155 simultaneous wavelengths of light over a single 7,000 km long fiber,it managed to achieve a speed of 100 peta bits per second per
kilometer, equal to a payload of 15.5 terabits (trillion bits) per second. This was enough capacity to carry 10,430 simultaneous uncompressed HD video signals. As all these technologies continue to evolve exponentially, it is a given that 10 years ahead, there will be new, incredible IT products sold in hundreds of millions that you can hardly imagine today. Maybe a small thing with an enormous collection of movies. Actually, some of the technologies for this scenario are already well on their way. Scientists at the University of California have demonstrated how it would be possible to store the equivalent of 250 DVDs on a device the size of a small coin, and a new ‘‘5-D’’ technology developed at the Center of Micro-Photonics at Swinburne University of Technology uses a color filter plus polarization to add two dimensions of data representation to the three that DVDs already have. The result should be a DVD with 2,000 times the normal capacity, which in my opinion would cover all movies ever made that are worth seeing. Let’s guess that we, with that capacity, could store 2,500 movies (ranging from classics, which have little data to more data-consuming, high-definition movies). If you are a complete movie freak, and yet you do go out from time to time and on holidays, then you might see 250 movies a year. So, one disk would keep you going for 10 years, and by the time you were finished, you could probably just start over again.
The 10 top IT gadgets in the future 1. The transparent smartphone. Mobile phone which enables you to look at the real world through a transparent screen and get the world in front of you explained/conceptualized. 2. The digital paper. A soft, bendable e-reader that can download and display any media. 3. The home movie server. A compact server that can contain thousands of searchable and annotated movies. 4. The media wall. Entire walls that look like monochrome shiny surfaces or mirrors,but can turn into media screens at the touch of a finger. 5. Widescreen PC display. A several meter wide, single, flat screen, where some areas can be turned transparent, if not used for work. 6. Car entertainment system. Back seat and passenger seat online entertainment with movies, television, internet, etc. 7. Wireless monitors. Small devices that monitor everything you own and let you see it anywhere you are. 8. Composable computing. The ability to easily project content from any intelligent device to any screen near you (e.g., from a smartphone to a media wall). 9. Automatic house cleaner. Cleans floors and surfaces while you are away. Recharges itself at wall socket. 10. N on-steal items. Once an object is reported stolen, it transmits its geographical position to the police,who can then track it. If automo biles are stolen, police can remotely stop them, or block them if they are already stopped.
Some of the new IT solutions will not be related to massive computing power, but to the efficiency of small sensors. In the future there will be three main methods to check where stuff is: RFIDs, GPS, and mobile phones. As I write this chapter I have just come home from skiing. Whenever I approached a skilift, it would automatically let me pass without showing my ticket. In the biggest lifts it would even show a photo of my face to the control guy. This is possible because the credit card^sized season card for the lifts that I carry in my pocket has glued on to it a tiny ‘‘radio-frequency identification tag’’, or ‘‘RFID’’ tag. This is a very small, very inexpensive, chip that contains a grain-sized integrated circuit surrounded by a flat, printed metal antenna. All of it glued onto my plastic card and barely noticeable. How does this RFID work? When I approach the gates of a lift, there is a little sensor that transmits a radio signal towards me. This signal creates an electromagnetic field in the antenna of my RFID, and the power from that field enables the integrated circuit to send a return signal back. This return signal contains my personal subscription code, which is cleared with the lift systems’ computers before the gate opens and I can enter the lift. Furthermore, the computers bring up a stored photo of me so that the lift guard can check that my card is not stolen (except that I am impossible to recognize due to my goggles, helmet, and blue nose). RFIDs do much the same as bar codes, but as my ski example shows, you don’t need to expose them directly to a scanner—just being close to one will do. They are getting cheaper and cheaper, and they can be made so tiny that you can glue them onto live ants. (In fact, some scientists who wanted to know about ant movement patterns already have. I kid you not.) Today RFIDs are being placed on countless consumer products, on containers, parcels, parking tickets, and even stuck to the ears of pigs and cows. They are also used for toll roads (automobiles with a valid RFID can pass; others not), on museum pieces, etc. In the future there will be RFIDs on almost every product, for several reasons. The first is that it will enable you to load up with goods in a supermarket and then just pass the exit gate. The RFIDs will reveal themselves to an automated reader and you will just have to click ‘‘accept’’ on the detailed shopping list and the bill pops up on a screen. By doing so, it will bill your RFID-equipped payment card, if not your mobile phone. Another reason that we will see an explosion in RFIDs is that they can not only identify a product, but also trigger the launch of its ‘‘story’’. Point your smartphone towards it and you may read, see or hear everything the supplier has to tell you on a screen big enough to read (remember: there will be lots of old people unable to read small print on a package). Perhaps even what other people have to say about the same product, like consensus ratings. The combination of RFIDs, corporate product stories, and ratings will be big. Ratings, by the way, will be of everything: corporate ethics and sustainability, holiday resorts, restaurants, automobiles, people, and this book. It has come pretty far already. If you want a corporate rating of transparancy and ethics, check the ISO 2600 standard. Wine? Parkers Wineguide (and many others). Books: Try Amazon. com. Investment opportunities? Ask your bank. Holiday resorts? tripadvisor. com. Here is a third killer app for RFIDs: washing instructions. The reason the robot in your future washing room will not wash your black socks with your white shirts is that it will check the RFIDs and understand what doesn’t go together.
The second location technology is GPS, or the global positioning system. This is based on a fleet of satellites orbiting the Earth which each transmit time signals. A GPS receiver reads signals from several of these satellites and uses a combination of these to locate itself to a typical accuracy of 5m (less, if the weather is terrible). The satellites broadcast their signals but do not receive any feedback from all the gazillion GPS receivers that people have in their boats, automobiles, or smartphones, etc. So, these types of satellites cannot ‘‘track people’’, as you sometimes hear, but if a GPS receiver is connected to a transmitter (such as a mobile phone it may be embedded in), then this transmitter might evidently send out coordinates of where it is. In fact, as soon as you turn on your mobile phone, you reveal to the networks roughly where you are, since they can read your signal strengths at various mobile phone antennas, and this makes phones the third critical location technology. If they read you from just one antenna then they will have a very rough idea of where you might be, but if there are three antennas reading you, then they can triangulate and pinpoint your location very accurately. This has frequently been used for catching criminals and terrorists, and it has another extremely useful function: It reveals where there are traffic jams. Since most people have their mobiles turned on as they drive, it is easy to track statistically how many automobiles there are on any major road such as a highway, and how fast they are driving. Through this information it is thus possible to not only discover traffic jams instantly, but also to predict when and where they may appear. This information can then be fed back to the drivers via radio broadcasts, and the GPS systems in the automobiles can automatically alert the drivers and reroute them. The creative possibilities coming from the combination of RFIDs, GPS, and mobile phones are countless, and so are the derived business opportunities. How about that you just click for ‘‘taxi’’ on your smartphone, and the phone sends your coordinates to the taxi, which finds you? This would be extra smart if in fact the taxi is robotic. Or how about stuff that calls either its owner or the police if it is removed from its expected location (like your expensive camera), or you, if it deviates from its expected route (your child coming home from school, or your senile parent). You just type in for them what their max authorized travel distance is (for your stereo: 10 m), or show it all authorized routes. Indeed, your child may carry a tracker which sends a message upon arrival at the school, tennis club, or wherever. Here is more: GPS-controlled lawn movers. Car radios that inform you of upcoming events in the places you are approaching. Food that transmits an alert when it’s about to expire (stick your smartphone into your fridge and get a list of what you need to eat soon). Basic innovation in IT will also continue to change electronic media. People will want to be informed and entertained on their mobile devices, in real time and at any time. Perhaps there will be two of those mobile gadgets: the smartphone, which fits into a pocket and has two modes (transparent screen and normal screen), and the tablet computer/e-reader, which also has two displays (one with a backlight for indoor use and another with a liquid e-reader interface for outdoor viewing). Another change will be the increased growth in popularity of online games, and in particular massively multiplayer games, where millions of people simultaneously play against each other or in some cases against real-time
challenges playing out in the real world, such as a live automobile race. As the latter begin to resemble high-definition movie quality, such games can become natural, seamless extensions of movies. You see an adventure movie, and the moment you are finished, you go back to your favorite scene and start playing in it. Perhaps these will be called ‘‘moviegames’’. Furthermore, news and debates on television may morph into video conferences, and thousands or millions of such special interest programs take market share from large, standard TV packages. For instance, there may be 20,000 premium subscribers to a television channel; and the users will be able to ‘‘be there’’ and join in during question rounds, just as in any other video conference. ‘‘TV conferences’’ may be a good term. If we assume for a moment that Moore’s Law remains valid until 2020, single-chip computers will then handle approx.4 million MIPS, or 4‘‘TIPS’’, for ‘‘trillion instructions per second’’. Since the human brain is assumed to have approximately 100 TIPS, we shall have reached approx. 4% of brain capacity by 2020. We shall also have surpassed Feynman’s vision of 24 million books in a tiny grain. However, if the doubling every 24 months continues after that, chips will reach human capacity just after 2030. However, 2030 is not the time where the biggest computers will surpass the human brain. That will actually happen around 2020. How is that? If we go back to 1997, an IBM computer called Deep Blue won a chess game against the ruling champion Gary Kasparov. Deep Blue had a capacity of approximately 3,000,000 MIPS (or 3TIPS), since it had 256 state-of-the-art chips, which enabled it to make 200 chess move simulations per second. This means that Kasparov was beaten in chess by a computer that only had 3% of his own data capacity, but that was possible because Deep Blue did nothing else than play chess. The computer was simply capable of calculating all possible moves and countermoves 14 steps ahead. This was enough to overwhelm the grandmaster, and the result was so impressive that he suspected the computer was being fed personally by another grandmaster. In fact, he said that he sometimes saw deep personality in Deep Blue’s behavior—something original, creative, and brilliant. Simple functions may create complex and elegant outcomes. However, the point here is that Deep Blue was massively powerful for its time because it combined the power of 256 chips. Such multichip/ multicore computers will be on par with humans by 2020, if not considerably more powerful. Such technologies are in fact already par for the course; also for PCs. If one chip annum 2020 does 4 TIPS and the human brain does 100, you might need to put 25 chips into the computer to match a brain. OK, more chips or cores cooperating with their combined horsepower is generally not as efficient as a single one, but multi-chip computers can nevertheless be extremely powerful. But if the combination of many chips doesn’t fully add up efficiently, you put in more. As I mentioned, Deep Blue had 256 chips. One way or the other, we are closing in on the brain. ...chapter continues
The Great Reflation
The Great Reflation How Investors Can Profit From the New World of Money Anthony Boeckh
978-0-470-53877-7 • Hardback • 336 pages April 2010 • £23.99 / €28.00 / $34.95
Chapter 5 Money and the Great Reflation Inflation is always and everywhere a monetary phenomenon. —Milton Friedman and Anna Schwartz 1 Investors are understandably concerned that the Great Reflation will turn into the Great Inflation. In this chapter, we look at some of the issues relating to those fears. In previous chapters we pointed out why inflation is the single most important factor affecting investments. We also emphasized that inflation should be understood as an increase in money and credit beyond the growth requirements of the economy. In the previous chapter, we explained how the implosion of the 25 - year private debt binge is creating a government debt supercycle of its own. The explosion of government debt is one component of the Great Reflation. The other is money printing and near - zero interest rates. The Federal Reserve is the institution behind the monetary component, and it will play the starring role in whether we have another inflationary drama. The Great Reflation experiment is pushing an avalanche of new money into the economy and financial system. This new money must find a home somewhere. By the end of 2009, the government had succeeded in its initial purpose of stabilizing the financial system, reflating asset prices, and generating economic recovery, albeit a hesitant and artificial one. However, being an experiment, the ultimate outcome of the total reflation package is far from certain. That is a reality that all investors must continuously keep in mind as they struggle to understand how the future will unfold. The Great Reflation has ensured that the 100 - year - old Age of Inflation remains intact. Possible outcomes are further declines in the purchasing power of the dollar, another mania in asset prices, or some combination of both. But eventually, all inflations result in deflations.
Central Banks and Inflation The central bank is at the core of the modern inflationary process through its creation of excess money and credit. Historically, before World War II, central banks were independent and frequently privately owned; and, before the
eighteenth century, very few countries had them. Paper money that circulated was substantially backed by specie—gold and/or silver. Therefore, inflation was not easily created by governments, even though they frequently had a desperate need for money. There were two main causes of inflation before central banks. The more frequent was the clipping (shaving the edges) of coins by monarchs to pay their bills when they could not squeeze more taxes out of their people. An inflow of new gold and silver was the other main cause of inflation, as we discussed in Chapter 1. There have been some paper money inflations in countries without central banks, but they have been rare. Probably the most famous was the assignat inflation in France associated with the French Revolution. 2 The assignats were originally bonds, later currency, issued by the National Assembly after the French Revolution, and were backed by confiscated church properties. There were no brakes on the issuance of notes (a theme running through this book), which were increased to the point where they had no value (i.e., hyperinflation). The Bank of France was created in 1800 to bring monetary stability and to introduce the new French franc in 1803. Inflations in the nineteenth century up to 1914 were temporary and episodic, almost always related to war. Since then, inflation has become chronic; periods of stability have been temporary. There is one overriding reason why we have had this experience since 1914. The monetary system is based on fiat paper money, which we described in Chapter 1 . It is money that has no backing other than promises made by the issuer, usually a central bank. Therefore, we must look to central banks for an understanding of the modern inflationary process. They are the heart of the financial system with the monopoly power to print money if they so desire.
The Challenges of Central Banks It is not easy being a central bank. They face many challenges that are as old as central banking itself. Two hundred years of history suggest clearly that central banks have had mixed success, at best, in meeting these challenges. The primary ones are maintaining the stability of the purchasing power of the money they issue and maintaining the financial system on an even keel. Horrendous mistakes have been all too frequent; money has not retained its value and the financial system has experienced frequent crises of great magnitude. What periods of stability there have been may have had more to do with luck than skill. Because of this sorry track record and the fascination with financial crises, there have been thousands of books and learned papers written on money, central banks, and the challenges they face. One of the earliest and most important of these was the Bullion Committee Report 3 of 1810 that resulted from an inquiry into why the pound sterling had fallen on the exchanges, and why the gold price and inflation had gone up during the earlier part of the Napoleonic Wars. The report was one of the early attempts to understand the issues surrounding inflation, the definition of money, and the role of the central bank. That and the great volume of other literature on the subject is testimony to the great challenges
The Great Reflation
that central bankers have faced over the centuries. The following summarizes seven of these because they relate particularly to the challenges the Federal Reserve faces in the aftermath of the Great Reflation and the implications if the Fed fails to meet these challenges. 1. Money does not look after itself. It has a long and varied history of running to excess or deficiency. 2. Money defies accurate definition. Financial innovation and technology continually create new instruments with money - like properties, and the central bank always has trouble knowing what to control, and how much is too much or too little. 3. T he time lag between a central bank’s action and its impact is long and variable. 4. C entral banks are frequently conflicted in objectives. For example, the necessary action of supplying lender of last resort liquidity in a crisis may exacerbate inflation and moral hazard (the increasing tolerance for risk) later. 5. C entral bankers often disagree among themselves on what they should be targeting. The choices are: money supply, interest rates, price inflation, asset inflation, credit, or the foreign exchange value of their currency. 6. O ne of the greatest challenges for central banks is knowing to whom they are ultimately responsible and knowing clearly what their ultimate objectives are. These are muddy issues even in the best of times. Most would argue that the central bank is, in the final analysis, responsible to the government; but that is a tricky one, particularly in the United States where the executive branch of government is separate from the Congress. Both the president and Congress derive their power from being elected by the people. The Federal Reserve chairman is not elected. He is appointed by the president but must report to Congress, a murky situation. Short - term political objectives can frequently trump long - term stability objectives, and the Federal Reserve is caught in the middle. It is clearly responsible for the long - term purchasing power of the currency, but, in the short term, it does not have a mandate to defy elected politicians. They are responsible to the people who all too frequently clamor for easy money and low interest rates. Regulation of financial institutions and markets is only partly in the hands of the Federal Reserve. Many other regulatory authorities are also involved. Frequently they have views different from the Federal Reserve, and conflict results. 7. The responsibility for the dollar’ s international role belongs to the U.S. Treasury, which is always going to be more politically oriented than the Fed. The key currency role of the dollar in foreign central bank reserves is critical for international monetary stability and U.S. inflation. The potential for conflict is obvious. The Fed will always have at least one eye on the stability of the dollar and general prices, while the Treasury will always have at least one eye on politics, unemployment, and the next election.
The history of central banking shows clearly, as we have just summarized, the great difficulty that those in charge have in fulfilling their mandate of fostering a stable economy, currency, and price level. Central bankers, with full access to the reams of literature and research over the past two centuries, have still managed to make a mess of things on a pretty regular basis. Take the Federal Reserve, for example. It is managed by highly intelligent, academically solid, experienced, dedicated, well - meaning people. However, they are nonetheless just humans, and humans can make huge mistakes. Unfortunately, there have been many since the Federal Reserve was set up in 1913. As pointed out in Chapter 1 , the purchasing power of the dollar has fallen by 95 percent since then, indicating that the Federal Reserve, on balance, has preferred to listen all too often to its political masters rather than risk the consequences of a single - minded focus on stable money. There have been great economic booms and busts over the Fed ’ s centurylong history. The experience includes repeated asset inflations and deflations and enormous volatility in the foreign exchange value of the dollar. Any way you cut it, it ’ s not a great scorecard for generating the sort of confidence investors need to see as the Federal Reserve enters into perhaps its biggest challenge of all— managing the Great Reflation—in the aftermath of the biggest credit bust and banking collapse since the 1930s. The Fed, in contrast to its performance from 1929 to 1932, did achieve a timely rescue of a collapsing financial system. It showed great financial leadership in fulfilling its classic role of lender of last resort at a time when there was a political vacuum in Washington. However, the reflation story is far from over. The Federal Reserve in the years ahead will be faced with an activist, interventionist, populist government that will stand or fall on getting the United States out of its economically depressed, high - unemployment quagmire. The age - old conflict between short - term political objectives and long - term stable money objectives will be a constant feature of life until full recovery is secured, balance sheets are rebuilt, and the government fiscal house is put in credible order. And that is not going to happen anytime soon.
Mechanics and Operations of Central Banks The mechanics and operations of central banks are for technicians, and we needn’t spend much time on them. The interesting things are what happens in the real world of decision making and the consequences of those decisions. Central banks, formerly called banks of issue, have two main technical functions: the issuance of paper money, for which they have a monopoly, and the depository for commercial banks to hold their reserves. The overwhelming majority of the central banks ’ assets are held in government bonds and Treasury bills. The Fed can hold foreign exchange, but, in practice, amounts are small. The liabilities of the Fed are notes in circulation and deposits, the latter being an asset of commercial banks that make up the bulk of their reserves. Various securities and loans make up most of the rest of commercial bank assets. Their liabilities are mainly deposits, made up of different types—demand, savings, and certificates of deposit (CDs). Capital is the difference
The Great Reflation
between the assets and liabilities of the commercial banks. One hopes that it is positive and by a large enough margin so that depositors are confident, not just that the bank is solvent, but that it has sufficient liquidity to honor, beyond question, demands for deposit withdrawal. Hard bank capital is composed of issued common and preferred stock, and retained earnings. The control mechanism, in very simplified form, works as follows. Let ’ s assume that the Federal Reserve wants to increase the money supply by 5 percent. In the short run, currency in circulation is fixed, so the Federal Reserve focuses on increasing its liabilities (reserves) to commercial banks. It can do this only by increasing its assets. Typically, it would buy Treasury bills in sufficient quantity to increase commercial bank reserves by 5 percent. After the first - round effect, commercial banks would find that they have excess reserves earning nothing, so they would put this money to work either buying securities or making loans. They would write checks on themselves to buy securities or, when they make a loan, credit the depositor’ s bank account. Money starts to move around the banking system as each bank adjusts its assets and liabilities to the increased reserves it holds. When all the activity is completed, the great mystery of paper money creation has done its magic. Excess reserves no longer exist because commercial banks, in their profit - maximizing mode, have done their job. Bank deposits, alias money supply, have increased by 5 percent, and the reserve ratio is once again equal to what it was before. Bank reserves and other bank assets have risen together by 5 percent, just managing to equal the increase in commercial bank liabilities (money supply). As banks ’ earning assets have increased, they would acquire the additional profits to add to their capital base to meet the increased need as a result of their increased liabilities. This example applies to a healthy financial system. In a balance sheet recession, the money - creation process breaks down because either the banks don’ t want to lend new reserves or borrowers want to repay loans, not borrow more. This is financial constipation, and the government must short circuit the breakdown by doing the borrowing through increased deficits to keep money circulating and growing. Financial constipation occurred after the crash in 2009. The Federal Reserve, remembering the lessons of 1929, flooded the banking system with reserves by doubling the size of its assets. As we pointed out, when the Fed adds to its assets, it also must add to its liabilities and these become additional reserves of the commercial banks. These reserves are the base for monetary expansion. It increases the base on which the banks can make more loans and expand the money supply. Figure 5.1 shows how the Fed ’ s extreme efforts at monetary ease through asset purchases caused the monetary base to double in a matter of months. This has given rise to fears of accelerating inflation. However, the commercial banks simply held the excess reserves at the Fed rather than putting them to work. The result was that the money multiplier—the ratio between bank reserves and the broad measure of U.S. money supply (M2) — collapsed, almost completely neutralizing the potential inflationary impact of the Fed ’ s action, at least for the time being. This is shown in Figure 5.2 . The collapse in the multiplier is also true of other measures of money.
When the financial system moves out of the convalescent ward and people want to borrow money again, the banks will want to put their excess reserves to work. The money multiplier would then reverse, and the money supply would start to grow again. Then fears of accelerating inflation would become more realistic. When this might happen is difficult to gauge, and investors will have to pay close attention to these relationships. The reason is that the Fed ’ s long - discussed exit plan from the massive monetary ease will have to be executed at some point. The Fed will have to tighten policy, shrink its balance sheet, reduce bank reserves, and raise interest rates at a time when the economy may still be vulnerable and fragile. Such are the difficult decisions central bankers will soon be forced to make, and they spill over to investors and the decisions they, in turn, have to make.
Figure 5.2 Money Multiplier Note: M2 divided monetary base. Source: Chart courtesy of BCA Research Inc.
Another control mechanism over commercial banks is the requirement that capital be maintained at a certain percentage of bank assets. The purpose is mainly to provide a cushion against inevitable losses on loans or securities. If a bank wants to grow its assets (as in the preceding example), or if it faces losses greater than predicted that would eat into its cushion, it must acquire more capital, either out of profits or by the sale of eligible securities. ...chapter continues
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Dear Mr. Buffett
Dear Mr. Buffett What An Investor Learns 1,269 Miles From Wall Street Janet Tavakoli
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Chapter 1 An Unanswered Invitation Be sure to stop by if you are ever in Omaha and want to talk credit derivatives . . . —Warren Buffett in a letter to Janet Tavakoli, June 6, 2005 It was August 1, 2005, and I was rereading a letter in my correspondence file dated June 6, 2005. The letter was from Warren Buffett, the CEO of the gargantuan Berkshire Hathaway conglomerate. I had not yet responded and had no explanation for the delay save for a little awe. For the several years prior, Fortune listed Warren Buffett as either the richest or second richest man on the planet. He and Bill Gates annually jousted for the top spot, with the outcome depending on the relative share prices of Berkshire Hathaway and Microsoft. Several years earlier, I had sent Warren Buffett a copy of my book, Credit Derivatives & Synthetic Structures. In his letter Buffett wrote that he had been looking at the book again and had just found a letter I had tucked between the pages,“ Please accept my apologies,” he continued, “for not replying to you when I first received it.” He invited me to stop by if I were ever in Omaha. I looked up. After all this time, I could not remember what I had written in that old letter. I did know that I had not expected a response. But certainly now a response was needed from me, a belated one.“Dear Mr. Buffett,” I began. I am an investor in Berkshire Hathaway “A” shares, but Mr. Buffett would have no way of knowing that since I hold shares in brokerage accounts. Perhaps Mr. Buffett had a bone to pick with me, but I had warned about the risk of credit derivatives and the hidden leverage they created. I was so persistent in exposing the flaws in the financial system that Business Week called me the “Cassandra of credit derivatives.”2 But most journalists overlooked a much more important derivatives quote in Mr. Buffett’s 2002 shareholder letter. Berkshire Hathaway invests in multinational businesses with a variety of complex operations, and that means that investments have to be hedged or entered into in ways that create tax or accounting advantages. Mr. Buffett had also written:“ I sometimes engage in large - scale derivatives transactions.” Yet I dithered and had not responded to his letter. In 1998, Berkshire Hathaway acquired General Reinsurance. Warren Buffett initially called it his “problem child,”4 and its General Reinsurance (Gen Re) Securities
unit was its problem sibling. Even before the acquisition, both Warren Buffett and Berkshire Hathaway vice - chairman Charlie Munger realized that the value of Gen Re Securities derivatives transactions was overstated and vainly tried to sell it. Some of the contracts were for 20 - year maturities, and the operation would take years to wind down. Furthermore, the models valuing the derivatives give poor approximations of the true mark - to - market value — the price at which the derivative can be bought and sold in the market — of some of Gen Re Securities’esoteric derivatives contracts. There was no real market. Instead, the derivatives contracts were priced or marked based on model valuations known as mark to model. Buffett wrote that in extreme cases, it was a “mark to myth.”5 In his 2002 letter to Berkshire Hathaway shareholders, Buffett wrote that it sometimes seemed “madmen” 6 imagined new derivatives contracts. His pique was prompted by the multiyear-long hangover of losses from derivatives, chiefly credit derivatives, in the GenRe Securities unit. It showed a loss of $ 173 million, partly due to restating faulty, but standard, derivatives accounting from earlier years. The loss inspired Buffett to call derivatives “financial weapons of mass destruction.” 7 His viral sound bite quickly circled the globe.After reading Buffett’s quote in the financial press, one investment banker joked that my book on credit derivatives is “the manual on how to blow up the world.” Warren Buffett’s letter to me arrived in June 2005, a hectic month. One of my clients was a law firm representing a large money center bank as plaintiff in a securities fraud case involving another large money center bank. The defendants’ lawyers had hired a former chairman of the U.S. Securities and Exchange Commission (SEC) as their expert witness. Earlier, I had written both my expert opinion report and a report rebutting the former SEC chairman’s point of view. I prepared to give a two - day-long deposition to discuss my opinion in the case in which hundreds of millions of dollars had been lost.The defendants had read my work, knew they faced serious trouble, and subsequently changed their strategy. In fact, they sent their most experienced litigator to depose me. I put Buffett’s letter in my purse to remind myself to respond to it.The morning of the deposition’s first day, I saw the letter and felt a glow of confidence. I am not a superstitious person, but I couldn’t help thinking of the letter as an auspicious sign. I put it in my pending correspondence fi le and forgot about it again. The deposition came and went, and the plaintiff’ s lawyers were delighted.“ Everyone gets bloody in a battle, but you slaughtered them.” The defendants’ arguments fell apart in the face of the facts, and the case never went to trial. Shortly thereafter, the defendants came to a settlement agreement to the plaintiff’ s satisfaction. At the end of June, I reviewed my correspondence file and read the letter again. Client business would not take me to Omaha, and I was fairly certain Warren Buffett did not need my help. July 2005 was another busy month: I had focused so much on the securities fraud case that I had a backlog of business, so I took a much-needed week - long vacation to decompress.At the end of July, I reviewed my pending correspondence file, and it contained only one item: the letter. After rereading the letter on August 1, I wrote a letter in reply and offered three
Dear Mr. Buffett
dates, with August 25, five days before Warren Buffett’s 75th birthday, being the earliest of the three: It is my turn to apologize for being so late getting back to you . . . . . Business isn’t taking me in that direction anytime soon, but I would be happy to fly in for the day — just because I would enjoy doing it . . . On August 3, I received an e-mail from Warren Buffett through his assistant stating that August 25 would work: If you can make it for lunch, I would be glad to take you to a place with no décor but good food. Everyone in the global financial community knew Warren Buffett by reputation, and his name continually popped up in the fi nancial press, but I operated in specialty niches of the industry, and he was just part of the background noise of my world. I hadn’t read any of the books about him, and I hadn’t read the many articles about Warren Buffett, the man. But I had read many of Berkshire Hathaway’ s annual reports including Mr. Buffett’s shareholder letters, which I enjoyed very much. Warren Buffett was already a billionaire at age 60.That in itself was an achievement beyond the reach of all but a miniscule percentage of humans, but his future success dwarfed that accomplishment. Due to the benefits of continued compounded growth off of a greater base of wealth, the bulk of Buffett’s wealth accumulated after the age when most men retire to spend their money. Throughout my career, I worked with people who eventually met or did business with Warren Buffett. It was as if we attended the same university and he were a popular senior and I a freshman. I was well respected in my field, and was a self made woman; but Warren Buffett was a financial legend superlatively good at making money for himself and for his shareholders. In 1987,Warren Buffett and Charlie Munger rode to the rescue of John Gutfreund, the CEO of Salomon Brothers.Their “white knight” investment of $ 700 million of Salomon Inc.’ s convertible preferred stock enabled Gutfreund to fend off Ronald Perelman’s hostile takeover. Perelman, a famous, colorful cigar - loving corporate raider with a reputation for ruthlessness, had already swallowed up Revlon, Sunbeam, Panasonic and other companies in the 1980s. In contrast, Buffett and Munger were not well known, and their lifestyles didn’t provide salacious material for the media frenzy that surrounded corporate raiders. Initially, Salomon’s preferred stock was an ideal Berkshire Hathaway investment. Buffett never supplied management; he looked for good honest managers, and he thought he had found one in Gutfreund. Things changed in 1991. Paul Mozer, a trader on the Arbitrage Desk, pleaded guilty to felony charges after a government bond trading scandal. John Meriwether, the head of Salomon’s Arbitrage trading desk, told Gutfreund that Mozer had confessed to him. Their failure to immediately come forward compounded the scandal, and neither of them survived the fallout. Buffett was compelled to protect Berkshire Hathaway’ s investment. In the summer of 1991, he became Salomon’s reluctant CEO for 10 months. Mr. Buffett’s leadership and reputation for integrity salvaged Salomon’s business, which rapidly recovered. The convertible bonds outperformed the fixed income securities that Berkshire Hathaway had sold in their place, but by 1995, the option to convert to common shares of Salomon stock was worthless. In 1997, Buffett off loaded the investment on Sandy
Weil, and Salomon eventually became a part of Citigroup. I had joined Salomon Brothers’ summer 1985 training class lampooned by my classmate Michael Lewis in his book, Liar’s Poker. Unlike Lewis, I was one of the trainees actually paying attention at the front of the class, but by the time Mr. Buffett served his brief time as CEO, I was no longer working at Salomon Brothers. After almost 20 years working for Wall Street firms in New York and London, I made my living running a Chicago - based consulting business. My clients consider my expertise the product they consume. I had written books on credit derivatives and complex structured fi nance products, and financial institutions, hedge funds, and sophisticated investors came to me to identify and solve potential problems. Although I was an experienced finance professional, I did not focus on value investing.The University of Chicago was steeped in the myth of efficient markets and leaned to theories put forth by eminent economists. Warren Buffett had earned his MBA at Columbia Business School. He became a friend and disciple of Benjamin Graham, and later worked for Graham’s hedge fund. I had read Security Analysis by Graham and David Dodd in 1985, but I had not actively practiced its principles for my own investment portfolio. Around the same time, I read John Burr Williams’The Theory of Investment Value, and the fourth edition of The Intelligent Investor. My edition includes an introduction by Warren Buffett with a tribute to the late Benjamin Graham as well as Warren Buffett’s 1984 commencement address at Columbia University titled “The Superinvestors of Graham - and - Doddsville.” I remembered both the tribute and the address and reread them in preparation for meeting Mr. Buffett. My focus was chiefly on derivatives and complex securities. While I applied many of the principles of value investing to my analysis of complicated financial products, I did not yet focus on it for my own investments or as a way of looking at the global markets as a whole. Derivatives are financial bets that something will or will not happen. Any financial investment involves a bet, but derivatives are leveraged bets. For very little money down — sometimes no money down — you can make gobs of money (or lose gobs of money). The part about losing gobs of money is something most investors try hard not to think about. Sometimes investment banks selling the products help investors achieve this goal by putting the part about gobs of losses in very fine print buried in hundreds of pages of documents. Leveraged bets are so popular that there is more money at risk in derivatives than in stocks or bonds.The problem with leverage-driven binge banking is that everyone tends to disgorge assets at the same time, depressing market prices. Financial leverage sometimes moves global markets, and if allowed to get out of hand, leverage can theoretically trigger a global market Chernobyl. Warren Buffett disproved the theory of efficient markets that states that prices reflect all known information. His shareholder letters, readily available through Berkshire Hathaway’ s Web site, told investors everything they needed to know about mortgage loan fraud, mispriced credit derivatives, and overpriced securitizations, yet this information hid in plain “site.” I knew the financial markets were at great risk — like children playing with matches in a parched forest — but those thoughts were far from my mind on that hot summer morning in 2005 as I boarded the plane for Omaha. I was about to meet a financial legend, the greatest investor who ever lived.
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