Tuesday, June 01, 2004
Wall Street Tell-Alls
I recently finished reading a string of interesting, and somewhat related books about the financial industry. The first is Liar's Poker, by Michael Lewis. The book is basically the story of his four years at Salomon Brothers in the mid-80s. It's pretty fascinating, and very readable, though I wouldn't go so far as to describe it as hilarious, as I've seen others do. It will probably surprise you with what Wall Street can actually be like, and that certainly makes it amusing, though. What I really liked about it was his detailed description of the evolution of mortgage bonds, and how they work. He takes several chapters in the first half of the book to describe this, and it's a pretty good history lesson. He's got a few other detailed passages, but the rest of it is glossed over (understandably so). That section interrupts the story of how he got hired there (he met a managing director's wife at a party, and she decided her husband would hire him), the bizarre training program, what it was like starting out as a bond salesman (they start you off with small accounts, you know, less than $100 million, and leading a few to their deaths before you figure things out is par for the course), and his front-row seat to the crash of 1987 and the spectacular crash and burn of the company.
Monkey Business is a much raunchier look at the investment banking industry by John Rolfe and Peter Troob (who also write from personal experience), and it could probably surprise you even more. From a pure shock/humor/slander standpoint, it's much more entertaining. You wouldn't believe the anecdotes in this book, and really, maybe you shouldn't. But there's something about the casualness with which the authors describe incidents they were personally involved in, like the time when Rolfe got drunk at the company holiday party and decided to piss into a beer bottle under a table which he and his bosses were sitting at, that makes you wonder. Maybe investment bankers really are a bunch of sailors in suits (the authors themselves seem to have picked up the incredibly gross language and lack of shame they describe in their peers). There isn't a lot of economics or finance in this book, though I suppose that's largely due to the fact that there isn't much of that in investment banking itself, according to the book. It's also a sort of inspiring book to read because it paints a very detailed picture of just how crappy life can be even if you are making obscene amounts of money (there's a reason they pay you that much). It leaves you going, "Man, I'm glad I'm not doing their job."
However, better yet is the other book I read recently, When Genius Failed, by Roger Lowenstein. In some sense, this is a continuation of Liar's Poker, which ends at the end of the 80s with the end of Salomon Brothers. When Genius Failed is about the huge hedge fund created by John Meriwether, the head of the arbitrage department at Salomon Brothers during the period of time Liar's Poker takes place. In fact, he's mentioned throughout Liar's Poker. Meriwether ended up leaving Salomon Brothers, and taking almost the entire group of finance PhDs that made up its highly profitable arbitrage department with him.
They created a company called Long-Term Capital Management, which was essentially their way to continue the highly profitable arbitrage work they did at Salomon Brothers. Arbitrage is a way to make money by exploiting mispricings in markets. For example, where I work, there are two vending machines in different areas of the basement level. One sells my beloved Fig Newtons for $.60, while the other sells them for $.70. An enterprising arbitrageur could take advantage of this by buying all of the Fig Newtons for $.60, and then standing around in front of the other vending machine and offering them for $.70 or less. The difference would be his profit.
As you can see, this only lets you make pennies at a time, since the necessary discrepancies tend to be very small. However, at Salomon Brothers, Meriwether and his group had the tremendous amount of money Salomon put at their disposal to multiply this by. So by going into transactions millions or billions of dollars at a time, they could make great returns, without doing anything other than exploiting what is essentially a mistake everyone else is making. This would be equivalent to doing the vending machine thing with millions of Fig Newtons in order to make those nickels into millions of dollars. Without Salomon, Long-Term needed another swimming pool of money to make arbitrage profitable for them. So they went around and got billions of dollars invested into the fund, which they then leveraged into over a hundred billion dollars to make all their trades. Obviously, this degree of leverage is incredibly risky. By the time the firm spectacularly collapsed in 1998, it had over a trillion dollars in derivatives obligations (If you're having a problem picturing what a huge exposure that is, the federal budget in the US is around $2 trillion a year, the GDP of the United States is around $10 trillion a year, and world GDP is around $40 trillion). The Fed feared a systemic collapse of financial markets and managed to broker a private bailout, but the principles left with almost nothing.
I found this book much more interesting than Liar's Poker. The one big problem with it is that it sometimes doesn't do a very good job of explaining many of the financial concepts necessary to understand it all, which can result in the book sounding like a lot of gibberish for pages at a time if you're not familiar with the terminology. The author also writes from a very skeptical standpoint about arbitrage and derivatives, using the collapse of Long-Term as an example of how it's all a big house of cards, and these instruments need to be highly regulated, and so on. I don't know that he's wrong, but I don't think Long-Term's demise proves his point. He himself points out that Long-Term's biggest losses were due to tremendous, unhedged directional bets that turned out to be wrong, way more than any problems with their financial models (though those problems were substantial). The bigger problem was that the principles of the firm, smart as they are, were too confident in their intelligence and seemed to think they could do no wrong, taking risks that everyone else (including the two Nobel Prize winners in their partnership) thought were foolish. So the book is also incredibly satisfying, as you see these guys tumble terribly due almost entirely to their own arrogance.
Monkey Business is a much raunchier look at the investment banking industry by John Rolfe and Peter Troob (who also write from personal experience), and it could probably surprise you even more. From a pure shock/humor/slander standpoint, it's much more entertaining. You wouldn't believe the anecdotes in this book, and really, maybe you shouldn't. But there's something about the casualness with which the authors describe incidents they were personally involved in, like the time when Rolfe got drunk at the company holiday party and decided to piss into a beer bottle under a table which he and his bosses were sitting at, that makes you wonder. Maybe investment bankers really are a bunch of sailors in suits (the authors themselves seem to have picked up the incredibly gross language and lack of shame they describe in their peers). There isn't a lot of economics or finance in this book, though I suppose that's largely due to the fact that there isn't much of that in investment banking itself, according to the book. It's also a sort of inspiring book to read because it paints a very detailed picture of just how crappy life can be even if you are making obscene amounts of money (there's a reason they pay you that much). It leaves you going, "Man, I'm glad I'm not doing their job."
However, better yet is the other book I read recently, When Genius Failed, by Roger Lowenstein. In some sense, this is a continuation of Liar's Poker, which ends at the end of the 80s with the end of Salomon Brothers. When Genius Failed is about the huge hedge fund created by John Meriwether, the head of the arbitrage department at Salomon Brothers during the period of time Liar's Poker takes place. In fact, he's mentioned throughout Liar's Poker. Meriwether ended up leaving Salomon Brothers, and taking almost the entire group of finance PhDs that made up its highly profitable arbitrage department with him.
They created a company called Long-Term Capital Management, which was essentially their way to continue the highly profitable arbitrage work they did at Salomon Brothers. Arbitrage is a way to make money by exploiting mispricings in markets. For example, where I work, there are two vending machines in different areas of the basement level. One sells my beloved Fig Newtons for $.60, while the other sells them for $.70. An enterprising arbitrageur could take advantage of this by buying all of the Fig Newtons for $.60, and then standing around in front of the other vending machine and offering them for $.70 or less. The difference would be his profit.
As you can see, this only lets you make pennies at a time, since the necessary discrepancies tend to be very small. However, at Salomon Brothers, Meriwether and his group had the tremendous amount of money Salomon put at their disposal to multiply this by. So by going into transactions millions or billions of dollars at a time, they could make great returns, without doing anything other than exploiting what is essentially a mistake everyone else is making. This would be equivalent to doing the vending machine thing with millions of Fig Newtons in order to make those nickels into millions of dollars. Without Salomon, Long-Term needed another swimming pool of money to make arbitrage profitable for them. So they went around and got billions of dollars invested into the fund, which they then leveraged into over a hundred billion dollars to make all their trades. Obviously, this degree of leverage is incredibly risky. By the time the firm spectacularly collapsed in 1998, it had over a trillion dollars in derivatives obligations (If you're having a problem picturing what a huge exposure that is, the federal budget in the US is around $2 trillion a year, the GDP of the United States is around $10 trillion a year, and world GDP is around $40 trillion). The Fed feared a systemic collapse of financial markets and managed to broker a private bailout, but the principles left with almost nothing.
I found this book much more interesting than Liar's Poker. The one big problem with it is that it sometimes doesn't do a very good job of explaining many of the financial concepts necessary to understand it all, which can result in the book sounding like a lot of gibberish for pages at a time if you're not familiar with the terminology. The author also writes from a very skeptical standpoint about arbitrage and derivatives, using the collapse of Long-Term as an example of how it's all a big house of cards, and these instruments need to be highly regulated, and so on. I don't know that he's wrong, but I don't think Long-Term's demise proves his point. He himself points out that Long-Term's biggest losses were due to tremendous, unhedged directional bets that turned out to be wrong, way more than any problems with their financial models (though those problems were substantial). The bigger problem was that the principles of the firm, smart as they are, were too confident in their intelligence and seemed to think they could do no wrong, taking risks that everyone else (including the two Nobel Prize winners in their partnership) thought were foolish. So the book is also incredibly satisfying, as you see these guys tumble terribly due almost entirely to their own arrogance.
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