Friday, June 22, 2012

Reflections on The Ascent of Money, Part 1

The Ascent of Money: A Financial History of the World    

I finished reading Niall Ferguson's book (which I started after reading Michael Lewis' The Big Short) while traveling this weekend and there are a few connections that I made that I thought were worthy of note. Mind you that this book was written in 2009 during the beginning of the financial crisis and covers the history of finance, which was deeply shaped by innovations and crises caused by those innovations.

Despite the crises, it becomes pretty clear that financial innovation, when properly regulated,  has caused a tremendous growth in wealth over the last several centuries. Why did Britain and the Netherlands create long-term wealth in the 1600s when the Spanish did not? The Spanish brought in literally tons of gold and silver from the new world, but because it was not properly managed by a Central Bank - the value behind the money was simply inflated away. On the other hand, Britain and Netherlands built trading empires built upon more modern finance and consistent accounting.

The importance of the latter could not be stressed enough. The Gold Standard brought countries closer together because openly floating currencies were too difficult to manage in the 1800s, when it still took months to cross the Atlantic. The Gold Standard allowed a way for traders to consistent know what pieces of paper were worth despite not being in contact with their motherlands for weeks at a time. Likewise, consistent accounting standards allowed countries to know what companies were worth and therefore the market could properly value these pieces of paper.

This is crucial point when talking about modern finance, because banks naturally have the desire (profit) to write complex contracts that make it difficult to understand the underlying meaning and value. Some banks made a killing in the OTC derivative market when selling products to their counter-parties that they could not possibly understand what they were buying. The buyers (and almost everyone else for that matter) trusted the rating agencies that the products were safe, but the rating agencies did not do their homework to properly evaluate risk in the portfolios of mortgage-backed securities. More than anything else, no one understood how financially correlated these products were to one another. So when one went bad, they all went bad.

This brings us to the history of Long Term Capital Management (LCTM). A firm founded by John Meriwhether - former head trader at Salomon Brothers - and a couple of Nobel Prize winner economists out of Harvard that thought they had beat risk. Through computer models, they could evaluate risk much better than everyone else on a micro and macro scale. They bought up an incredibly diverse portfolio of physical and financial assets; anything and everything from Thai commercial fishing boats to South American pipelines. The correlation of all these assets was essentially zero. They became so wildly successful that imitators started popping up left and right, doing the exact same thing that they were and buying up all sorts of strange assets as well. Then something went wrong. Terribly, terribly wrong. Despite a surging global economy (with some minor hiccups), all of their assets went bad at once. How could this be? Their assets had statistically zero correlation. Except something had changed. Their imitators bought the same assets as they did and as they started to make mistakes and fold, it lead to a domino effect to all with similar holdings. In other words, LCTM became the correlation. Wall Street meet unintended consequences. Unintended Consequences, Wall Street.

These two would become much more familiar with each other in the financial crisis of the late 2000s.

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