Invisible Dangers Leave You Visibly Shocked

We know electricity is dangerous. We know we should treat electricity with the utmost of caution. But each year, people are still killed or injured.

According to an Australian Institute of Health and Welfare report dated 30 November 2018:

A total of 1,065 people hospitalised between 1 July 2014 and 30 June 2016 had sustained an electrical injury, and 55 people died as a result of electrocution or lightning strike.

Workplace and household safety measures have improved considerably over the past 40 years, yet, accidents still occur.

Why?

The danger is invisible…and when it makes its presence known…it’s too late.

The same is true of investing.

The power surges in markets

Every second of every day, live currents (money flows) are powering up markets…currencies, derivatives, shares, property, bonds, cryptos, commodities (agricultural, mineral, and livestock), private equity, venture capital.

And within these markets, there are offshoots of other markets. In the bond market there are government bonds, corporate bonds, and junk bonds. There are small-, mid-, and large-cap stocks. Commercial, residential, industrial, and rural property markets.

In addition to the primary market, there is a myriad of structured products — designed primarily by the investment industry for fee generation purposes — that are manufactured to access a variety of ‘opportunities’.

Then there’s the interconnectivity of cables between markets — interest rates to property values to share prices to currency fluctuations to bullion price.

If someone could draw a flow chart of the power lines that exist within and between markets, it would look like a giant bowl of spaghetti.

There are times when the voltage (money) flowing through certain markets — cryptos, subprime debt, tech stocks, corporate debt, margin lending, et al. — is sufficient to power a major city.

The crimson glow coming from the cables powering these ‘hot’ markets should serve as a warning…but somehow, the danger remains invisible…even to the trained eye.

A reminder of what Fed Chair Bernanke said in May 2007:

We believe the effect of the troubles in the subprime sector on the broader housing market will be limited and we do not expect significant spillovers from the subprime market to the rest of the economy or to the financial system.

The person charged with the smooth operation of the world’s economic generator had absolutely no idea the subprime power cable was connected to the financial and economic grid.

If Bernanke didn’t see it, what hope did the average home handyman (investor) have?

Bernanke had no excuse for not knowing. These red-hot power surges aren’t without precedent.

In the 1990s, a firm called Long-Term Capital Management (LTCM) was founded by highly-trained and well-qualified ‘sparkies’ — John Meriwether (former head of fixed interest trading at Salomon Brothers) and two Nobel Prize-winning economists, Myron Scholes and Robert Merton.

The LTCM founders all came to the table with extensive experience in derivatives investment…they knew how to outperform the market.

And they delivered on that promise.

In 1995, LTCM returned 42.8% and backed this up with 40.8% in 1996.

These returns were achieved AFTER LTCM trousered 27% in fees.

There’s nothing quite like stellar past performance to amp up the voltage flow…money poured into LTCM.

According to a report compiled by Berkeley University (emphasis added):

Some of LTCM’s biggest competitors, the investment banks, had been clamouring to buy into the fund. Meriwether applied a formula which brought in new investment, as well as providing him and his partners with a virtual put option on the performance of the fund. During 1997, under this formula…UBS put in $800 million in the form of a loan and $266 million in straight equity. Credit Suisse Financial Products put in a $100 million loan and $33 million in equity.

Investment bankers — those who are paid to see the invisible dangers — turned a blind eye to an overheating power line.

And once they were in, there was no easy way out.

This is from the Berkeley University report:

Investors in LTCM were pledged to keep in their money for at least two years.

In 1997, LTCM managed to sidestep the fallout from the Asian crisis…recording an annual return of 17.1%.

The first year for UBS and Credit Suisse was a good one.

When 1998 came around, LTCM had ballooned into a hedge fund giant…with US$125 billion of assets.

But there was a danger hiding in plain sight. Around US$121 billion of this money was borrowed.

All it needed was an unexpected event — one that didn’t fit neatly into the risk management parameters of their mathematical models — to seriously threaten the US$4–5 billion of investor equity.

And, that shock came from Russia. As the Berkeley University report stated:

On August 17,1998 Russia declared a moratorium on its rouble debt and domestic dollar debt. Hot money, already jittery because of the Asian crisis, fled into high quality instruments.

LTCM was on the wrong side of the trade.

The hot money flowing into quality assets resulted in the power being turned off to the LTCM fund. The fund’s assets started to freeze up.

A little over a fortnight after Russia’s surprising announcement (emphasis added):

On September 2, 1998 Meriwether sent a letter to his investors saying that the fund had lost $2.5 billion or 52% of its value that year, $2.1 billion in August alone.

In the space of a few days, investors lost half their money…that’s what you call a lightning strike.

But wait, it gets worse…and not just for LTCM investors:

LTCM’s on balance sheet assets totalled around $125 billion, on a capital base of $4 billion, a leverage of about 30 times. But that leverage was increased tenfold by LTCM’s off balance sheet business whose notional principal ran to around $1 trillion.

There was leverage upon leverage — turning US$4 billion of equity into US$1 trillion of notional principal.

Did the Nobel Prize winners not see the dangers in this structure?

LTCM was like one of those DIY disasters where you have multiple extension cords plugged into a multitude of power boards…running alongside the bathtub and pool. What could possibly go wrong?

The cables powering LTCM were connected from investor equity to lenders to derivative contract counterparties to the US banking system.

No one saw the danger in all these exposed cables lying around Wall Street.

How was it possible for all these trained professionals to not see danger? According to the Berkeley University report (emphasis added):

Surely LTCM, with two of the original masters of derivatives and option valuation among its partners, would have put its portfolio through stress tests to match recent market turmoil. But, like many other value-at-risk (Var) modellers on the street, their worst-case scenarios had been outplayed by the horribly correlated behaviour of the market since August 17. Such a flight to quality hadn’t been predicted, probably because it was so clearly irrational.

The industry thought — wrongly — that the Nobel Prize winners would have rigorously safety tested the product’s ‘power cords’ to ensure they could handle an unexpected power surge…afraid not.

Please take note of the language used in the highlighted section…‘horribly correlated behaviour’ and ‘clearly irrational’.

Professional market players were ‘shocked’ by people panicking when the invisible danger became visible. Really? What did they expect,sort of gentlemanly, ‘You first…No, I insist, you go first…’ discourse?

Human nature — especially when it moves to the extremities of the emotional scale — is a highly visible ‘known known’…which has been happening ever since tulip mania in the 1600s.

The failure to factor this obvious risk into the stress test was a grave oversight.

In the end, the New York Fed organised for 11 banks to provide US$3.6 billion in funding for the bailout of LTCM.

Crisis averted.

The threat posed by the interconnectivity of LTCM to the US banking system was so serious it warranted an official inquiry…and not just your run-of-the-mill Congressional inquiry.

The President’s Working Group on Financial Markets was convened.

Failure to learn lessons

The key people in the working group were…

Vice President Al Gore. Treasury Secretary Robert E Rubin. Fed Chairman Alan Greenspan.

I told you it was serious.

In April 1999, the ‘Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management Report’ was presented to US President Bill Clinton.

The report began with (emphasis added):

Dear Mr Speaker:

We are pleased to transmit the report of the President’s Working Group on Financial Markets on Hedge Funds, Leverage, and the Lessons of Long-Term Capital Management (LTCM).

The principal policy issue arising out of the events surrounding the near collapse of LTCM is how to constrain excessive leverage. By increasing the chance that problems at one financial institution could be transmitted to other institutions, excessive leverage can increase the likelihood of a general breakdown in the functioning of financial markets. This issue is not limited to hedge funds; other financial institutions are often larger and more highly leveraged than most hedge funds.

As I said earlier, the Fed (firstly Greenspan, then Bernanke) knew about the dangers of running extension cords into double adapters to power-up markets.

The warnings about the risks of excessive leverage went completely unheeded.

As reported by The Balance in its later analysis of the LTCM crisis:

Unfortunately, government leaders did not learn from this mistake. The LTCM crisis was an early warning symptom of the same disease that occurred with a vengeance in the 2008 global financial crisis.

Those charged (no pun intended) with control of the power supply to markets flicked the switch to overload and then wondered why the system almost fried its brains out.

On 23 October 2008, The New York Times coverage of the Congressional hearing into the US housing crisis, ran with the headline ‘Greenspan “shocked” that free markets are flawed’.

According to Wikipedia:

Greenspan admitted fault in opposing regulation of derivatives and acknowledged that financial institutions didn’t protect shareholders and investments as well as he expected.

This is the same Greenspan who, less than a decade earlier, co-signed a report to none other than the US president, warning of the very dangers he now professed to be shocked by.

Please, spare me.

Clear and visible danger

The dangers were clear and visible. The cosy power sharing arrangement between the Fed and Wall Street meant the real shock in 2008 would be felt by mum and dad investors.

Wall Street made sure it was insulated from any serious harm.

And here we are today…with the most supercharged asset markets — shares, property, bonds, and cryptos — in history.

The danger is, once again, clear and visible.

Anyone expecting a different outcome is in for a very nasty shock.

Regards,

Vern Gowdie Signature

Vern Gowdie,
Editor, The Rum Rebellion

PS: Vern is also the Editor of The Gowdie Letter and The Gowdie Advisory — investment services designed to help everyday Australians avoid the financial pitfalls of a volatile economy and make informed decisions to grow their wealth for generations to come.


Vern has been involved in financial planning since 1986.

In 1999, Personal Investor magazine ranked Vern as one of Australia’s Top 50 financial planners.

His previous firm, Gowdie Financial Planning, was recognised in 2004, 2005, 2006 & 2007, by Independent Financial Adviser magazine as one of the top five financial planning firms in Australia.

In 2005, Vern commenced his writing career with the ‘Big Picture’ column for regional newspapers and was a commentator on financial matters for Prime Radio talkback.

In 2008, he sold his financial planning firm due to concerns about an impending economic downturn and the impact this would have on the investment industry.

In 2013, he joined Fat Tail Investment Research as editor of Gowdie Family Wealth. In 2015, his book The End of Australia sold over 20,000 copies and launched his second premium newsletter, The Gowdie Letter.

Vern has since published two other books, A Parents Gift of Knowledge, all about the passing of investing intelligence from father to daughter, and How Much Bull can Investors Bear, an expose on the investment industry’s smoke and mirrors.

His contrarian views often place him at odds with the financial planning profession today, but Vern’s sole motivation is to help investors like you to protect their own and their family’s wealth.

Vern is Founder and Chairman of The Gowdie Advisory and The Gowdie Letter advisory service.


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