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Lindley Estes is a business writer for The Free Lance-Star and Fredericksburg.com. This blog is on Fredericksburg-area business. Send an e-mail to Lindley Estes.

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Ignoring risk, embracing greed can burst bubbles

THE DETAILS that caused the recent credit crunch on Wall Street and the collapse of the subprime mortgage market are far too complex for most to truly understand, including this column’s author.

But I don’t feel too bad about this. Many of the country’s brightest investors have refused to buy stock of the companies most affected by the collapse, as they can’t understand exactly what is on their balance sheets.

That’s what happens when mortgages get sliced into tiny pieces and sold time and again. After the euphoria of the boom dies down and the bubble bursts, there are no longer any buyers to keep it going. And balance sheets prove impossible to analyze.

It seems that nearly all bubbles share similar characteristics–notably an abandonment of fundamental principles of investing and a lack of focus on risk.

This past week I read Roger Lowenstein’s "When Genius Failed." It’s the story of the rise and fall of a hedge fund called Long-Term Capital Management. And it’s a great read for anyone seeking to understand the all-too-human factors behind the latest collapse.

LTCM included some of the brightest financial minds of the 1990s. Its trading strategy focused on identifying mispriced bonds and making massive bets on prices to return to normal.

The team created complex financial models that helped them identify lucrative investment targets. For a while, it worked like a charm. The firm quadrupled investors’ money from its founding in the early 1990s to its collapse in 1998.

But much of the returns were due to the extreme leverage that LTCM used. That’s financial jargon for borrowed money. Leverage leads to skyrocketing returns when times are good, but things move as quickly downward in bad times.

At first LTCM had trouble attracting investments from major Wall Street banks. But as the returns soared, the banks jumped in. Never mind that the banks were earning ridiculously low fees given the amount of money they were risking or that they were mostly kept in the dark about the hedge fund’s trading practices. They wanted a piece of the action.

LTCM’s success led to other hedge funds targeting the same parts of the market. As the hedge fund’s assets soared and the space grew crowded, it became increasingly difficult to find trading opportunities.

LTCM could have stayed on the sidelines and waited for better opportunities. But that’s not easy to do when short-term-minded investors clamor for double-digit returns year after year. So LTCM plowed forward, abandoning its models and engaging in speculation.

Many of the models were based on historical prices and market efficiency. The problem is, markets aren’t always efficient, and the present isn’t always like the past. How many people foresaw the collapse of the subprime market?

The Kelly Formula is an equation that helps gamblers, traders and investors determine how much of their bankroll they should wager. When they have an edge, they should bet big. When they don’t, they shouldn’t. Anybody who bets the house on an unsure proposition will eventually lose everything. The collapse of the Russian debt market in 1998 proved LTCM’s undoing.

Interestingly, many of the banks burned by LTCM also lost big in the most recent collapse. It’s tough to keep one’s greed in check while everyone around is profiting off the boom.

But some manage to do so. Barron’s had a cover story last week about Wells Fargo. Although the bank hasn’t come out unscathed by the recent market conditions, it’s done better than most by staying true to its principles of risk management.

Many of the situations in "When Genius Failed" seem remarkably similar to what’s happened of late. Some are undoubtedly quite different. But the lesson for investors is that anyone who strays from fundamentals and gets greedy will be burned.

Even if a bunch of geniuses are running the show.

Permalink: http://news.fredericksburg.com/businessbrowser/2008/02/24/ignoring-risk-embracing-greed-can-burst-bubbles/

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