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Mr. Marks, head of Oaktree Capital Management, tell the story in bullet points of how the word "risk" went from a pure bad to meaningless.
40 years ago America's financial industry was conservative and risk-averse. A growth engine. Money was invested close to home, based on what it would produce. Major investment shops preserved the value of capital.
Mr. Marks lists 27 distinct waves of change. Examples:
1977-79 saw the birth of the high yield bond market. Up to that time, bonds rated below investment grade couldn’t be issued. That changed with ...Michael Milken....
...
Computer modeling (in 2000-2005) was further harnessed to create "value at risk" and other risk management tools... (which) fooled people into thinking risk was under control
Over 40 years, risk became a meaningless mathematical cypher. A calc engine "greek" with little connection to event-level accounting payments and productivity.
Protection for investors and retirement funds became a sick joke. Details BTF:::
HERE for a Scribd copyof Mr. Marks's original letter. He offers it publicly with Zero Hedge. You can find more technical discussion there.
Of course, not all of these items are fails. Commodity Mercantile Exchange, in Chicago, is a solid operation. But then the smartest guys in the room turned this format into a tool for overwhelming the trade-oriented futures deals with massive speculation.
Oil got this play in 2007 and 2008. Falling demand and rising supply did not produce lower oil prices. Instead, irrational bloom-pattern speculation drove up the world's oil prices.
Every step listed here takes us down a path to irrational decisions and a system where criminal concealment of information will find open paths to billion dollar temptations:
In the mid-1960s, growth investing was invented, along with the belief that if you bought the stocks of the "nifty-fifty" fastest-growing companies, you didn’t have to worry about paying the right price.
The first of the investment boutiques was created in 1969, as I recall, when highly respected portfolio managers from a number of traditional firms joined together to form Jennison Associates. For the first time, institutional investing was sexy.
We started to hear more about investment personalities. There were the "Oscars" (Schafer and Tang) and the "Freds" (Carr, Mates and Alger) – big personalities with big performance, often working outside the institutional mainstream.
In the early 1970s, modern portfolio theory began to seep from the University of Chicago to Wall Street. With it came indexation, risk-adjusted returns, efficient frontiers and risk/return optimization.
Around 1973, put and call options escaped from obscurity and began to trade on exchanges like the Chicago Board Options Exchange.
Given options’ widely varying time frames, strike prices and underlying stocks, a tool for valuing them was required, and the Black-Scholes model filled the bill.
A small number of leveraged buyouts took place starting in the mid-1970s, but they attracted little attention.
1977-79 saw the birth of the high yield bond market. Up to that time, bonds rated below investment grade couldn’t be issued. That changed with the spread of the argument – associated primarily with Michael Milken – that incremental credit risk could responsibly be borne if offset by more-than-commensurate yield spreads.
Around 1980, debt securitization began to occur, with packages of mortgages sliced into securities of varying risk and return, with the highest-priority tranche carrying the lowest yield, and so forth. This process was an example of disintermediation, in which the making of loans moved out of the banks; 25 years later, this would be called the shadow banking system.
One of the first "quant" miracles came along in the 1980s: portfolio insurance. Under this automated strategy, investors could ride stocks up but avoid losses by entering stop-loss orders if they fell. It looked good on paper, but it failed on Black Monday in 1987 when brokers didn’t answer their phones.
In the mid- to late 1980s, the ability to borrow large amounts of money through high yield bond offerings made it possible for minor players to effect buyouts of large, iconic companies, and "leverage" became part of investors’ everyday vocabulary.
When many of those buyouts proved too highly levered to get through the 1990 recession and went bust, investing in distressed debt gained currency.
Real estate had boomed because of excessive tax incentives and the admission of real estate to the portfolios of S&Ls, but it collapsed in 1991-92. When the Resolution Trust Corporation took failed properties from S&Ls and sold them off, "opportunistic" real estate investing was born.
Mainstream investment managers made the big time, with Peter Lynch and Warren Buffett becoming famous for consistently beating the equity indices.
In the 1990s, emerging market investing became the hot new thing, wowing people until it took its knocks in the mid- to late 1990s due to the Mexican peso devaluation, Asian financial crisis and Russian debt disavowal.
Quant investing arrived, too, achieving its first real fame with the success of Long-Term Capital Management. This Nobel Prize-laden firm used computer models to identify fixed income arbitrage opportunities. Like most other investment miracles, it worked until it didn’t. Thanks to its use of enormous leverage, LTCM melted down spectacularly in 1998.
Investors’ real interest in the last half of the ’90s was in common stocks, with the frenzy accelerating but narrowing to tech-media-telecom stocks around 1997 and narrowing further to Internet stocks in 1999. The "limitless potential" of these instruments was debunked in 2000, and the equity market went into its first three-year decline since the Great Crash of ’29.
Venture capital funds, blessed with triple-digit returns thanks to the fevered appetite for tech stocks, soared in the late 1990s and crashed soon thereafter.
After their three-year slump, the loss of faith in common stocks caused investors to shift their hopes to hedge funds – "absolute return" vehicles expected to make money regardless of what went on in the world.
With the bifurcation of strategies and managers into "beta-based" (market-driven) and "alpha-based" (skill-driven), investors concluded they could identify managers capable of alpha investing, emphasize it, perhaps synthesize it, and "port" or carry it to their portfolios in additive combinations.
Private equity – sporting a new label free from the unpleasant history of "leveraged buyouts" – became another popular alternative to traditional stocks and bonds, and funds of $20 billion and more were raised at the apex in 2006-07.
Wall Street came forward with a plan to package prosaic, reliable home mortgages into collateralized debt obligations – the next high-return, low-risk free lunch – with help from tranching, securitization and selling onward.
The key to the purported success of this latest miracle lay in computer modeling. It quantified the risk, assuming that mortgage defaults would remain uncorrelated and benign as historically had been the case. But because careless mortgage lending practices unknowingly had altered the probabilities, the default experience turned out to be much worse than the models suggested or the modelers thought possible.
Issuers of collateralized loan obligations bought corporate loans using the same processes that had been applied to CDOs. Their buying facilitated vast issuance of syndicated bank loans carrying low interest rates and few protective covenants, now called leveraged loans because the lending banks promptly sold off the majority.
Options were joined by futures and swaps under a new heading: derivatives. Heralded for their ability to de-risk the financial system by shifting risk to those best able to bear it, derivatives led to vast losses and something new: counterparty risk.
The common thread running through hedge funds, private equity funds and many other of these investment innovations was incentive compensation. Expected to align the interests of investment managers and their clients, in many cases it encouraged excessive risk taking.
Computer modeling was further harnessed to create "value at risk" and other risk management tools designed to quantify how much would be lost if the investment environment soured. This fooled people into thinking risk was under control – a belief that, if acted on, has the potential to vastly increase risk.
At the end of this progression we find an institutional investing world that bears little resemblance to the quaint cottage industry with which the chronology began more than forty years ago.
By the time we got to "counterparty risk," it wasn't "risk" any more.
"Its not how you play the game; its how you spread the blame."
The worst of this is that President Obama is influenced by a collection of advisors who helped build this Tower of Babel, plus that they always favored deregulation and disinformation opportunities.
The most prominent is Larry Summers. He pushes his own specific points and projects, but blocks everything else. A card-carrying narcissist. The man who cost Harvard University $1,000,000,000 with one hidden deal written to a former employer, Goldman Sachs.
Not one step has been taken by the Obama White House to clarify industry information. Not in the oil business. The home mortgage system is still dominated by "privatized" multiple data systems -- where a single open-books database for mortgages and mortgage payments would eliminate ratings-fakery immediately.
Unbacked CDO/CDS contracts are still being written. Trillions of dollars hang in the balance -- carrying unknown, practically unknowable risk factors. (I still use the old meaning of that word.)
BTW: I work with databases and such as risk calculation engines. Do believe it... not one top manager on Wall Street or at the hedge funds knows enough about the mathematics AND about political economy to pass a realistic sit-down examination on risk analysis.
What these smartest guys on Wall Street end up doing is front-loading profit -- where their bonuses are generated -- while back-pushing the risks. With help from the likes of Summers, this will go on and on and on.
Mr. Marks misses some of the nastier recent developments. NYSE allowed Goldman Sachs and other high-ticket operations to "co-locate" computers inside the Exchange security web. Add a few tricks and the usual frontrunning scams -- adding pennies a share to customer trades -- got booted up to $100,000,000 a day megascams.
But that's all crooks and scams. Howard Marks is talking about what the whole system has done. How "risk" lost its meaning over four decades.
Careful reading of these items is worthwhile for anyone involved with politics in America.
Gold Rules.
Blunders from the past 40 years must be rolled back. Identifying blunders it the first step. Doubt we'll get any of that with Summers in place.