Monday, October 17, 2016

Lords of Finance (CH 4-6)

4. A Safe Pair of Hands
Chapter starts with crisis caused by archduke’s assassination in 1907. The focus was on the role that Benjamin Strong (41 years old president of bankers trust company.). First sign of financial crisis hit New York in July 28 when Austria declared war on Serbia.  Two days later Russian general mobilization while stocks experienced largest down by 7 percent on the same day. Major concern was that the European loans to Americans which amounted to $500 million, EU investors would demand immediate repayment under war conditions. on the same week major banking officials were summoned in offices of J.P. Morgan & Co., when London exchange been forced to stop trading, the bankers in New York decided to close the NY stock exchange. At that time the US was the only major economy without a central bank. That was motivated by the idea that putting power in hands of one institution was undemocratic(un-American) due to such attitude banking policy suffered. So with no central bank, the financial community turned to J.Pierpont Morgan. He had so much more experience in finance than any other. He assigned the best financiers to assist him Davison and Ben Strong and were able to contain some of the damage. After being hit with such a crisis the vulnerability of the U.S banking system was clear.  The U.S Congress decided to act to study assigning a central bank, but with efforts of lobbying the idea was turned down. Until the Glass Plan came to life which modified the idea of a single concentration of power, to having the Federal Reserve Banks and The federal Reserve Board were to be appointed by the president. So in October 14, Benjamin Strong aka “Safe Pair of Hands” was formally elected as the first governor of the Federal Reserve Bank of New York.

This chapter starts off with events(&scandals) occurring in France in 1914. Le Figaro, a newspaper opposing the finance French minister Joseph Caillaux, published an affair history of the minster. In response his second wife has purchased a gun and waited for the editor of Le Figaro Gaston Calmette and shot him dead instantly.  The incident lead to split in France between supporters of Caillaux and enemies. Rouvier who was prime minster got exiled for two years and came back as a minister of finance. France at the time was filled with political corruption and conflict of interest with government officials and politicians. In 1892 major company went bankrupt and 800,000 French investors lost $200 million. Rouiver along with 104 financiers got accused of corruption and was forced to resign.  Moreau admired Rouvier despite his ethical misdoings, so he worked under him and was very loyal to him. In 1905 Rouvier became prime minster again with Moreau as his right hand. Rouvier defused the crisis by helping to lead to the Anglo-French entente, but months later the government was voted out.  Moreau was sent to the central bank of Algeria and Tunisia (minor french insitution). In 1908 he was moved back to his hometown. At that time gold coins began to disappear from circulation. The French had a strong mistrust of banks, French peasant was told to keep his gold under the matters. In 1914 july veridtct of Caillaux's wife(who shot the editor)  was found guilty. At the time Parisians struggled on how to pay for their food because silver or gold were hard to get, almost everything stopped accepting banknotes. The banque announced it was prepared to continue paying out gold as it has been the largest gold hoarding entity. In 1914 they had more than $800 million in bullion. That gold was to support the French government in a national endeavor. When order for general mobilization was issued, French gold reserves were immobilized. When the war broke and in August the Germens were as close as 25 miles from Paris, they dropped bombs around Banque de France but the French had already secretly moved its $800 worth of gold from Banque by rail and truck to south of France. By September the vaults of Banque in Paris were empty.

6. Money Generals
As the war broke out, no one know why it happened, army generals were promising to return home by Christmas. Financial officials because they thought the war will be short they focused on being in a good financial shape. Everyone predicted that this war will be short by using European money and liquidity as a measure. Even in 1916 generals were saying it will end in 6 months, the truth of the matter is that Britain, France, Russia, Germany, Austria-Hungry were spending $3 billion each month which accounts to 50% of their collective GDP, it was said no other war in history absorbed so much wealth. So exhausting their funding approaches, they relied on inflation. They did that by turning to central banks and telling them to print money that is not backed by gold. Britain was the most responsible in its financial policy. For the U.S the war was like a fruit that fell from the sky. The demand for American materials from Europe was enormous the gold influx of U.S created expansion of credit and money supply doubled. Strong had two big fears. One was that at the end of the war, this gold would all pour back to Europe, radically destabilizing the U.S banking system. The other was that the gold would stay, potentially causing a shortage of reserves in Europe and threatening even greater inflation at home. So that Fed should coordinate with central banks of Europe. So he visited Europe and visited Paris Banque de France, then the bank of England where he met Norman and became good friends. Then he returned to the U.S in summer of 2016. At the same year Strong was diagnosed with tuberculosis which he got from his visit to Europe. He moved to Colorado to contain the infection but went back to NY to finance for the war when U.S entered it in 1917. The United States spent in total some $ 30 billion on the war, a little over $ 20 billion on its own actual expenditures and another $ 10 billion in the form of loans. The Fed was responsible for selling Liberty Bonds, which brought about $20 billion half of it from NY Fed Reserve. Towards the end of the war the Fed was a transformed system, unlike other centeral banks it had had resisted purchasing government bonds directly and only indirectly helped to fuel the expansion in money supply therefore, Fed secured some credibility.


What do you think would happen if the U.S economy continued without a central bank (Federal Reserve Bank) during the first Ground War?

Lords of Finance (CH 1-3)

Chapter 1 Recap: The reading starts off in 1914 in London setting the scene for that time. The gold standard was in effect at this time and it was considered the “lifeblood” of the financial system. It was believed that a war would be detrimental to everyone involved due to the economic chaos it would create. We then get introduced to Norman Angell who moved to the U.S. out of fear of what Europe’s future looked like. He then moved back to Europe where he started working for the Daily Mail. Angell wrote a piece tilted The Great Illusion which became very popular. Reginald Brett, one of Angell’s followers, founded the Committee of Imperial Defense which was designed to give the British Empire military advice. Lord Esher delivered lectures where he argued that the war is stupid because it leads to commercial disaster, financial ruin and individual suffering. The chapter ends by saying that Lord Esher and Angell underestimated to likelihood of a war amongst European countries breaking out.

Question: There wasn’t too much going on in this chapter as it was a brief introduction to set the scene and introduce some characters, but the concept of the gold standard was referred to in a positive manner. In today’s society, money is backed by government decree (i.e. nothing) while at this time money was backed directly by gold. Do you think the modern system we experience is dangerous as it is not backed by gold, or do you think we have moved on since these times and money can exist in the long-run without being backed by anything?

Chapter 2 Recap: A new character named Montagu Norman is introduced. He visits London the day Austria declares war on Serbia. Neither he nor anyone else knew that the financial system was about to completely fall apart. It was the middle of summer and Norman decided to depart from Brown Shipley. Norman had an exotic house that he took pride in but is described as being fairly modest. Norman did not fit in as a child and was constantly sick. He joined the militia and volunteered for active service and was sent to South Africa. Norman said he felt like a new man while away at war. He was awarded the Distinguished Service Order which became one of his greatest prides. After coming back home, Norman became one of the four main partners at Brown Shipley. At one point in time, he was engaged but the engagement fell apart and left Norman emotionally unwell. He then did some international traveling and finally came home to find out he had GPI and would only have a few months left to live. Meanwhile, the war going on in Europe started to pick up momentum as more countries were getting involved. All of the tension led to uncertainty in the financial markets – all of the loans that went through London would freeze up in the event of war and gold shipments would cease which could cause the gold standard to unravel. The stock exchange closed for the first time in over a century. People rushed to the bank to exchange their notes into gold. As gold was fleeing from the banks, they decided to raise interest rates to 10% to give people an incentive to leave their deposits with the bank. The bank was closed for a holiday and all the bankers wanted to “extend” the holiday to let the panic die down. Norman’s primary concern was the survival of Brown Shipley. All of this chaos was good for Norman’s health as it kept him distracted from his mental status.

Questions: Do you think the bankers’ desire to extend the holiday and keep the bank closed would have been a legitimate method to minimizing the financial chaos, or do you think this approach would have simply delayed the inevitable?
Do you think the action the banks took of raising the interest rates to 10% would have been sufficiently effective to deter individuals from withdrawing their wealth from the bank? Would you have withdrawn your deposits from the bank?

Chapter 3 Recap: Even though people had been anticipating a war for quite some time, everyone was surprised by how quickly it was escalating. The Austrian and German government leaders took vacations during the initiation of the war. A new character named Hjalmar Schacht is introduced and he is caught off guard by the crisis. He was not very high up on the totem pole at the bank he worked at named Dresdner and couldn’t really do much about the crisis but was surprised it was allowed to reach the point that it had. Schacht came from a lower-middle-class family but had a strong work ethic and desire to succeed. Schacht’s father moved to the U.S. temporarily but ultimately moved back to Germany with horrible timing as the economic downturn was just beginning. Schacht’s mother came from a family that was better off than his father, but when she chose to marry Wilhelm Schacht, she took a step down on the social ladder and inherited nothing. Schacht was bullied for his family’s poorness so once he finished school and escaped this misery, he found joy in poetry. After bouncing around from one university to another, he ultimately became a banker. He married a Prussian woman and they had two children. He never believed the war would actually happen and he thought there would be a diplomatic solution, but this was not the case. Germany declared war on France. As Britain stepped in to defend Belgium, Germany was now at war with another country. Despite all of this, Germany’s financial system seemed to be doing better than the rest of Europe’s. This didn’t last and one day in particular, Germany’s financial situation took a dramatic turn for the worse. As the bank almost fell below its minimum of gold backing, the Kaiser was worried of being driven off the gold standard. In August, the bank finally felt confident they had enough gold backings. As Schacht watched the war begin to unfold, he had a clear vision of his own future (though at this point in the novel, we do not know what that vision is).

Questions: As the war lead to overall uncertainty, if the bank had not held a sufficient amount of gold like they temporarily feared, do you think this would have had any impact on the development war itself? What do you suspect would have happened to the banks if they fell below this minimum holding requirement?

Sunday, October 9, 2016

When Genius Failed (Chapter 4)

In 1994, LTCM earned 28 percent which is a lot due to the fact that the average bond investor had lost money.  J.M. would write a letter to his investors on the possibility and odds of losses in the future and for investors to not expect a repeat.  Merton and Scholes used their advanced math knowledge to devise precise mathematical odds of when and how much they could possibly lose.
LTCM tried to quantify every aspect of trading, associating past volatility with their assessment of future risks.  They were basically conducting an experiment in managing risk by numbers.  LTCM trades were an attempt at exploiting spreads that reflected what they seemed to be inaccurate future volatility risk.  Black-Scholes made an assumption that the volatility of a security is constant.  Merton took that assumption a step further and assume that prices would trade without any jumps.  Merton found that a trader who owned both the price of an option and the price of the stock could operate in a perfect, risk-free arbitrage.  This would become an essential building block in LT’s hedging strategies. 
There were multiple people who either studied under or with Black, Scholes, and Merton that found inaccuracies in their assumptions, such as Eugene Fama.  He discovered that there were many more days of extreme price movements than would occur in a normal distribution.  The tail ends of the distribution differed from that of Merton’s because due to the fact he thought of them to be swollen.  Such an example was Black Monday.
Over the first two years, LTCM had only one month which they lost more than 1 percent.  Their equity capital had almost tripled to a total of $3.6 billion in that time.

Why do financial markets run to extremes more often than say, a coin flip?  How would this impact the market and investors?