Book Review - Market Panic

I just finished reading the book “ Market Panic” by Stephen Vines. I would say more like browsed through it. The book is ok read slightly repetitive but did have a few good things.

I liked the author’s structure on the various stages of a stockmarket cycle leading to the final panic exit that most markets demonstrate at the end of the cycle.

Listing down how the author has described the various stages of the cycle

Stage I
The cycle starts with some kind of external shock the system that creates important opportunities for atleast one sector of the economy. It could be a event like a war or new inventions like the railways or more recently the rise of the internet

Stage 2
This boom then gets enlarged largely fuelled by expansion of bank credit expanding money supply ( Greenspan being a case in point).

Stage 3
With greater liquidity in the system euphoria takes over and as “Adam Smith” put overtrading. This results in greater trading volumes and higher level of speculation and leverage that builds into the system

Stage 4
As the author quotes “There is nothing so disturbing to one’s well being and judgement to see a friend get rich”. So everyone one wants to get rich. People who haven’t thought of entering the stockmarkets suddenly start investing in the markets.

Stage 5
The real danger signals starts when the stockmarket news moves from the inner pages of non financial newspapers to the front pages. I quote the author “Illustrating this point was the alarming appearance of mutual funds as a “Playboy” cover story. When stocks replace scantily clad young ladies who are well endowed on the cover, logic has clearly taken a holiday’.

Stage 6
Not only does the stockmarkets get inundated with inexperienced participants but their very presence increases demand leading to the temptation and opportunity for many new equity issues designed to capitalise on the window of opportunity for selling all manner of assets at an inflated price. This also leads creation of new derivative products allegedly aimed at sophisticated investors increasing leverage in the system and building pressure. This starts process where lenders start calling in additional margin with central bankers stepping in to deflate the bubble.

Stage 7
As the bubble grows the markets starts losing all sense of connect with the underlying assets.

Stage 8
At this stage a number of scams and dubious investments start coming out. This is interesting as a symptom if not the cause of stockmarket panics.

Stage 9
At this stage the savvy investors sense the top and start exiting from the market. Newer players are unsure and tend to stay put resulting in brakes on the rapid upward price movement. As the “greater fool” becomes difficult to find there is increasing movement from assets into cash resulting in depressing prices leading to unwinding of leveraged positions.

Stage 10
Now the market is in full retreat and there is competition to get out or the rush thru the door. This is typically led/ followed by the dramatic failure of a bank or other institutions or a particular scam.

Stage 11
This is final stage where the very assets which were darlings of the market become the object of revulsion and there is a market wide panic that builds up invariably leading to the regulator putting on cap in terms of limits or acting as a lender of last resort to bring stability and confidence to the markets

I have personally seen about three cycles and I can say that this is a fair template of how the markets move. Of course to add to it I always hear the magical four words “ This time its different” :-).

Déjà vu

This story is about a organisation which was structured to look at potential mispricing in the bond markets in terms of spreads between 2 instruments and look at those spreads reaching the long term average. The organisation worked its models around bonds, mortgages, equities and derivatives across myraid asset classes. The organisation spearheaded extensive use of quant and modeling in bond trading.

The organisation worked on magnifying its return by taking enormous amount of leverage 30:1. In a 5 year tenure it delivered a return of over 40% per annum. However its enormous leverage in the derivatives market of over $1 trillion wend bad in a month when markets across the world collapsed with a correlation of 1 throwing all the models out of the window. So we reached the stage where the organisation was on the verge of bankruptcy and threatened to take the entire financial system down with them. The huge counterparty risk coupled with fear threatened to freeze markets across the globe.

The bankers of course rushed to the big daddy FED who promptly worked out a bailout package to save the organisation and the markets. And we all lived happily ever after or did we?

I m sure most of us will look at this and the names that will come to our mind are Lehman Bros, AIG, Citi etc

Well this was about a hedge fund called Long Terms Capital Management which went down under in 1998 before the bailout.

The fund was started by John Meriwether ex head of bond trading for Salomon Brothers where he was forced to resign after his top bond trader admitted to falsifying bids in the US treasury auction. J M managed to rope in Nobel price winners Robert Merton and Myron Scholes of the famous Black Scholes model as partners and the funds partners were positioned as a intellectual breed apart. I just finished the book When Genius Failed: The Rise and Fall of Long-Term Capital Management by Roger Lowenstein. Interesting read.

There is a strong sense of déjà vu that creeps in as you see the same cycle repeating itself bringing financial markets to a crisis and I can lay a bet that we will see it play out again. “We learn from history that we don’t learn from history” - I had earlier written a blog on this.

PS: Here’s the amazing follow up to the storyline - John Meriwether post the LTCM fiasco went on along with his colleagues to start JWM partners which floated a Relative Value Opportunity Fund where the fund document stated that it would keep its leverage down to 15:1.

The funds posted gains for several years, but in the first quarter of 2008 posted losses, of 31% in the flagship Relative Value Opportunity bond fund.

JM quotes “While we are clearly disappointed by our recent performance, we remain optimistic about the current opportunity set,".
"While we do not welcome the increased volatility in our returns, we believe that increased market volatility is one of the primary preconditions for creating interesting relative value situations," he added
And this was first quarter last year. Bond spreads kept widening significantly post that. History repeats.