When the Market Turmoil Hits Home

Thursday, Sept. 20, 2007 | I’ve been meaning for a few days now to direct anyone who was interested to a couple of stories. I recently finished a book, recommended by a friend, called “When Genius Failed: The Rise and Fall of Long-Term Capital Management” by Roger Lowenstein.

Every so often when turmoil hits the financial markets, people who write about them compare what is happening to what happened to Long-Term Capital Management, or LTCM. The hedge fund’s bets and borrowing reached such troublesome heights that nearly every major American bank, and some international ones, had to come to its rescue, fearing such a tremendous collapse that all trading would just cease.

LTCM came up in a recent story in the Wall Street Journal.

The story details how “market turmoil waylaid the ‘quants.’” The quants are quantitative investors at hedge funds who use complex mathematical systems to decide where and how to make big money.

LTCM also prided itself on its use of mathematical models. Its operatives plainly thought they were smarter than other traders and they bet on it accordingly. They lost, badly.

Now, closer to the point: Two of the “waylaid” quants mentioned in the story were the hedge funds D.E. Shaw and AQR. Both of which have received significant investments from the San Diego County Employees’ Retirement Association. The pension system invested $175 million in D.E. Shaw a couple of years ago and $50 million in AQR.

The article, as many have, ran through the troubles AQR and D.E. Shaw have had recently in the wake of the housing market crash, defaults on mortgages and the resulting crackdown on lending practices. It reports as well that AQR is telling investors it has “bounced back roughly 10% from its lows.”

And it has this bit of perspective:

The quants’ summer woes remind some of the near-meltdown almost a decade ago of high-flying hedge fund Long Term Capital Management. Like quant funds, LTCM was steered by brainy academics who made money exploiting out-of-kilter relationships between different securities. Unlike LTCM, though, today’s quant funds are far less leveraged and thus unlikely to sustain huge losses as LTCM did.

That’s nice.

County pension officials also remind us that these funds are different than the hedge fund that imploded last year — Amaranth Advisors LLC — because they have multiple strategies and investments. Amaranth also advertised that it had multiple strategies to earn its money — that if one of its bets failed, the others would ensure the fund was safe.

The county hired big-time lawyers — ironically, from the same firm who helped prevent LTCM from destroying the market. They now accuse Amaranth of defrauding them into thinking their money was safe.

Hedge funds, however, are secretive about how they invest by their very nature. The story of LTCM is one of people so frightened of public scrutiny they obsessed over secrecy.

Like the hedge funds now, LTCM confidently believed that its formulas for investing had distributed the risks enough to be absolutely certain that they would never lose everything.

What happened to them, they had determined, was an event “so freakish as to be unlikely to occur even once over the entire life of the Universe and even over numerous repetitions of the Universe,” Lowenstein wrote.

Pension fund managers do not like to admit that they are taking risk and they take great comfort in mathematical wizards like these who can swear that they are taking risks that are guaranteed not to completely come back to harm them. They prove this to themselves by using historical data detailing how the market has worked in the past. If it hasn’t done this or that in the past, it won’t in the future.

In other words, like the Journal article described, if Ford and GM stock had always seemed to trade and go up and down in value relatively in concert, then you can predict that they will in the future. If one of them starts to go down and the other one goes up, the market allows you to bet that they are acting inefficiently and will naturally return to their historical relationship.

These are still risky bets. Humans have a way of doing odd things and if you bet that Ford stock and GM stock will harmonize and they fail to, you can lose. Big.

I’m fascinated by a financial world that provides this forum. I think it’s exciting to imagine big-time investors playing this kind of high-stakes game and I wish them all the luck in the world.

But is this a place we want to throw the investments meant to pay for the pensions of public employees?

After all, the pensions are guaranteed. What’s not is how much taxpayers will have to pay to fund them.

BusinessWeek recently wrote an interesting piece wondering about that.

“Can Retirees Afford This Much Risk?” was the article’s headline:

Despite the sharp ups and downs of the market lately, public pensions show no sign of abandoning their recent push into hedge funds and other nontraditional investments. They really can’t afford to do so. State pension plans have deteriorated from a $20 billion surplus in 2001 to a $381 billion deficit last year, according to the National Association of State Retirement Administrators (NASRA).

What is with all this risk? Since when do governments become places where money is put on the line with so much aplomb?

The county’s pension system has graphs that show that even if it doesn’t make a dime in earnings over the coming years it will be fine. Its investment pro has said that we should expect one of his hedge funds to implode every year but the trust will be fine.

How do they know? The mathematicians tell them so.

Please contact Scott Lewis directly with your thoughts, ideas, personal stories or tips. Or send a letter to the editor.