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Monday, August 13, 2007 9:56 AM

Genius Fails Again

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Forbes is asking Goldman Sachs Alpha to Fail?

It's not looking good for Goldman Sachs's Global Alpha fund.

Despite rumors that the investment bank would wind up the ailing quantitative fund, Goldman Sachs continues to stand by its unit. It was widely reported in the media on Thursday that Global Alpha, a mega $9 billion hedge fund in Goldman's asset management group, was down 16% for the year.

Unlike the typical hedge fund, Global Alpha is a quantitative fund, meaning that its trades are determined by computers and convoluted mathematical models. Some quant funds are completely computer dictated, while others spew out investment options for a human trader to veto or accept.

Global Alpha was also engineered to place big, risky bets--one unexpected swing in the market could take a major bite out of the fund. After years of consecutive growth, the fund started to wobble--in 2006 it fell 6%.

This year has been worse-- much worse. Global markets have been rocked by confluence of circumstances including the unwinding of the carry trade, the credit crunch and a heightened fear of risk. So Global Alpha has been hurting. According to media reports, the fund's traders have been cleaning up certain positions.

Of course Global Alpha might not be alone. While it may be one of the most high-profile funds because of its size and the name of its parent, other quantitative funds may also be at risk.

Investors may still remember the epic 1998 collapse of one particular fund that was driven by quantitative formulas: Long-Term Capital Management.
When Genius Failed
When Genius Failed, by Roger Lowenstein, is the true story of Wall Street traders, academics and hubris. It is the story of the failure of Long-Term Capital Management, a hedge fund founded by John Meriwether.

The Genius mentioned in the title refers to Robert Merton and Myron Scholes. Nine months before LTCM failed 1997, Merton and Scholes shared the Nobel prize in economics. Merton, Scholes and Stanford's William Sharp (famous for developing the sharp ratio to measure risk) are some of the founders of modern finance, which attempts to apply quantitative techniques to market analysis. Merton and Scholes jumped at the chance to join LTCM where they could not only apply their theoretical work but make a great deal of money.

As a Big Swinging Dick hedge fund with the most stellar partners and a huge capital base, LTCM was able to convince banks to lend them money at rates that were not available to lesser mortals (including investment banks like Salomon Brothers). LTCM used this credit to leverage their capital base by a factor of twenty to thirty times. In the first few years this allowed LCTM to make spectacular profits for themselves and their investors.

One of the flaws of When Genius Failed is that Lowenstein sacrifices the details of the investment strategies used by LTCM to tell the story (Nicholas Dunbar's book Inventing Money does a better job explaining the details of the LTCM's financial strategies). Many of the strategies that LTCM used involved derivatives.

Lowenstein never fully explains what exactly a "swap" is and incompletely explains LTCM's "volatility" bets. As we will see below, LTCM lost most its money on swaps and volatility bets, so these derivatives play an important part in the story. I've included a footnote here on interest rate swaps and volatility bets. ...

LTCM's mistakes were made fatal by massive leverage and lack of liquidity. ... LTCM was not the only trading firm to lose large amounts of money. Virtually every investment bank lost money when interest rate spreads widened unexpectedly. This was largely because they were using the same kind of trading models. ...
Let's consider a second review of When Genius Failed.

Roger Lowenstein explains how Long-Term became arrogant due to its success and eventually leveraged $4 billion into $100 billion in assets. This $100 billion became collateral for $1.2 trillion in derivatives exposure! With this kind of financial leverage even the most minute market move against you can wipe you out several times over. Talk about financial weapons of mass destruction! This risk did not deter Long-Term, though.

Finally in 1998, Russia defaulted on its bonds- many of which Long-Term owned. This default stirred up the world’s financial markets in a way that caused many additional losing trades for Long-Term.

By the spring of 1998, LTCM was losing several hundred million dollars per day. What did LTCM’s brilliant financial models say about all of this? The models recommended waiting out the storm.

By August 1998, LTCM had burned through almost all of its $4 billion in capital. At this point LTCM tried to exit its trades, but found it impossible, as traders all over the world were trying to exit as well.

With $1.2 trillion dollars at risk, the economy could have been devastated if LTCM’s losses continued to run its course. After much discussion, the Federal Reserve and Wall Street’s largest investment banks decided to rescue Long-Term. The banks ended up losing several hundred million dollars each.

What became of Long-Terms founders? Were they jailed or banned from the financial world? No. They went on to start another hedge fund!

Here is the table of losses from the first article.

The Same Mistakes Only Bigger

The losses at LTCM are trivial compared to today. The Fed would not bat an eye over a $4 billion hedge fund failure today. In Who's Holding The Bag? I reported "Notional amounts of interest rate derivatives outstanding grew almost 14 percent to $285.7 trillion in the second half of 2006." Look closely at that figure. Yes, that is trillion not billion. And that numbers was from 2006. It is higher today. Is it any wonder the Fed is spooked?

Not only have we made the same mistakes but we have made them in orders of magnitude greater size. And look at the buzzwords. They are exactly the same.
  • massive leverage
  • lack of liquidity
  • quantitative funds
  • derivatives
  • credit default swaps
  • hedge fund blowups
One has to laugh about this: "According to media reports, [Goldman Sachs's Global Alpha fund's traders] have been cleaning up certain positions." Fancy that. Computer modeling has failed yet again and humans are cleaning up after them.

More Computer Models Fail

And speaking of computer models, what about those computer models of Moody's, Fitch, and the S&P. Those models are horrendously flawed as I pointed out in Fitch Discloses Its Fatally Flawed Rating Model.
Essentially Fitch extrapolated a model of constantly rising home prices forever into the future, in spite of obvious signs of rampant speculation and home price appreciation far above the long term average for four consecutive years. In addition, Fitch made no allowances for reversion to the mean on home prices, in fact did not even make provisions for a flattening market let alone a reversion to the mean at a time of massively declining lending standards, and with home price appreciation orders of magnitude above affordability indices and rental prices.
That is some set of assumptions that Fitch made in their model isn't it? One might think that those flaws are so obvious that anyone with any reasonable degree of competence would catch. And $trillions of dollars were of mortgage backed securities were rated by "the big 3" on the basis of those flawed models.

But the story gets even worse. Please consider this Press Release: Fitch: U.S. RMBS Criteria Changes for Newly Issued Transactions.

Tanta over at Calculated Risks blog dropped this bombshell about that Fitch press release: They're Just Mortgages. We're Not Expected to Understand Them.
This is big bad-ass deal. Fitch just came out and admitted that "ResiLogic" is working with corrupt or missing data, that Fitch's analysts don't know how to "crack" a mortgage tape (that is, how to map an originator-specific data field into a standard one that can compare across deals), and that there is no reason for any of us to believe them when they say that certain loan characteristics are more or less predictive of default. Some of you may have suspected this before today. But I'll admit that I didn't think they were making mistakes at this elementary a level.
Inquiring minds might be asking "What's behind the explosive use of derivatives, CDOs, LBO, computer trading, massive leverage, and enormous faith in poor models including implicit trust in automated scoring algorithms that supposedly could measure risk of default but obviously failed to deliver. The answer is simple: the Fed. Central banks are enablers of risk. Greenspan himself had high praise for derivatives and encouraged massive use of derivatives, adjustable rate mortgages at the bottom in interest rates, computer modeling and other such nonsense. And when anything has gone wrong the Fed has always been there to provide liquidity (see Bernanke Panics & Gold Responds).

But there comes a time when all such models break down. We saw it with LTCM, we see it now with Moody's, Fitch and the S&P, and we see it again with Goldman Sachs's Global Alpha quant fund that simply cannot trade. There is one more model that going to fail as well. That's the model thinks the Fed can keep engineering bigger bubble after bigger bubble to bail out the markets. That model is on the verge of collapse right now and that is what has nearly every central bank spooked. One can keep track of hedge fund genius failures at the Hedge Fund Implode O Meter and mortgage lending genius failures at the Mortagage Lender Implode O meter.

By the way Global Alpha is sinking by day. It is now down 26% as of a more current Bloomberg report: Goldman's Global Alpha Falls 26% in 2007.
Goldman Sachs Group Inc.'s $8 billion Global Alpha hedge fund has fallen 26 percent so far this year, a decline that may prompt more investors to withdraw their money, according to people familiar with the fund.

Goldman's largest hedge fund, managed by Mark Carhart and Raymond Iwanowsk, has dropped almost 40 percent since July 31, 2006, said the people, who declined to be named because the fund is private. The Standard & Poor's 500 Index of the biggest U.S. stocks has returned 16 percent during the same period.

"It's hard to imagine how investors can maintain confidence, because their losses have been taking place over a long period of time, starting last year," said Virginia Parker, who helps oversee about $1.8 billion at Parker Global Strategies LLC in Stamford, Connecticut. "There has been a broad range of market climates, and the fund has not demonstrated the ability to excel in any of them."
It's quite interesting that a computer quant fund that is supposed to make money in every market environment is now struggling to make money in any environment. Genius is fleeting.

Mike Shedlock / Mish

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