Apr

19

William D. Cohan's House of Cards is an exciting account of the fall of Bear Stearns and a great inside look at the personalities in high finance on Wall Street. The firm fell in just a few days when their overnight financing dried up. They were heavily leveraged up to 50x. Their inventory collateral had the mortgage securities that are causing so much consternation in the financial system. They were one of the leaders in making securities out of the mortgages. They had been successful in almost every year prior to that. Cohan blames Jimmy Cayne and his hubris-filled leadership style for the the downfall. He did not really understand the concentration of their business and how the strategic inflection might impact them, or how or why their financial structure was so vulnerable. There is little substantive insight on trading strategies other than you have to make money. Still there is much to learn.

Combining the lessons of Bear Stearns, with Andy Grove's ideas reveals how easily hubris can creep in with success. Hubris or success leads to emotional attachment to methods that worked. The attachment makes change harder when the outside change makes what worked before, not work. This is a very difficult thing to overcome in an individual, and harder in a firm. It makes it harder to see the change coming. It is good to have more than one viewpoint, more than one approach. A charismatic and dogmatic leader can change from an advantage to hindering change when it is necessary. This is what happened at Bear Stearns.

Many of Bear's market positions were known outside the firm. Their weakness was apparent. That is what allowed others to take advantage of them when the time came. Wall Street is a small community and ruthless. As an aside, an interesting aspect of short term electronic trading is that there are no negotiations or outside parties that are privy to the strategies, and other than the tape, transactions tend to lack any window for information to spread such at brokers,lawyers, outside parties, clerical staff that might exist in M&A deals. This one of the beauties of the the current electronic system. However, as in the past, study of the tape has good information.

In past years we have discussed risk, how to control it. One method is leverage. Price stops can lower variance but will not increase return. Another method of limiting risk is time. Variance increases with time, thus risk increases with time. Though return in theory should increase to a point, there is a sweet spot. It will differ according to your horizons, but time is one of the main risk factors. The objective should be to balance vig and the conditional expectation.

Apr

19

A GroveAndy Grove of Intel wrote "Only the Paranoid Survive". His main thesis is that strategic inflection points come along and totally change the landscape for businesses. If they don't recognize it, adapt, they will perish. Such changes are caused by technology, government regulation, and growth and public change. He suggests that at some points, data, being historical, will not capture the inflection points, and intuition or anecdote must come in to play. Grove says that firms that have experimented, and have other irons in the fire are better equipped to change their focus. Its a scary thing to change from your bread and butter to the unknown. He says the reason CEO change is not that one is a better leader, its just that they are not emotionally tied to the old ways and methods that were successful before, but which are not working in the new regimes.

The financial system has passed a strategic inflection point. Government regulation will further change the landscape. Many firms who failed to see it coming, or see it happening have failed. Firms such as Bear Stearns and Lehman whose very success in mortgages, lead to the concentration in mortgage debt, lead to its demise when the inflection point came. Looking back, of course the signals are clear, but at the time, was it clear what 2/2/07, Bear Stearns, Lehman meant to the system? Few, very very few, recognized the signals. Fewer still capitalised on it, or protected themselves. The ones that did either changed, or were in a niche that wasn't impacted.

Grove is insightful. Its remarkable how any endeavor, business, sports, can lead to insight into the human condition. In Eastern philosophy the simple actions of living can lead to the ultimate truth.

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