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Oct 13, 2020 111 tweets 21 min read Read on X
1/ How Money Became Dangerous: The Inside Story of Our Turbulent Relationship with Modern Finance (Christopher Varelas, Dan Stone)

"How did our financial system become so labyrinthine and perilous as we became more disconnected from its workings?" (p. 2)

amazon.com/How-Money-Beca… Image
2/ "Do we really not care about looming crises (national debt, underfunded pensions/Social Security/health care, student debt), or is it that we feel shackled by our lack of understanding?

"As money continues to become a bigger part of our lives, we understand it less." (p. 2)
3/ "Not too long ago, we didn’t have the advantages the financial world now provides. For example, mortgages weren’t widely available to the general public. If you wanted to buy a house, you had to save up the entire purchase price." (p. 3)

More on this:
4/ "So the increase in complexity in the financial world has also brought with it products that have made many people’s lives better. Modern finance always seems a double-edged sword, which is why the universe of money has long intrigued me." (p. 4)
5/ For commercial lending, "with the change to the computer spreadsheet, you could skip the thinking stage and jump straight to inputting numbers and running scenarios. If you didn’t like the outputs, you could tinker with the assumptions until you got the result you wanted.
6/ "With paper , your primary question while working on any financial analysis was, What is the most likely outcome? This rewarded analysis that was right down the middle of possible outcomes. If I can map only one outcome, the thinking went, then it should be the most probable.
7/ "Capital was made more available as we came to understand the limits of how much a business or individual could use additional debt or equity for growth. New products were created to support specific needs, ranging from insurance to investment advisory to risk management.
8/ "A new world was opened to identify a need and then create the product to satisfy that demand. But it was also a Pandora’s box of new challenges.

"It facilitated bundling individual products to create new instruments centered around scale, scope, and diversification.
9/ "Once computer analytics were taken to a macro level, everything became unduly complicated and hard to explain.

"Minimal consideration as to how new products fit into the bigger financial system created situations that were more susceptible to unforeseen changes or errors.
10/ "The construction and sale of bundled mortgages freed up banks’ capital, allowing them to make more loans and making the homeownership possible for more people.

"It has been said that every bad idea on Wall Street started as a good idea. But, in time, it all turned tragic.
11/ "We’ve ended up with a system of evaluation that encourages only those behaviors that can be quantified, diminishing the importance of qualities that are less easily measured—trust, loyalty, resilience, and judgment." (p. 23)
12/ "Often the people who look and feel the most honest are not. They’re simply selling the perception of honesty.

"A salesperson can be masterful at smiling and putting you at ease, then selling you whatever he or she wants." (p. 42)
13/ "The outsized risks and bonuses for which Wall Street is known today didn’t exist under the Salomon Brothers partnership. The partners had a personal stake in the firm's success; their own money was on the line.

"But across Wall Street, partnerships were coming to an end.
14/ "Salomon's move from privately owned to publicly owned changed everything. It instilled a new Wild West culture at Salomon Brothers, ushering in an every-man-for-himself atmosphere, in which individual employees made colossal gambles for the possibility of lucrative payouts.
15/ "Traders started playing with house money, the balance sheet of the public company, rather than their personal capital. This led to higher risk tolerance and larger losses.

"A phrase on the Street described the new culture: “Heads, I win; tails, the firm loses.” " (p. 52)
16/ "The transition to a public corporation gave Meriwether the opportunity to instill an “eat-what-you-kill” bonus structure, as he fiercely protected his arbitrage-specialist crew of mathematicians and former Ivy League professors." (p.63)

More on this:
17/ ">99% of everything that I saw take place at Salomon each day was legal and ethical. Most of its eight thousand employees were decent people. Unsurprisingly, abuses seemed most prevalent at the top, with those who had the most power to wield and faced less accountability.
18/ "Would Mozer have done what he did under a partnership? Or, more to the point, could he have? The partnership had been built on a culture of togetherness and shared accountability, so people would self-monitor and make sure that others didn’t take unnecessary risks.
19/ "Those controls evaporated after the move to a public corporation, and then you could have one bad apple like Mozer—one among thousands of employees—take actions that could destroy the entire firm." (p. 74)
20/ "An efficient bond market makes borrowing cheaper, requiring fewer tax dollars to cover interest payments. Traders and salespeople—many of whom seem greedy beyond measure—contribute to society, if only as a byproduct of their actions, because the market itself is essential.
21/ "But this financial system forced new questions:

"What is the new standard for good?
"What is our own responsibility to act with integrity?
"Given human nature, should we be expected to be good if no longer constrained by the threat of losing one’s own capital?" (p. 78)
22/ "Companies with lower credit ratings couldn’t effectively get financing. These weren’t necessarily bad companies; many of them were simply companies that had taken on too much debt, enough to threaten solvency, but they were still likely to survive and to pay investors back.
23/ "Milken recognized that if someone were to focus on the outcasts that most of Wall Street didn’t want to touch, the higher fees from issuing and trading those riskier bonds could bring great profits.

"That was the idea that Milken brought to Drexel." (p. 91)
24/ But "developing a great product doesn’t mean survival is guaranteed. Drexel Burnham Lambert eventually became an ink smudge in the history books." (p. 96)

More on this (from Liar's Poker):
25/ "Hostile takeovers were a nuanced and complicated subject. The world was not black and white, despite what my youthful idealism had me believe.

"Milken had possibly revamped American business for the better by introducing a way to go after underperforming management.
26/ "Holding management accountable for profits would make America competitive in the 1990s and beyond. Milken’s junk bonds later provided the financial vehicle for the rise of the telecom industry, the cable industry, and, one could argue, the technology world.
27/ "Junk bonds changed the U.S. by funding entrepreneurs that could not get traditional funding from banks, by creating markets that didn’t exist, by creating the buy-side before there was the sell-side. It shouldn't have been just triple-A companies that had access to capital.
28/ "For better or worse, financial services became the star of the show rather than the hidden operator of the lights and curtain.

"That an Oscar would be awarded for the portrayal of a corporate raider (1987, Wall Street) would have been unimaginable only a few years prior.
29/ "Steinberg’s corporate raid attack on Disney in 1984 was one of the first moments in which the greed-is-good Wall Street culture of the ’80s stepped into the public spotlight. It provided a swift education for many Americans in this previously unfamiliar world." (p. 97)
30/ "An outside agent is often required to force change. For Disney, it was the corporate raider. To incumbent managers—and employees whose futures are uncertain—the disruptors are the bad guys. But the changes that they bring about can be necessary for the company to survive.
31/ "Yet in that shift to maximizing shareholder value, something important was lost. Business became much more impersonal and antiseptic. We ourselves no longer had to fire Bob or Sue. Now it could be blamed on a “reduction in force.”
32/ "There was now less latitude to take into account considerations beyond profitability. The phrases 'It’s nothing personal' and 'It’s just business' became common justifications for any action that may have previously been viewed as ruthless.
33/ "An change has taken place in the public perception of raiders. They aren’t even called corporate raiders anymore, but rather activist investors. They’re viewed as good guys because they keep management teams honest and motivated. Junk bonds are now 'high-yield bonds.'
34/ "How do we find a middle ground, a place where managers don’t become complacent but are also not frightened into worrying only about today’s profit at the expense of tomorrow’s happiness for customers, employees, and shareholders? Is it possible to restore balance?" (p. 105)
35/ "A majority of ownership is now passive, leaving few shareholders as the watchdogs of accountability. Most of that responsibility is in the hands of activist investors. Once considered bad guys, now they have become the conscience and protectors of public markets." (p. 106)
36/ "Investment banking at Salomon Brothers was governed under a classic hierarchy. Junior people needed to hustle to earn the attention of senior bankers. They were expected to meet every demand, no matter how unreasonable the request and how brutal the hours.
37/ "The worst feeling was when, in the middle of the night, the numbers didn’t support the arguments senior bankers expected to make at the client meeting later that day. You had two bad choices: (1) change the presentation to match the numbers or (2) fudge the numbers.
38/ "A third option was to wake your managing director with a phone call. That was never smart. So you would alter a revenue assumption here and a margin assumption there: not too aggressive but enough to get to the profitability and earnings growth needed to justify the deal.
39/ " Where is the line, you would wonder briefly, between subjective business judgment and manipulation of data? Then you’d yawn and look at the clock and reply, Who gives a s***?

"Sheer exhaustion could also lead to errors that weren’t caught until it was too late.
40/ "The models were so complicated that usually no one would notice, but big decisions were being based on erroneous information. How many deals were done or people laid off because some sleep-deprived analyst got a model wrong? Steve forgot to hit F9; 10,000 people got fired.
41/ "Email and cell phones were a great boon for efficiency and convenience but also brought increased complexity, higher expectations of analytical precision, and accelerated time frames—ingredients that didn’t promote prudent decision-making and optimal outcomes." (p. 127)
42/ "U.S. Filter’s 250+ acquisitions frequently allowed the firm to reset its accounting and paint whatever financial picture was desired.

"When the acquisition targets began to dry up, sooner or later it would become impossible to keep meeting earnings expectations.
43/ "The truth would surface; one missed quarter could kill the stock price.

"Meeting Wall Street’s earnings expectations every quarter was exhausting. Wall Street loves to finance an exciting story, but then it suffocates the entrepreneur with impossible expectations." (p. 174)
44/ "Pooling had allowed U.S. Filter and GE to go many quarters in a row beating and raising expectations. But today, years after the death of pooling, the markets continue to demand that steep, consistent growth be maintained, even though companies no longer have the tools.
45/ "That puts pressure on the short-term. To meet earnings expectations, a company may be forced to close a sale quickly, settling for worse terms, or, more concerning, to pursue less profitable business lines because they provide more immediate revenue opportunities.
46/ "Quarterly reporting requirements were instituted in 1970 due to the need for transparency for individuals without access to information available to institutions. It’s hard to imagine anyone predicting those well-intentioned changes evolving into what they are today.
47/ "Today, there are fewer public companies—half the number from the peak. Private companies forsake the benefits of going public to avoid the costs and pressures of public reporting.

"What we’ve gained in transparency, we’ve lost in broader access to investment opportunities.
48/ "The financial system seemed to require constantly stretching the truth. Ultimately, the winners would be rewarded for their discernment, while the losers would be penalized for buying a failed story." (p. 179)

The Law of Unintended Consequences:
49/ “If the board and executives admitted that they saw the risk, that would have entailed pulling the plug on revenue growth. You pull the plug on revenue growth, you pull the plug on the stock price. You pull the plug on the stock price, the entire house of cards comes down.
50/ ”To acknowledge what I’d found—that what was being booked as revenue was not quality revenue, and it shouldn’t have been booked at all—would have been to accelerate what was bound to happen anyway. That would have triggered a stock price run in the blink of an eye.” (p. 193)
51/ "In the first week of 2000, Lucent announced that it had missed its expected quarterly earnings forecast. The stock took a quick dive of 28%. Then it came to light the sales team had been less than forthright in their reporting of revenue and use of vendor financing.
52/ “Accounting magic: money from loans appeared on Lucent’s income statement as new revenue while dicey debt got stashed on its balance sheet as an allegedly solid asset.”

"It'd had $7 billion in loan commitments to customers—many of them financially unstable start-ups.
53/ ”It was a perfect storm—a stock market that was rewarding inherently bad business behavior, overpriced acquisitions, vendor financing, low-quality revenue, and a management team that didn’t understand fundamentally what it meant to run a public company.” " (p. 194)
54/ "You can’t hire an investment bank to handle your IPO if they’ve got a sell rating on you.

"While an equity analyst’s rating was grounded in real analysis, most people understood that it was something that could be influenced—part truth and part marketing." (p. 197)
55/ Related research:

"Analysts forecast in the wrong direction (more over-optimistic for stocks that will later have lower returns)."


"Analysts expect quality to perform worse than junk, but the opposite tends to be true."
56/ "Citi was a paper tiger that expended energy on managing the rule followers in areas that pertained to costs rather than risk. This left the firm with less ability to monitor and manage inappropriate behavior, as evidenced by its significant role in the financial crisis.
57/ "NY's attorney general investigated Merrill Lynch’s equity analyst Henry Blodget, finding through interviews, depositions, and 100,000 emails that he'd conspired with ML’s investment bankers to attach overly favorable ratings to clients so ML could retain their business.
58/ "This was done at the expense of regular investors who had trusted the advice of Merrill’s analysts, especially Blodget, who had attained rock-star status on the Street. Many people lost enormous amounts of their personal savings, all so Merrill could make more money.
59/ "(Other firms, of course, were doing the same thing, but Spitzer went after Merrill Lynch first.) Merrill, hit with penalties and fines, agreed to multiple reforms, and Blodget was banned from the securities industry for life." (p. 207)
60/ "People on Wall Street are often placed in compromising situations in which it’s easy to rationalize IPO spinning, putting out a positive rating to win business, or issuing excessive vendor financing to boost sales numbers, because everyone else is doing it." (p. 210)
61/ IPO spinning: "Analysts put undeserved favorable ratings on companies so bankers could land those companies’ business, then shares of those hot IPOs would be given as gifts to the executives of up-and-coming companies, who would then use that bank to execute their own IPOs.
62/ "Regular investors who trusted the bank got screwed.

"The banks were eager to be rid of Spitzer's investigation and agreed to reforms that would help ensure the integrity of research analysis, as well as fines amounting to $1.4 billion and a ban on spinning IPOs." (p. 212)
63/ "When a company gets large, it becomes too easy to justify immoral behaviors by hiding behind accepted industry practices.

"Was it any surprise that Citi was at the center of the 2008 financial crisis, given Citi’s size, global reach, and lack of centralized risk management?
64/ "It’s not easy to tame or kill these beasts once you’ve created them. Although many people are concerned that the financial supermarket firms may be too big to fail, they may also be too big to succeed." (p. 215)
65/ Dot-com bubble: "It seemed every kid could slap the dotcom suffix on the end of anything—stamps.com, shoes.com, drugstore.com, webvan.com, eToys.com, garden.com—and become a millionaire overnight.
66/ "Venture capitalists poured money in, and valuations soared.

"Most people can’t (or don't want to) recognize when they’re in a bubble. Markets and industries are cyclical by nature. During periods of innovation, bubbles form because expectations grow faster than reality.
67/ "Hope gets too far out in front of a future that doesn’t currently exist. The problem was that the structures, timing, and valuations of startups were dependent upon assumed growth and the execution of ambitious plans, and those assumptions weren’t achievable." (p. 229)
68/ "At the end of the year, every Wall Streeter bought a holiday gift—a car, a new wardrobe, a beach house. It was as if material things could make the bonus feel real. They needed to overcorrect for the loss of control in their lives by manufacturing happiness." (p. 269)
69/ "Wall Street it obliterated your ability to maintain healthy relationships. There just wasn’t time. Even basic hygiene and errands seemed impossible. You canceled plans again. You skipped another holiday with your family. You returned friend’s call seven months late.
70/ "You might get a few days’ furlough, but that respite would arrive without warning. Walking in Central Park and reading the Sunday Times seemed like the ultimate luxury. Catching a movie. Drinking a cappuccino. So this is normal life, you remembered." (p. 271)
71/ "Today, the youth of America flock to Silicon Valley the way they used to flock to Wall Street. They can make a lot of money in the tech world, but they can also convince themselves that it’s a noble pursuit. Or they target private equity, where big money still exists.
72/ "Investment banks have to pay more because they’re not only competing with the fortunes to be made in tech but also with Silicon Valley’s mantra to “make the world a better place”—regardless of whether it's actually true. Wall Street no longer attracts the best and brightest.
73/ "Even if most people who work in the financial services industry today still contribute positively to a functioning society, the increase in complexity over the past thirty years has so obscured that connection that it has become all but undetectable to Main Street." (p. 277)
74/ The Hamptons effect: "Contrarian play was advantageous. As the weekend guest, I would insist on paying for everything—drinks, dinners, tolls, gas money. That made me a coveted guest, allowing me to go wherever I wanted, whenever I wanted.
75/ "It cost me a fraction of what the others were spending to lease their summer places. As a result, I had full flexibility and none of the logistical or financial headaches associated with having my own Hamptons house." (p. 288)
76/ "In order to make college available to more people, federal student loans were created in the 1950s. Despite good intentions, it contributed to a social ill.

"Rather than reward vocational careers, we have come to define success by acceptance by a well-known college...
77/ "with a greater emphasis on brand name than actual education. The student loan market has facilitated schools’ raising the cost of education astronomically. Our national education bubble has swelled to $1.6 trillion—larger than both credit card and auto loan debts.
78/ "Two million people in our country owe more than $100,000 in student loans.

"After being told their whole lives about the importance of college, then working hard to get into the best school, they graduated shackled to debts they have a limited ability to repay." (p. 292)
79/ "We used to interact with people who didn’t share our belief system. We used to live in the same neighborhoods, watch the same sitcoms and news, share a flight, a sports experience, the grocery store.

"But we no longer intersect with that which might disrupt our narrative.
80/ "The insulation we’ve constructed leads to judging other people's priorities.

"It helps form financial bubbles: we choose to ignore government debt, unfunded pension obligations, and student debt—just as we failed to see the mortgage bubble that blew up in 2008." (p. 307)
81/ Orange County:

"Corbat dialed back to the New York office from a pay phone to report that Bob Citron had no idea what he was doing and that Salomon would not be pursuing business with the county. If one had wanted to heed the warning signs, they were there to see." (p. 315)
82/ "Orange county combined Citron's role with the job of treasurer, giving him control over the county's assets, though he had no experience in finance.

"He relied on Wall Street for guidance—most of all, Merrill Lynch—and began investing for the county in the early 1970s.
83/ "Citron wasn’t buying bonds but derivatives tied to interest rates, betting rates would continue to decline.

"That trend continued for so long that public confidence in his abilities soared. Rates didn’t need to move much for him to make/lose a great deal of money." (p. 317)
84/ "He borrowed to increase his bets. By the early ’90s—twenty years into his run as treasurer—Merrill Lynch had lured Citron into increasingly exotic securities like “step-up double inverse floaters.” For a while, things went well—one year, the derivatives yielded $344 million.
85/ "In Feb 1994, rates tilted upward, wiping out a chunk of the pool’s assets, yet Citron—again advised by Merrill Lynch—doubled down. Rates continued to move against him, but still Citron increased his bets, naïvely confident that rates would resume their long downward trend.
86/ "Wall Street gauged Citron’s losses and wanted repayment of the loans, forcing liquidation of a big chunk of the pool at distressed prices.

"Finally, on December 4, 1994, county officials took the dice away from Citron. Two days later, the county filed for bankruptcy.
87/ "No one saw it coming—except, perhaps, the bankers. Merrill Lynch had circulated internal memos about the risks in Citron’s portfolio as early as 1992. Senior people within the bank let it continue, selling him riskier and riskier derivatives and collecting fees.
88/ "Orange County had become one of Merrill’s top-five clients, as well as one of the largest purchasers of derivative securities in the world. The bank wasn’t willing to jeopardize the loss of that business, no matter how precarious and unsuitable Citron’s investments were.
89/ "Citron's lawyer argued that the 69-year-old tested at a 7th-grade level in math and had a severe learning disability and dementia. Citron himself admitted he lacked basic knowledge and had simply been following his bankers' advice. They’d led him to the slaughter." (p. 319)
90/ "Orange County had become the largest municipal bankruptcy in U.S. history.

"The financial illiteracy of the elected officials and the board of supervisors shocked us. None had an elementary grasp of derivatives. And it was their job to oversee Citron's activities." (p. 323)
91/ "Merrill Lynch was sued many times for its role and reluctantly shelled out $400 million to settle Orange County’s claim. This was a considerable penalty: a quarter of Merrill’s annual earnings. Merrill also paid $30 million to settle its criminal charges." (p. 344)
92/ " ‘You just lost billions trying to run a county hedge fund. You’re in bankruptcy because you borrowed to try to make a higher return. Now you want to issue pension obligation bonds to bet on the stock market?’ And they did. They all thought it was a great idea.” (p. 345)
93/ "A happy ending doesn’t make a decision prudent. It only reinforces the belief that risks are minimal.

"Memory of Citron’s ignorant investment strategies was already beginning to fade. Not many years later, Merrill Lynch was hired as an underwriter for the county." (p. 345)
94/ "Depending on assumptions, pension and healthcare benefits for a single fifty-year-old retiree creates a future obligation with a present value of $1.5 million.

"In times, overcommitting on pensions doesn't seem risky. City managers expected the good times would never end.
95/ “The presumption was that the rate of growth in our tax revenue would continue to increase at astronomical numbers in perpetuity. Folks did voodoo math to make things work out.”

"Everyone remembers what happened next. Beginning in 2007, the bottom fell out of the markets."
96/ "Stockton led the nation in foreclosures per capita. Property tax revenue evaporated, and soon the arena and other major development projects proved reckless, as Stockton was unable to make its debt payments. The city managers found themselves facing budget shortages.
97/ "Business closures and cessation of construction projects put people out of work, who sank deeper into poverty and, in many cases, lost their homes. The city transformed from pride, optimism, and construction cranes to resentment, despair, and homeless encampments." (p. 323)
98/ "In 2007, Stockton’s mounting pension crisis arrived. The city hadn’t reserved enough cash to cover its payments.

"Police officers moved to communities where their benefits would be less at risk of getting slashed. This led to an increase in murders and violent crimes.
99/ "Unemployment was among the highest in the nation. And the city leaders who had written and produced this tragedy would soon exit stage left and melt into the crowd.

"Stockton may be a warning, a look into our nation’s potential future.
100/ "Municipalities are not making sufficient payments to fund future obligations. Both the Illinois and New Jersey state pension systems are conservatively estimated to be less than 40% funded, with pension shortfalls of $150 billion.
101/ "Retirement systems have been promising an annual return of 7%+. But experts now project a 5% long-term expected return; when markets shifted, retirement systems didn’t adjust accordingly.

"The estimated national shortfall is somewhere between $4-20 trillion—and growing.
102/ "Why don’ retirement systems simply increase the funding requirements to match future obligations and adjust their expected returns down to 5%?

"The answer: politics. The oversight boards for most retirement systems are populated by elected officials and union leaders.
103/ "Lower expected returns would put a bigger cash burden on the municipalities, and the board members would be blamed.

"No one has political will, so everyone looks the other way, hoping the day of reckoning will not arrive until after their term on the board has finished.
104/ "Municipalities also use aggressive return assumptions to justify promising even more benefits. In the face of budgetary pressures, politicians bridge the gap of a cash shortfall by offering employees more retirement and health benefits rather than higher wages or salaries.
105/ “To a politician, 60% funded is as good as 100% funded, since the day of reckoning won’t arrive until after they leave office.”

"Pension math is something politicians either don’t understand or choose not to understand. This happening right in front of our eyes." (p. 339)
106/ "In mid-2018, the Social Security system went cash-flow negative: more cash is being distributed to retirees than is being taken in.

"Large public plans currently have just 70% of what they need to pay future benefits to their retirees; some states are as low as 35% funded.
107/ "Puerto Rico reported that its nonuniform government pension plan was less than 1% funded. There will come a time when money simply doesn’t exist to provide for pensioners. People who worked entire careers toward collecting their retirement may get a lot less than promised.
108/ "Nobody will dodge the fallout from an entire portion of the population being forsaken. At a minimum, it’ll have implications on growth and stability. At its worst, given the size of the problem, it may lead to a breakdown of our communities and societal structures." (p.352)
109/ "There’s an increasingly common saying about the United States: that we’re going to end up being one big retirement system with an army. Our pension and healthcare obligations will crowd out everything else government is intended to do.
110/ "We’ll need to cut spending on infrastructure, services, education, police, and fire departments. Taxes will need to be raised; borrowing will increase, which will limit growth and may put us in a downward cycle. This is the crisis within the next twenty years." (p. 359)

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What is the best way to manage an absolute return portfolio?

"As an AI language model, I do not have personal opinions, but here are some general guidelines for managing an absolute return portfolio."

chat-gpt.org/chat Image
2/ Do you hedge out market beta in order to make the portfolio more risk balanced?

"Yes, hedging out market beta can help.... This can be achieved through various methods such as shorting market index futures or investing in negatively correlated assets." Image
3/ What are some examples of negatively correlated assets that offer positive CAPM alphas?

"Some examples of negatively correlated assets that have historically offered positive CAPM alphas include gold and equities, government bonds and equities, and REITs and equities." Image
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