Money Changes Everything

But You Might Not Like What You Get

"The filthy lucre", by helmet13, with Creative Commons licence (Attribution 2.0 Generic)Money can fool the most rational of people, lure them into the most egregious assumptions about wealth, how to attain it, and the ways it which it should be maintained. Take, for instance, the investors in Bernard Madoff’s Giant Lie, who really didn’t see it coming despite at least two respected analysts specifically noting that no hedge fund – or any other investment vehicle for that matter – could maintain almost identical returns, month in, month out. In retrospect the danger seems obvious. Perhaps those with less money to throw around have more of the wisdom that comes with caution, but hindsight is a beguiler and we’ll never really know.

In the late 1990s no-one questioned the capacity of Long-Term Capital Management to drag in bumper, low-risk returns with 50 times more debt than it had in assets. With two respected financial economists on board, a gaggle of market boffins who had defected from Salomon Brothers investment bank and an overwhelming arrogant belief that the market would work the way it should and no other, the company even managed to lure investment from central banks around the world. The returns were truly staggering for a while . . .

Another cautionary tale of American excess about to wind up, you might think. But, no, it’s bigger than that. In late 1998 Russia defaulted on its debt denominated in rubles, a few arbitrage trades went bad, and one small hedge fund came within a weekend of destroying the world’s financial system.

Hang Glider, by J0nB0n, with Creative Commons Licence (Attribution-Noncommercial-Share Alike 2.0 Generic)So, debt and arrogance dazzle – that’s the unfortunate nature of investment, the turbid mainstream of making money and making it work. Relatively few people make money investing, the risks are always as high as the returns and homespun wisdom is decidedly absent from many wealth-creation schemes. Even my mother knows that, and tells me I should take out a mortgage to buy a property. But I’m not particularly interested in debt and am furiously studying how to invest wisely. My mother counters with her argument that the stock market is, well, evil, and it’s hard to argue with that these days. But she stumbles and uses the example of Storm Financial, an investment advice company in my home town of Townsville. Now, I know something about that.

Storm Financial is the little investment advisory that could. The two principals are, or at least were, worth around A$450 million, having dragged their money-making expertise out of my metaphorical backyard and bought up a few similar companies along Australia’s east coast. Now, the ever-present cynic in me complains that no couple (the principals are married) from Townsville is ever going to be worth that much, and given that they’re currently under investigation by the Australian Securities and Investment Commission it probably was too good to be true.

This is how they worked, why my mother is wrong, and why it’s so easy to link Storm Financial back to Long-Term Capital Management and the like, even though it isn’t an active investor of client funds. One of the easiest to understand investment concepts is that a relatively small amount of capital will bring no substantial gain, regardless of how high the interest rate or expected rate of return. Fifty percent might sound fantastic, but if you only have $100 to invest you won’t be able to buy much more when your cash comes back. You could save for a while and invest a larger amount. That would be sensible. Or, you could just borrow huge wads of cash.

Don't Panic! By by hufse, with Creative Commons licence (Attribution-Noncommercial-Share Alike 2.0 Generic)Now anyone with a sense of financial history will know that the first people who went to the wall in the stock market crash of 1929 were margin traders, which is a spiffy name for those who make a deposit with a brokerage and then borrow up to 50% of the purchase price of a stock from the broker. The broker charges interest, and the investor triples his or her risk. There is the obvious risk of the stock falling below the purchase price, and the slightly less obvious risk of having to pay interest on the loan in a bad market, and then the killer – once the price falls to certain level, called the maintenance margin, the broker will ask you to increase your deposit.

Of course, if the market is plummeting this margin could well be the end of your money, and just about everything else you own.

Now this isn’t exactly what Storm Financial did – banks took on the margin lending role, which is just as surely a reasonable position for a bank as any other form of debt making in which it is involved. But Storm Financial encouraged its clients to go into debt to the tune of 60% of their current liquidity. So, the deal was, if you have a million to invest you should borrow to increase those funds to $1.6 million and then invest. Wait for a while, repeat the process. Not all investors took up the offer, but enough did. With management fees or around 7% of the total capital invested, Storm Financial would have had a very lucrative little earner.

But, you guessed it, the market dived. Usually that would have been advantageous for Storm clients, because the proffered investment strategy was one of buying undervalued stocks in a declining market and selling them over the longish term when they were overvalued. That, incidentally, is a very sound position – similar to the value investment strategy espoused by Benjamin Graham that created the basis for his wealth and of Warren Buffet’s colossal fortune.

Cash Paid Out No Sale, by Thomas Hawk, with Creative Commons licence (Attribution-Noncommercial 2.0 Generic)But the market kept going down and the Storm advised its clients to cash out of stocks because they weren’t likely to recover. No value investors here – not even rational market observers, it seems. The cash-out option might appear to be sensible, but if you were a diamond buyer, would you buy fewer diamonds just when the price started to make them very affordable for a while? Probably not.

So, something wasn’t quite right. At around the same time the banks were issuing margin calls on Storm clients, increasing their debt.  Storm Financial is still around and most of its investors are in it for the long run, but about 450 of its cashed-out former clients are completely overwhelmed with new debt and reports have put the  total margin-call bill at around A$1 billion.

With Long-Term Capital Management the partners took some of the horrendous debt (but a group of banks took on the multi-billions of excess) and the investors lost it all. This time only the investors took it in the eye; hence the investigation I mentioned earlier.

The Pied Piper Of Hamelin, by ®DS, with Creative Commons licence (Attribution-Noncommercial-Share Alike 2.0 Generic)Storm Financial hasn’t brought the world to its knees; it hasn’t even bothered Townsville very much. But it has shown how ready to follow the scent of money made over and over again that people can be, and how likely they are to become irrational in doing so. To contradict my mother, debt is pure risk – a bet on today that rarely pays out tomorrow. Admittedly, to recall her argument, a mortgage is less troublesome than a margin debt, but try telling that to those who heard the tune of the subprime pipers as they whistled their way through suburbia.

Toot-peep, money for free. Toot-peep, if only you believe.

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4 Responses to Money Changes Everything

  1. Bill Cash says:

    Great stuff! Thanks!

  2. bog loser says:

    I’ve lost 12 million dollars because of this mob….. I hope your are having lots of fun at my expense… making light of the situation may make you feel good…but you are no better than the likes on Emannual & Jule Cassimatis…. have a great 2009… I know mine will suck…thanks for nothin

  3. Mike Poole says:

    Thanks for your comment. The post was in no way meant to be humorous, and I’m surprised that you seem to think I had any fun with it. The point is that no investment is without risk (not volatility, but the likelihood of losing everything), and that debt is the highest form of risk. It magnifies other forms of risk such as market decline – which is why I focused on margin buying in the second half.

    I did point out twice that the company was under investigation by the ASIC, and it seems to have been excessively self focused (I didn’t mention the failed IPO) for what is supposed to be an advisory company.

  4. Great Article. Graham is considered the first proponent of Value Investing, and I am a great fan of Benjamin Graham myself, I follow most of his rules, I started a site on value investing. The site mainly screens out Low PE, Low PB, High Divident Yeild. Low PB+ High Div etc.. for the India markets. I really appreciate the effort you have put in your blog. Best Wishes.

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