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In
An Uncertain World: Tough Choices from Wall Street to Washington by
Robert E. Rubin Rating: ••• (Recommended) |
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Reality Political
buffs looking for a cabinet-level kiss and tell will have to look elsewhere
because former Treasury Secretary Bob Rubin’s book, In An
Uncertain World, is all about thinking, policies, and the reality that
upsets everything. After an exciting opening chapter on a financial crisis in
The
analytic mind-set I further developed doing arbitrage led me to look for
inefficiencies or discrepancies elsewhere in the relative value of different
related securities, and thus to the arcane business of stock options. Like
arbitrage, options trading is a risk-reward, probability-based business,
although more directly quantitative. At the time, even most people on Wall
Street knew little about it. I read quite a bit on the topic, including a
newsletter about opportunities in warrants. A warrant, similar to a
"call option," is a security that conveys the right to purchase a
share of stock at a set price for some period of time, usually a certain
number of years. One
article in the newsletter said that warrants in Phillips Petroleum
were overpriced—based on valuation models—relative to the price of the
Phillips stock. That created an opportunity in what is often called relative
value arbitrage or relationship trading. Relative value arbitrage means going
long one instrument—a security or a derivative—and short another related
instrument, when one of these instruments is considered undervalued relative
to the other. The bet you’re making is that the prices of the two instruments
will return to their proper relationship and provide a profit from that
movement. The instruments might be a common stock or bond and a
"derivative"—an option or future that is convertible into the
underlying stock or bond on some basis. Not yet a partner at that point, I wrote a
complicated memo recommending that we go short the Phillips warrants and long
the common stock, betting that the price of the warrants would go down
relative to the price of the stock. I gave the memo to L. Jay, who agreed
with the recommendation. The warrants were overpriced relative to the stock,
but the short position could still lose money if the stock price rose, so
that the long position was an essential hedge. With that hedge, one would
make a profit regardless of what happened to the price of the stock, as long
as the discrepancy in relative value disappeared. L. Jay gave my memo to Gus,
and Gus called me in. "Ahh, I don't
want to do all that," Gus said of my proposal to hedge. Let's just go
short the warrants." „ "Gus," I said, "you know we have to be
hedged." Gus responded with a five-word sentence
conveying that he didn't care about hedging, didn't care about my memo, and
didn't care about explaining the matter—because if I didn't know this stuff,
I shouldn't be at the firm in the first place. I
went back to L. Jay, concerned about what to do. L. Jay said, "You
better just go short the warrants, if that's what Gus wants to do." So
we went short the Phillips warrants, and fortunately the stock didn't run up
while we were holding the position. The
same thinking that drew me to that transaction—and a lifelong tendency to
restlessly reach into new areas—led me to other kinds of options. Stock
options—instruments that allow, but do not require,
an investor to buy shares at a prearranged price during a fixed period of
time—had long existed but had always been extremely illiquid. To buy
an option, you went to one of several small put-and-call houses, which ran
ads in the newspapers and had a slightly questionable reputation. They traded
options "over the counter," which meant not listed on any exchange.
Prices were nontransparent, to say the least. I thought that perhaps relative
value arbitrage transactions could be done against these over-the-counter
options. As I became increasingly involved, I saw that Goldman Sachs might
well do what the put-and-call houses did—trade stock options directly with
our clients, other brokerage firms, and the options dealers themselves. My proposal met some resistance at the
firm. During the Depression, stock options had led to vast losses on Wall
Street. As a result, I was told, Sidney Weinberg had a rule against Goldman
Sachs being involved with them. But by the time I first discussed this with
Gus, Mr. Weinberg had died. At the end of our conversation, Gus said, in his
gruff way, "If you want to get involved with options, go ahead,"
and he got my proposal approved by the firm's management committee. Options are one type of derivative—a
security, such as a warrant or a future, whose price depends on the price of
an underlying instrument like a common stock or bond—and this was the
beginning of Goldman Sachs's trading in derivatives on securities. That business eventually became massive at our firm and across
Wall Street as ever more new instruments developed that were based on
equities, debt, and foreign exchange. But at the time, the options business
was still at a primitive stage. Traders grasped that prices of options should
reflect the volatility of the stock but as yet had no system for calculating
values. However, an unpublished paper by Fischer Black and Myron Scholes was circulating that detailed a valuation formula
based on volatility. For their work on option pricing, Scholes
and another colleague, Robert Merton, won a Nobel Prize in 1997. Sadly,
Fischer Black died too soon to share it. The now famous Black-Scholes formula was my first experience with the
application of mathematical models to trading, and I formed both an
appreciation for and a skepticism about models that
I have to this day. Financial models are useful tools. But they can also be
dangerous because reality is always more complex than models. Models
necessarily make assumptions. The Black-Scholes
model, for example, assumes that future volatility in stock prices will resemble
past volatility. I later recruited Fischer away from a full professorship at
MIT to Goldman, and he subsequently told me that his Goldman experience
caused him to develop a more complex view of both the value and the
limitation of models. But a trader could easily lose sight of the
limitations. Entranced by the model, a trader could easily forget that
assumptions are involved and treat it as definitive. Years later, traders at
Long-Term Capital Management, whose partners included Scholes
and Merton themselves, got into trouble by using models without adequately
allowing for their shortcomings and getting heavily overleveraged. When
reality diverged from their model, they lost billions of dollars, and the
stability of the global financial system might have been threatened. What made options trading possible on a
large scale was the Chicago Board Options Exchange, the first listed market
for stock options, which opened in 1973. The key was the creation of
standardized terms for the listed options and a clearing system, so that
options could trade in a secondary market. I remember Joe Sullivan, the first
head of the CBOE, coming to Goldman to tell me about his plans. I took Joe to
meet Gus, who listened to him and said, with a twinkle in his eye, that this
was just a new way to lose money, and then offered his support. I joined the
founding board. Joe called the day before the CBOE first opened to say that
he was afraid nobody would show up to trade. In fact, 911 contracts traded
the first day, on 16 different stocks. Within a relatively short period,
options trading turned into a genuinely liquid market and led to the creation
of larger markets in listed futures on stock indices and debt. I began as a Goldman partner during a
period of ups and downs for Wall Street. The year 1973 was the first year the
firm had lost money in many years, and 19 74 wasn't much better. Our chief
financial officer, Hy Weinberg, told me that we
junior partners would be unlikely to ever do as well financially as the older
partners had because there would never be another period as good as the one
that had just passed. That seemed highly plausible at the time, but turned
out not to be the case. During one particular bad stretch in 1973-74, the
stock market fell 45 percent from its high. We had very large losses in risk
arbitrage and block trading. We were still holding the acquiree
stocks in several deals that broke up—contrary to our usual practice—because
they seemed so badly undervalued. But as the market continued declining, these
stocks' Prices kept falling. We thought our positions would eventually come
back, and so we held on. But sometimes, even if the market has
gone way down and positions seem cheap, holding on may not make sense. I
remember a customer who had a big position in a commodities arbitrage
transaction. He bought soybean mash and sold soybeans because the mash was
cheap relative to the soybeans. He expected to profit when the inefficiency
corrected and prices converged. Instead, the spread widened and he had to put
up more cash margin to creditors. As the spread kept widening, he ran out of
cash and couldn't put up more margin, so his positions were liquidated to
meet obligations. Eventually the prices did converge. But by that time our
client was bankrupt. As John Maynard Keynes once reportedly said,
"Markets can remain irrational longer than you can remain solvent."
Psychological and other factors can create distortions that last a long time.
You can be right in the long run and dead in the short run. Or you can be
wrong in your judgments about value, for any of a whole host of possible
reasons. In that
1973-74 slump, we, like the trader with the soybean mash,
were overextended relative to our staying power. In our case, the issue
wasn't solvency but the limits on our tolerance for loss. I finally went to
Gus. We reexamined the merits of each of our holdings and how much risk we
were willing to accept going forward, and we decided to sell about half of
our positions. Looking back at that episode, I realize
that we hadn't really been reevaluating our positions as the economic and
market outlook changed. Holding an existing investment is the same as making
it again. When markets turn sour, you have to forget your losses to date and
do a fresh expected-value analysis based on the changed facts. Even if the
expected values remain attractive, the size and risk of your portfolio must
be at levels you can live with for a long time if conditions remain
difficult. Praying over your positions—a frequent tendency in trading rooms
during bad times—isn't a sensible approach to coping with adversity. Around the time L. Jay Tenenbaum
retired from Goldman Sachs in 1976, Ray Young, who was in charge of equities
sales at the firm, gave me some advice. He said that now that L. Jay was
leaving, I had to make a choice. I could continue to act in the manner I had
developed working in a trading environment—focusing intently on my business,
being short with people, and projecting an impersonal attitude. If so, Ray
predicted, I would continue as a successful arbitrageur. But as an
alternative, I could start thinking more about the people in the trading room
and in sales—about their concerns and views—and how to enable them to be
successful. In that case, Ray said, I wouldn't be limited to arbitrage but
could become more broadly involved in the life of the firm. Ray Young's advice pointed me toward a
whole new world that I hadn't thought much about. My tendency to be abrupt
and peremptory—characteristic of Wall Street traders of that era—is exemplified
by a typical episode: a colleague from investment banking came to ask me
about the market impact of a deal she was working on. She had trouble
explaining the deal to me, and I told her I was busy and didn't understand
how someone could work at Goldman Sachs and not understand some basic
corporate finance. I dismissively suggested she go back upstairs and return
when she was properly prepared. Ray made me understand that that kind of
attitude limited how far I would go at the firm and how interesting my career
there would be. My general experience in life has been
that most people can change only within a narrow range, if at all. Many
people can acknowledge criticism and advice, but relatively few internalize
it and alter their behavior in a significant way. Sometimes someone can
change in one respect but not in another. I was involved in many discussions
at Goldman over the years that centered on the question of whether a person
who was highly capable professionally, but limited in some way, could grow to
assume broader responsibilities. Often the limitations revolved around the
ability to work effectively with colleagues and subordinates. I've
often asked myself why this advice affected me so much. Perhaps I Simply
responded when someone whom I respected, who clearly had my best interests at
heart, raised a problem I hadn't thought about and opened up new vistas.
Judy's view was that the harshness of manner Ray critiqued was a superficial
attribute. Most likely, both reasons were true. In any case, my mind-set did
change and I began to listen to people better, to try to understand their
problems and concerns, and to more appropriately assess and value their
views. And as I’ve since said to others, this not only had the effects in my
business career that Ray had suggested but gave me something I hadn't
expected, a new satisfaction in the accomplishments of others. I also connected what Ray told me with
a comment that Richard Menschel, another more
senior colleague who took a supportive interest in my career, had made a
couple of years after I arrived at Goldman. Dick said that early in your
career you may be concerned about bringing strong, younger people into your
world. For some, that feeling remains; they continue to think that bright,
more junior people threaten to outshine them in some way. But after a certain
point, Dick predicted, I would become comfortable enough in my own position
to eagerly seek out extremely capable young people for the arbitrage
department. He was right. Initially I felt uneasy
about bringing a strong junior associate into the arbitrage department. But
soon that changed and I wanted effective, aggressive people working with me
in order to get the job done better. Moreover, as I found in everything I did
thereafter, sharing credit with others didn't mean less credit for me. To the
contrary. I got credit not only for the results being better, but also for
sharing the credit. I also enjoyed the recognition given to people I worked
with. Dick was right that a lot of otherwise successful people never figure
this out. They view smart junior associates as a threat rather than as a
reflection of their own capabilities as managers. I'd never given one second of thought
to management as such. Once I began to think about these issues, however, I
found them engrossing. How do you get people to work well with one another?
How do you attract and keep strong people? How do you motivate them to do
their best? How do you get a whole organization to be strategically dynamic
and to act on difficult issues? I'd never been to business school or even
read any books about management, but I developed views on all of this through
experience. If
those questions intrigue you, continue reading In An
Uncertain World and discover how Rubin approached answers. Steve
Hopkins, January 22, 2004 |
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ã 2004 Hopkins and Company, LLC The recommendation rating for
this book appeared in the February 2004
issue of Executive Times URL for this review: http://www.hopkinsandcompany.com/Books/In
An Uncertain World.htm For Reprint Permission,
Contact: Hopkins & Company, LLC • E-mail: books@hopkinsandcompany.com |
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