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You Can't Become Rich In Your Pocket Until You Become Rich In Your Mind | ||||
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Since your investment in WCOM is worth $100,000, you can borrow up to this amount from your brokerThe Lure of Illegal Leverage Because of the leverage possible with the purchase, sale, or mere possession of options, they sometimes attract people who arent content to merely play the slots but wish to stick their thumbs onto the spinning disks and directly affect the outcomes. One such group of people are CEOs and other management personnel who stand to reap huge amounts of money if they can somehow contrive (by hook, crook, or, too often, by cooking the books) to raise their companies stock price. Even if the rise is only temporary, the suddenly valuable call options can earn them tens of millions of dollars. This is the luxury version of pump and dump that has animated much of the recent corporate malfeasance. (Such malfeasance might make for an interesting novel. On public television one sometimes sees a fantasia in which diverse historical figures are assembled for an imaginary conversation. Think, for example, of Leonardo da Vinci, Thomas Edison, and Benjamin Franklin discussing innovation. Sometimes a contemporary is added to the mix or simply paired with an illustrious precursor-maybe Karl Popper and David Hume, Stephen Hawking and Isaac Newton, or Henry Kissinger and Machiavelli. Recently I tried to think with whom I might pair a present-day ace CEO, investor, or analyst. There are a number of books about the supposed relevance to contemporary business practices of Plato, Aristotle, and other ancient wise men, but the conversation Id be most interested in would be one between a current wheeler-dealer and some accomplished hoaxer of the past, maybe Dennis Koslowski and P. T. Barnum, or Kenneth Lay and Harry Houdini, or possibly Bernie Ebbers and Elmer Gantry.) Option leverage works in the opposite direction as well, the options-fueled version of short and distort. One particularly abhorrent example may have occurred in connection with the bombing of the World Trade Center. Just after September 11, 2001, there were reports that Al Qaeda operatives in Europe had bought millions of dollars worth of puts on various stock indices earlier in the month, reasoning that the imminent attacks would lead to a precipitous drop in the value of these indices and a consequent enormous rise in the value of their puts. They may have succeeded, although banking secrecy laws in Switzerland and elsewhere make that unclear. Much more commonly, people buy puts on a stock and then try to depress its price in less indiscriminately murderous ways. A stockbroker friend of mine tells me, for example, of his fantasy of writing a mystery novel in which speculators buy puts on a company whose senior management is absolutely critical to the success of the company. The imaginary speculators then proceed to embarrass, undermine, and ultimately kill the senior management in order to reap the benefit of the soon-to-be valuable puts. The WorldCom chatroom, home to all sorts of utterly baseless rumors, once entertained a brief discussion about the possibility of WorldCom management having been blackmailed into doing all the ill-considered things they did on pain of having some awful secrets revealed. The presumption was that the blackmailers had bought WCOM puts. Intricacies abound, but the same basic logic governing stock options is at work in the pricing of derivatives. Sharing only the same name as the notion studied in calculus, derivatives are financial instruments whose value is derived from some underlying asset-the stock of a company, commodities like cotton, pork bellies, and natural gas, or almost anything whose value varies significantly over time. They present the same temptation to directly change, affect, or manipulate conditions, and the opportunities for doing so are more varied and would also make for an intriguing business mystery novel. The leverage involved in trading options and derivatives brings to mind a classic quote from Archimedes, who maintained that given a fulcrum, a long enough lever, and a place to stand, he could move the earth. The world-changing dreams that created the suggestively named WorldCom, Global Crossing, Quantum Group (George Soros companies, no stranger to speculation), and others may have been similar in scope. The metaphorical baggage of levers and options is telling. One can also look at seemingly non-financial situations and discern something like the buying, selling, and manipulating of options. For example, the practice of defraying the medical bills of AIDS patients in exchange for being made the beneficiary of their insurance policies has disappeared with the increased longevity of those with AIDS. However, if the deal were modified so that the parties put a time limit on their agreement, it could be considered a standard option sale. The option buyer would pay a sum of money, and the patient/option seller would make the buyer the beneficiary for an agreed-upon period of time. If the patient happens not to expire within that time, the option does. Maybe another mystery novel here? Less ghoulish variants of option buying, selling, and manipulating play an important role in everyday life from education and family planning to politics. Political options, better known as campaign contributions to relatively unknown candidates, usually expire worthless after the candidate loses the race. If he or she is elected, however, the call option becomes very valuable, enabling the contributor to literally call on the new officeholder. There is no problem with that, but direct manipulation of conditions that might increase the value of the political option is generally called dirty tricks. For all the excesses options sometimes inspire, they are generally a good thing, a valuable lubricant that enables prudent hedgers and adventurous gamblers to form a mutually advantageous market. Its only when the option holders do something to directly affect the value of the options that the lure of leverage turns lurid. Short-Selling, Margin Buying, and Familial Finances An old Wall Street couplet says, He who sells what isnt hisn must buy it back or go to prison. The lines allude to short-selling, the selling of stocks one doesnt own in the hope that the price will decline and one can buy the shares back at a lower price in the future. The practice is very risky because the price might rise precipitously in the interim, but many frown upon short-selling for another reason. They consider it hostile or anti-social to bet that a stock will decline. You can bet that your favorite horse wins by a length, not that some other horse breaks its leg. A simple example, however, suggests that short-selling can be a necessary corrective to the sometimes overly optimistic bias of the market. Imagine that a group of investors has a variety of attitudes to the stock of company X, ranging from a very bearish 1 through a neutral 5 or 6 to a very bullish 10. In general, who is going to buy the stock? It will generally be those whose evaluations are in the 7 to 10 range. Their average valuation will be, lets assume, 8 or 9. But if those investors in the 1 to 4 range who are quite dubious of the stock were as likely to short sell X as those in the 7 to 10 range were to buy it, then the average valuation might be a more realistic 5 or 6. Another positive way to look at short-selling is as a way to double the number of stock tips you receive. Tips about a bad stock become as useful as tips about a good one, assuming that you believe any tips. Short-selling is occasionally referred to as selling on margin, and it is closely related to buying on margin, the practice of buying stock with money borrowed from your broker. To illustrate the latter, assume you own 5,000 shares of WCOM and its selling at $20 per share (ah, remembrance of riches past). Since your investment in WCOM is worth $100,000, you can borrow up to this amount from your broker and, if youre very bullish on WCOM and a bit reckless, you can use it to buy an additional 5,000 shares on margin, making the total market value of your WCOM holdings $200,000 ($20 x 10,000 shares). Federal regulations require that the amount you owe your broker be no more than 50 percent of the total market value of your holdings. (Percentages vary with the broker, stock, and type of account.) This is no problem if the price of WCOM rises to $25 per share, since the $100,000 you owe your broker will then constitute only 40 percent of the $250,000 ($25 x 10,000) market value of your WCOM shares. But consider what happens if the stock falls to $15 per share. The $100,000 you owe now constitutes 67 percent of the $150,000 ($15 x 10,000) market value of your WCOM shares, and you will receive a margin call to deposit immediately enough money ($25,000) into your account to bring you back into compliance with the 50 percent requirement. Further declines in the stock price will result in more margin calls. Im embarrassed to reiterate that my devotion to WCOM (others may characterize my relationship to the stock in less kindly terms) led me to buy it on margin and to make the margin calls on it as it continued its long, relentless decline. Receiving a margin call (which often takes the literal form of a telephone call) is, I can attest, unnerving and confronts you with a stark choice. Sell your holdings and get out of the game now or quickly scare up some money to stay in it. My first margin call on WCOM is illustrative. Although the call was rather small, I was leaning toward selling some of my shares rather than depositing yet more money in my account. Unfortunately (in retrospect), I needed a book quickly and decided to go to the Borders store in Center City, Philadelphia, to look for it. While doing so, I came across the phrase staying in the game while browsing and realized that staying in the game was what I still wanted to do. I realized too that Schwab was very close to Borders and that I had a check in my pocket. My wife was with me, and though she knew of my investment in WCOM, at the time she was not aware of its extent nor of the fact that Id bought on margin. (Readily granting that this doesnt say much for the transparency of my financial practices, which would not likely be approved by even the most lax Familial Securities Commission, I plead guilty to spousal deception.) When she went upstairs, I ducked out of the store and made the margin call. My illicit affair with WCOM continued. Occasionally exciting, it was for the most part anxiety-inducing and pleasureless, not to mention costly. I took some comfort from the fact that my margin buying distantly mirrored that of WorldComs Bernie Ebbers, who borrowed approximately $400 million to buy WCOM shares. (More recent allegations have put his borrowings at closer to $1 billion, some of it for personal reasons unrelated to World.Com. Enrons Ken Lay, by contrast, borrowed only $10 to $20 million.) When he couldnt make the ballooning margin calls, the board of directors extended him a very low interest loan that was one factor leading to further investor unrest, massive sell-offs, and more trips to Borders for me. Relatively few individuals short-sell or buy on margin, but the practice is very common among hedge funds-private, lightly regulated investment portfolios managed by people who employ virtually every financial tool known to man. They can short-sell, buy on margin, use various other sorts of leverage, or engage in complicated arbitrage (the near simultaneous buying and selling of the same stock, bond, commodity, or anything else, in order to profit from tiny price discrepancies). Theyre called hedge funds because many of them try to minimize the risks of wealthy investors. Others fail to hedge their bets at all. A prime example of the latter is the collapse in 1998 of Long-Term Capital Management, a hedge fund, two of whose founding partners, Robert Merton and Myron Scholes, were the aforementioned Nobel prize winners who, together with Fischer Black, derived the celebrated formula for pricing options. Despite the presence of such seminal thinkers on the board of LTCM, the debacle roiled the worlds financial markets and, had not emergency measures been enacted, might have seriously damaged them. (Then again, there is a laissezfaire argument for letting the fund fail.) I admit I take a certain self-serving pleasure from this story since my own escapades pale by comparison. Its not clear, however, that the LTCM collapse was the fault of the Nobel laureates and their models. Many believe it was a consequence of a perfect storm in the markets, a vanishingly unlikely conf l uence of chance events. (The claim that Merton and Scholes were not implicated is nevertheless a bit disingenuous, since many invested in LTCM precisely because the fund was touting them and their models.) The specific problems encountered by LTCM concerned a lack of liquidity in world markets, and this was exacerbated by the disguised dependence of a number of factors that were assumed to be independent. Consider, for illustrations sake, the likelihood that 3,000 specific people will die in New York on any given day. Provided that there is no connection among them, this is an impossibly minuscule number-a small probability raised to the 3,000th power. If most of the people work in a pair of buildings, however, the independence assumption that allows us to multiply probabilities fails. The 3,000 deaths are still extraordinarily unlikely, but not impossibly minuscule. Of course, the probabilities associated with possible LTCM scenarios were nowhere near as small and, according to some, could and should have been anticipated. Are Insider Trading and Stock Manipulation So Bad? Its natural to take a moralistic stance toward the corporate fraud and excess that have dominated business news the last couple of years. Certainly that attitude has not been completely absent from this book. An elementary probability puzzle and its extensions suggest, however, that some arguments against insider trading and stock manipulation are rather weak. Moral outrage, rather than actual harm to investors, seems to be the primary source of many peoples revulsion toward these practices. |
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