Marc Rich

When I saw Sam Mendes’ Skyfall, I focused on the island scene where the villain Raoul Silva (Javier Bardem) tells James Bond (Daniel Craig) about Silva’s ability to intervene in geopolitical events, such as to affect election outcomes. It’s a classic scene about geopolitical risk arbitrage.

 

Two weeks ago I bought Daniel Ammann’s King of Oil (New York: St. Martin’s Press, 2010) and A. Craig Copetas’s Metal Men (E-Reads, 2010) about the legendary commodities trader Marc Rich. I remembered Bill Clinton’s last-minute pardon of Rich, whilst I was editing the alternative news website Disinformation. Now, over a decade later, I had a new appreciation of Rich’s oligarchical, market-making career.

 

I didn’t know Rich had passed away the week beforehand. I missed this Economist obituary:

 

From there, with cat-like tread, Mr Rich found his way round any political or moral obstacle. He sold Soviet oil to apartheid South Africa, despite a UN embargo, and between 1979 and 1994 made profits of around $2 billion there. He sent Soviet and Venezuelan oil to Cuba in exchange for sugar, ignoring America’s ban on trade. He sold on the global market surplus Iranian oil that had flowed to Israel down a secret pipeline, and kept the arrangement going seamlessly despite the Iranian revolution of 1979, another embargo, and the American hostage crisis. The Iranians respected their contracts, he explained. They could not sell their oil, so he bought and sold it for them, using shell companies wherever necessary. Keeping well below the radar, as he always did, he was soon the world’s largest independent oil-trader, with a turnover in 1980 of $15 billion.

 

John Allen Gay relied on The Economist obituary for his National Interest profile of Rich:

 

The quintessential Davos man was Marc Rich. Born in Belgium, which he left for the United States to escape the Nazis, he revolutionized the world trade in commodities. Markets emerged where none had existed—most consequentially, for oil. Breaking the grip of the big producers required creativity, both in business and in law. He carried out transactions that a more nationalistic—or merely more ethical—trader would have spurned.

 

Rich is perhaps a real-life model for Skyfall‘s Raoul Silva. The Economist obituary — and Ammann and Copetas’s books on Rich — are filled with the kind of juicy, biographical details which are necessary to trade the commodities and foreign exchange markets, but which are often missing from trading books.

Errors In Quantitative Models & Forecasting

Could the roots of the 2007 subprime crisis in collateralised debt obligations (CDOs) and residential mortgage-backed securities (RMBS) lie in financial analysts who all used similar assumptions and forecasts in their quantitative models?

Barron’s Bill Alpert argues so
, pointing to a shift of investment styles after the 2000 dotcom crash from sector-specific, momentum and growth stocks to value investing.  Investment managers who prefer the value approach then constructed their portfolios with ‘stocks that were cheap relative to their book value.’  In other words, the value investors exploited several factors — the gaps in asset valuation, asymmetries in public and private information sources, price discovery mechanisms and market participants — which contributed to mispriced stocks compared to their true value.

However, the value investing strategy had a blindspot: many of the stocks selected for investment portfolios also had a high exposure to credit and default risk.  The 2007 subprime crisis exposed this blindspot, which adversely affected value investors whose portfolios had stocks with a high degree of positive covariance.

Alpert quotes hedge fund manager Rick Bookstaber who believes that financial engineers have accelerated crises and systemic risks via the complex dynamics of new futures contracts, exotic options and swaps.  These new financial instruments create interlocking markets (capital, commodities, debt, equity, treasuries) which have the second-order effects of larger yield curve spreads and trading volatility.  Alpert and Bookstaber’s views echo Susan Strange‘s warnings a decade ago of ‘casino capitalism’  and ‘mad money’ as unconstrained forces in the international political economy.

Quantitative models also failed to foresee the 2007 subprime crisis due to excessive leverage, difficulties to achieve ‘alpha’ or above-market returns in market volatility, and the separation of risk management from the modelling process and testing.  Other commentators have raised the first two errors, which have led to changes in portfolio construction and market monitoring.  Nassim Nicholas Taleb has built a second career on the third error, with his Black Swan conjecture of high-impact events, randomness and uncertainty (see Taleb’s Long Now Foundation lecture The Future Has Always Been Crazier Than We Thought).

Alpert hints that these three errors may lead to several outcomes: (1) a new ‘arms race’ between investment managers to find the new ‘factors’ in order to construct resilient investment portfolios; (2) the integration of Taleb’s second-order creative thinking and risk management in the construction of financial models, in new companies and markets such as George Friedman’s risk boutique Stratfor; and (3) a new ‘best of breed’ manager who can make investment decisions in a global and macroeconomic environment of correlated and integrated financial markets.