With all the current volatility, huge losses and uncertainty in the markets, a friend recommended reading “A Short History of Financial Eurphoria” by John Kenneth Galbraith. So I picked it up and read through the history of euphoric moments in market history, starting, of course, with Tulipmania (tulip bulbs, what were they thinking?) and reading up to the Crashes of 1929 and 1987. It’s interesting to see similarities to what’s happening in today’s markets. In discussing common denominators, Galbraith notes that “Contributing to and supporting this euphoria are two further factors little noted in our time or in past times. The first is the extreme brevity of the financial memory. In consequence, financial disaster is quickly forgotten....There can be few fields of human endeavor in which history counts for so little as the world of finance....The second factor contributing to speculative euphoria and programmed collapse is the specious association of money and intelligence.”
When looking at the ravages on Wall Street today, these two Galbraith insights hold up. Short memories are a commodity and “sophisticated investors,” those who don’t need any regulatory protection because they know better, now litter the street of dreams. This book became especially relevant while watching the Sentinel Management Group failure unfold.
Sentinel was a cash management firm. For the average trader, this may not mean much (see “The Science of cash management,” below). A trader puts his margin with a brokerage firm, and typically it holds his excess margin. This margin is put into overnight funds by the firm to earn interest. No use letting sleeping cash lie. By pooling the customer funds, brokers used to be able to make some big income off of this when interest rates were high. Today it’s still a business, but one that may be outsourced to cash management firms. Sentinel was such a firm, in fact a pioneer, but somewhere along the way they got lost in the euphoria of grabbing a better return in instruments that, say, aren’t as liquid as overnight T-bills.
And that’s where our story begins: when the liquidity crisis hit the markets, some instruments that Sentinel apparently invested in could not be liquidated without a loss. Clients were informed there was a freeze on redemptions and all hell broke loose. (see Trendlines, below). In swept a supposed white knight, Citadel Investment Group, the behemoth hedge fund that has made fortunes on such distressed sale strategies and purchased one of the Sentinel portfolios at a discount. But there were problems: the firms that had money at Sentinel had been assigned the paper that had been sold to Citadel; and two, what Citadel had bought was the quality part of the portfolio, that is, the paper could have been traded/sold and customers would have gotten the full 100% back. Further, there are clients in other portfolios who haven’t seen their money yet, and chances are they won’t. Many of these folks are long-time friends/acquaintances of the Blooms, who owned Sentinel.
Much of the money can’t be found, at least not yet, and questions about the fund’s investments, bookkeeping and auditing are now under scrutiny. As are the regulators, especially the National Futures Association, which not only was Sentinel’s self-regulatory organization, but allowed the Citadel sale to happen.
One thing pops out: no one is blaming the Sentinel customers, most of whom would be called “sophisticated investors.” Perhaps that’s fair because if it was fraud, it’s hard to catch. But as one cash manager told me, there were red flags long before this happened because Sentinel was claiming returns that just weren’t available in the overnight market. These customers, most of whom are in the markets themselves, should have known better or at least asked tougher questions of Sentinel, of the Bank of New York and of the regulators.
