Sunday, August 19, 2007

LTCM All Over Again?

ducktaped
[Thanks to spamsters.com for the image.]

In this article at SeekingAlpha.com, Michael Shedlock paints a stark picture of our present sticky financial crisis and the computer modeling that created it. (I would go even further than he does and blame it on the Fed and the central banks of this world, who believe that they can wave the interest-rate wand over any problem and make it disappear, when all they really do is gunk up the works with excess liquidity. But I digress.)

If I understand correctly, he believes that we are worse off than in 1998 during the Long-Term Capital Management crisis. I concur, mainly because I perceive this one to involve so many more and larger institutions.

Perhaps some of you don't even know we had a crisis back in 1998, but we did, and here's a pretty succinct description of what happened. To make a long story short, some pretty smart people created some pretty wild mathematical/computer models to make lots of money on some pretty risky bets. Unfortunately, their models failed to take into account (1) the time factor, and (2) the panic factor.

By "time factor" I mean the same thing that Keynes (or someone else, maybe) meant when he said something like, "although markets do tend toward rational positions in the long run, the market can stay irrational longer than you can stay solvent." In other words, you can have the best play in the world, but if you can't put your cards down at the right time, you lose anyway. (Or vice versa: When they force you to show your hand before you've acquired all the right cards, you lose even if you'd have gotten them eventually.)

By "panic factor" I'm referring to the irrationality of investors when they are fearful. They can pull their money at any time (within limits), and those who are using that money have somehow to come up with it or die in the process.

In LTCM's case, their positions were sound (reportedly); but they couldn't withstand the violent gyrations that came about in the situation that consumed them. Such situations require liquidity, which requires collateral, which collateral LTCM didn't have, because of some pretty extreme leveraging (i.e. they allowed themselves to get too far out on a financial limb).

The circumstances behind the problems we're having today are much broader and deeper, according to several writers. These fears are confirmed even by such a staid group as the Bank of International Settlements. Here are a couple of quotes from their most recent annual reports:

"The current [2006] environment places a premium on system-wide risk management. It highlights the importance of making available information about risk as well as the interplay, and need for consistency, between financial reporting standards, risk management practices and the overall prudential framework.... [T]here are considerable uncertainties and associated risks, not least concerning inflationary pressures on the one hand, and a possible unwinding of accumulated economic and financial imbalances on the other. These could lead to financial market turbulence or a long period of relatively slower global growth developments, or both. [Emphasis added] " (From the 2006 report.)

"The implications of past risk-taking related to property investments and to the leveraged financing boom will depend critically on the future path of interest rates and overall economic conditions." (From the 2007 report.) How true. It is indeed interest rates that are causing all ruckus, but they are only the catalyst. The real problem is the original excess liquidity created by the central banks.

Here's the scariest part of Shedlock's piece:

After LTCM, what happened? "What became of Long-Terms founders? Were they jailed or banned from the financial world? No. They went on to start another hedge fund!"

Now that's scary. So they went right out and did it again, and others have now copied them. Good grief. How bad is this going to get?

Oh, and by the way, a pox on computer models.

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