Deja Vu All Over Again

September 24th, 2008

Posted by: Roger Pielke, Jr.

From The Economist, November 12, 1998:

Financial firms employed the best and brightest geeks to quantify and diversify their risks. But they have all—commercial banks, investment banks and hedge funds—been mauled by the financial crisis. Now they and the world’s regulators are trying to find out what went wrong and to stop it happening again. . .

One reason is that everyone was up to the same thing. Shareholders tend to shun institutions that take outright punts on markets. Better instead, they think, to take what appear less risky bets on the difference in price between two assets: in the jargon, “relative-value” trades.

The eagerness to do such trades was also the product of a bull market and a strong economy, especially in America. Yields on government bonds fell, so investors and financial firms bumped up returns by, among other things, taking more credit risk. . .

Returns on such trades were low but apparently safe, so the firms borrowed heavily to leverage their bets. . . It was easy to increase leverage because borrowing, using assets as collateral, became much cheaper—lenders were overly sanguine about credit risk. . . By earlier this year some hedge funds were able to borrow 95% of the value of this splendid collateral. And the biggest hedge funds were able to borrow from banks without any “haircut” at all against better government securities.

That, as one risk manager now admits, is like a banking system without reserve requirements. Banks lent to one another on similar, if not quite so generous, terms. Of late many funds and weaker banks have had less generous treatment from lenders.

All this was wonderful for traders. In a bull market, the bigger their bets, the more money they made. Few thought much about potential losses. The rewards for punting with abandon were huge, while the penalties were small—they could walk into another job if they were fired. Very few had their fat bonuses tied to the long-term value of the firm. And the more money they had already tucked away the bolder they became. Greed, says the boss of one big firm, meant that “traders took risks that put you at the edge.”

But what made their eventual losses so huge was that many financial firms had the same positions. Which is not surprising: their data was similar, and their traders had learnt the same financial theory. So had their risk managers. Yet in a crisis, unwinding all these positions simultaneously became almost impossible. Liquidity dried up.

2 Responses to “Deja Vu All Over Again”

  1. MarkR Says:

    Hedge Funds are not in trouble (yet). Holders of bundled sub prime mortgages are, and weak financial institutions on the receiving end of short selling are. Also the market for the insurance of corporate loans is next for the “treatment”.

    Hedge funds have in fact done exactly and ruthlessly, what they were designed to do. ie use leverage money to accelerate the destruction of illusory shareholder value in flawed companies.

    The villains are the management of financial institutions who have recklessly and negligently underestimated the risk in the loans they were trading, the sellers of loans to outragously risky borrowers, and the politicians who forced/encouraged loans to minorities without the usual lending criteria.

    The Capitalists (the Shareholders) are in fact the victims in all this. (Won’t be mentioned on the News though)

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  3. stan Says:

    Some years ago a geek, too clever by half, convinced Wall Street that it was a great idea to lend to countries because they couldn’t go broke. Hubris.

    Other geeks came up with trading programs which very confidently predicted that the turbulence which happened on a number of trading days in Aug 2007 could never happen. Hubris.

    Others had the “great idea” that creative slicing and dicing could turn junk into prime investment grade debt. Hubris.

    Now we survey the wreckage wrought by a bunch of computer geeks employing creative applications of statistics and modeling which wildly overstate confidence levels. Hmmmm, sounds very much like a bunch of climate scientists slicing and dicing tree rings. Only the damage done will be far greater.