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Derivatives: Wall Street Fiddles While Rome Smolders   (March 23, 2006)


A fire is already smoldering in the gasoline warehouse, but Wall Street is fiddling away, fanning the embers. Rome won't burn, it will explode. What's the gasoline? Derivatives--trillions of dollars' worth. What's the smoldering fire? Wall Street's insatiable appetite for ever riskier "investment vehicles" and "hedges."

But don't take my word for it. Check out the March 22 edition of the business-centric Wall Street Journal for this story: Debt Party: Investors Scoff at Risk, But Their Borrowing May Haunt Them This isn't exactly a new story--note that the second chart dates from last Fall--but that doesn't mean the risks aren't real. If anything, they're increasing in a heretofore unimaginable manner. Like a rubber band being stretched tauter and tauter, the risks can only increase so much; at some point, the band (and market) will snap.

Longtime readers know that I have suggested reading mathematician Benoit Mandelbrot's exploration of market risk, The Misbehavior of Markets.

In a nutshell: Mandelbrot proves that standard "portfolio management" models and tools radically underestimate the risks inherent in any chaotic system, i.e. the market. He graphically illustrates with historical charts that the stock market does not perform as statistical models would suggest; rather, it is prone to sudden highly volatile drops and upward spikes, much as the fractal geometries he developed would predict. He then shows you a real stock chart and one based on fractals; you won't be able to tell them apart.

In other words, the full amount of risk in the market cannot be accurately predicted. We can, however, look at these charts and see that risks are completely underestimated, and that the amount of money being leveraged in derivatives is truly frightening. But let's hear what the Wall Street Journal has to say about risk and complacency:
Debt investors expect prices in the market to be stable and returns to be meager for as far as the eye can see. So they are coming to a natural conclusion: It is time to borrow more money and make riskier bets. That type of thinking is often dangerous.

Investors make these bets mainly through esoteric products designed by Wall Street math whizzes to spread the risk of owning debt. These products bundle bunches of loans and slice them up into less-risky and more-risky sections that are sold to investors.

The problem is that nobody knows just how much the few investors who buy the riskiest portions stand to lose if things go badly. Nobody knows how much is at risk in the entire market if there is a big blowup.

Why investors are so confident the markets will be placid is a troubling puzzle. The optimism seems misplaced. It is unclear when the Fed will stop raising rates. And the bond market -- where long-term rates have been incongruously lower than short-term rates -- is forecasting an economic slowdown that few believe is really coming.

That suggests that debt-market prices are facing a rocky road. Yet investors are becoming more confident that prices will have fewer sharp moves up or down than in the past. Merrill Lynch's index for measuring expectations of bond-market volatility fell below its all-time lows at the end of February.

The previous low was set in July 1998. Two months after that bout of optimism, the Long-Term Capital Management crisis hit and the index -- along with global financial markets -- went haywire. In other words, investors are feeling more confident now that debt markets will be smooth than at any time since LTCM went on an overconfident risk binge.
Long-Term Capital Management, you'll recall, was the outfit which believed they'd discovered the secret to managing risk--the Black-Scholes formula for pegging the value (price) of options (a form of risk management which even regular investors can buy--the familiar puts and calls). Lo and behold, the market stubbornly refused to follow their predicted models, and LTCM's over-exposure to derivative losses collapsed the firm and very nearly the global banking system. Only the sudden mobilization of the storied "Plunge Protection Team" saved the day.

Interestingly, the market has floated along without any prolonged or severe spikes of risk since that blow-up in 1998--almost eight years of ever lower measurements of volatility. (Take a look at the VIX, a measure of option volatility, if you need more proof.) Gazing at these charts, one wonders if the market isn't due for one of the sudden, seemingly random appearances of risk predicted by fractal geometries. Perhaps it's a good time to recall the old dictim: Cash is King.

                                                           


copyright © 2006 Charles Hugh Smith. All rights reserved in all media.

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