The Misbehavior of Markets: The Financial Tsunami

The following provides us a picture of the complexities of the financial market now being dealt with.  The world was warned in 1998 of the current crisis scenario as explained below.  This equates to the Hezekiah Factor of a 10 year delay.  As you read this summary, it is more important to understand the big picture than the details of the tangled web of men’s understanding.  Rather than seeking the Wisdom from above, men created formulas which appeared to be right in their own eyes.

2Ki 20:10 And Hezekiah answered, It is a light thing for the shadow to go down ten degrees: nay, but let the shadow return backward ten degrees.

Let’s begin:

The multi-trillion dollar US-centric securitization fiasco began to unwind in June 2007 with the liquidity crisis in two hedge funds owned by Bear Stearns, one of the world’s largest and most successful investment banks. The funds were heavily invested in sub-prime mortgage securities. The damage soon spread across the Atlantic to a little-known German state-owned bank, IKB. In July 2007, IKB’s wholly-owned subsidiary, Rhineland Funding, had approximately €20 billion of Asset Backed Commercial Paper (ABCP). In mid-July, investors refused to rollover part of Rhineland Funding’s ABCP. That forced the European Central Bank to inject record volumes of liquidity into the market to keep the banking system liquid.  The intervention of KfW, rather than stopping the panic, led to hoarding of reserves and to a run on all commercial paper issued by international banks’ off-books Structured Investment Vehicles (SIVs).  Asset Backed Commercial Paper was one of the big products of the asset securitization revolution promoted by Alan Greenspan and the US financial establishment. They were the stand-alone creations of the major banks, set up to get risk off the bank’s balance sheet. (You may not understand the details, be assured that most of those making the decisions affecting the U.S. don’t either.)

A structured investment vehicle (SIV) is a fund which borrows money by issuing short-term securities at low interest and then lends that money by buying long-term securities at higher interest, making a profit for investors from the difference.

The risk that arises from the transaction is twofold. First, the solvency of the SIV may be at risk if the value of the long-term security that the SIV has bought falls below that of the short-term securities that the SIV has sold. Second, there is a liquidity risk, as the SIV borrows short term and invests long term; i.e., out-payments become due before the in-payments are due. Unless the borrower can refinance short-term at favorable rates, he may be forced to sell the asset into a depressed market.

In the case of IKB in Germany , the cash flow was supposed to come from its portfolio of sub-prime US home mortgages, mortgage backed Collateralized Debt Obligations (CDOs). The main risk faced by investors was asset deterioration—that the individual loans making up the security default—precisely what began to cascade through the US mortgage markets during the summer of 2007.

The problem with CDOs was that once issued, they were rarely traded. Their value, rather than being market-driven, were based on complicated theoretical models.

When CDO holders around the world last summer suddenly and urgently needed liquidity to face the market sell-off, they found the market value of their CDOs was far below book value. So, instead of generating liquidity by selling CDOs, they sold high-quality liquid blue chip stocks, government bonds, precious metals.

That simply meant the CDO crisis led to a loss of value in both CDOs and stocks. The drop in price of equities triggered contagion to hedge funds. That dramatic price collapse wasn’t predicted by the theoretical models built into quantitative hedge funds and led to large losses in that part of the market, led by Bear Stearns’ two in-house hedge funds. Major losses by leading hedge funds further fed increasing uncertainty and amplified the crisis.

That was the beginning of colossal collateral damage. The models all broke down.

Lack of transparency was at the root of the crisis that had finally and inevitably erupted in mid-2007. That lack of transparency was due to the fact that instead of spreading risk in a transparent way as foreseen by accepted economic theory, market operators chose ways to “securitize” risky assets by promoting high-yielding, high-risk assets, without clearly marking their risk. Additionally, credit-rating agencies turned a blind eye to the inherent risks of the products. The fact that they were rarely traded meant even the approximate value of these structured financial products was not known.

Ignoring lessons from Long Term Capital Management (LTCM)

With that collapse of confidence among banks in the international inter-bank market, the heart of global banking and which trades in Asset Backed Commercial Paper, the banking system stared a systemic crisis in the face. A crisis now threatened of a domino collapse of banks akin to that in Europe in 1931, when the French banks for political reasons pulled the plug on the Austrian institutions. Greenspan’s New Finance was at the heart of the new instability. It was his Age of Turbulence, to parody the title of his ghost-written autobiography.

The world financial system had faced a systemic crisis threat as recently as the September 1998 collapse of the Long-Term Capital Management (LTCM) hedge fund in Greenwich , Connecticut . Only extraordinary coordinated central bank intervention then, led by Greenspan’s US Federal Reserve, prevented a global meltdown.  That LTCM crisis contained the answer of all that is going wrong with the multi-trillion dollar asset securitization markets today. Curiously, Greenspan and others in positions of responsibility failed to take those lessons to heart.

The nominal trigger of the LTCM crisis was an event not foreseen in the hedge fund’s risk model. Its investment strategies were based on what they felt was a predictable mild range of volatility in foreign currencies and bonds based on data from historical trading experience. When Russia declared it was devaluing its rouble currency and defaulting on its Russian state bonds, the risk parameters of LTCM’s risk models were literally blown out of the water, and LTCM with it. Sovereign debt default was an event that was not “normal.”

Unlike the risk assumptions of every risk model used by Wall Street, the real world was also not normal, but rather highly unpredictable.

To cover their losses LTCM and its banks began a panic sell-off of anything it could liquidate, triggering panic selling by other hedge funds and banks to cover exposed positions. In response, the US stock market dropped 20%, while European markets fell 35%. Investors sought safety in US Treasury bonds, causing interest rates to drop by over a full point. As a result, LTCM’s highly leveraged investments started to crumble. By the end of August 1998, it lost 50% of the value of its capital investments.

In the summer of 1997 amid the hedge fund-led attacks on the vulnerable currencies of Thailand , Indonesia , Malaysia and other Asian high-growth “Tiger” economies, Malaysia ‘s Prime Minister Mahathir Mohamad openly called for greater international control on the murky speculation of hedge funds. He named the name of one of the largest involved in the Asian attacks, George Soros’ Quantum Fund. Because of US pressure from the Treasury Department by Secretary Robert Rubin, the former head of Goldman Sachs, and from the Greenspan Fed, no oversight of opaque offshore hedge funds was ever undertaken. Instead they were let to grow into funds holding more than $1.4 trillion in assets by 2007.

Fatally flawed risk models

The point about that LTCM crisis that rocked the foundations of the global finance system, was who was involved and what economic assumptions they used—the very same fundamental assumptions used to construct the deadly-flawed risk models of the asset securitization debacle.

At the beginning of 1998, LTCM had capital of $4.8 billion, a portfolio of $200 billion, built from its borrowing capacity or credit lines loaned from all the major US and European banks hungry for untold gains from the successful fund. LTCM held derivatives with a notional value of $1,250 billion. That is one unregulated, offshore hedge fund held a portfolio of options and other financial derivatives nominally worth one and a quarter trillion dollars. Nothing of that scale had ever before been dreamed of. The dream rapidly turned into a nightmare.

The major global banks who had poured their money into LTCM hoping to coattail the success and staggering profits included Bankers Trust, Barclays, Chase, Deutsche Bank, Union Bank of Switzerland, Salomon Smith Barney, J.P.Morgan, Goldman Sachs, Merrill Lynch, Crédit Suisse, First Boston, Morgan Stanley Dean Witter; Société Générale; Crédit Agricole; Paribas, Lehman Brothers. Those were the very banks that were to emerge less than a decade later at the heart of the securitization crisis in 2007.

Speaking to press at the time, US Treasury Secretary Rubin declared, “LTCM was a single isolated instance in which the judgment was made by the Federal Reserve Bank of New York that there were possible systemic implications of a failure, and what they did was to organize or bring together a group of private sector institutions which then made a judgment of what was in their economic self interest."

The source of the awe over LTCM was the “dream team” who ran it. The fund’s CEO and founder was John Meriwether, a legendary trader who had left Salomon Brothers following a scandal over purchase of US Treasury bonds. That hadn’t dented his confidence. Asked whether he believed in efficient markets, he once modestly replied, "I MAKE them efficient." The fund’s principal shareholders included the two eminent experts in the "science" of risk, Myron Scholes and Robert Merton. Scholes and Merton had been awarded the Nobel Prize for economics in 1997 for their work on derivatives by the Swedish Academy of Sciences. LTCM also had a dazzling array of professors of finance, doctors of mathematics and physics and other "rocket scientists" capable of inventing extremely complex, daring and profitable financial schemes.

Summary:

1. Long Term Capital Management was the precursor to the current financial tsunami- the warning shot.

2. Mathematical models were developed by man to attempt to analyze the behavior of investors, markets, countries, hence the universe and ultimately GOD.

3. They were wrong.

4. GOD defies mathematical definition.

5. The idols of man’s heart will rationalize anything including incorrect assumptions contained in mathematical models.

6. These idols will ultimately be the downfall of the current economic/financial system.

7. Man will turn from his wicked ways out of desperation.

8. The party is just about over.

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