I think LTCM believed things would go back to normal in a micro sense, i.e. in terms of their positions themselves and they were right technically, they were just not liquid enough to wait out the adverse moves. On a macro sense the marekt as a whole does go back to normal. Any futures or options side which is taking huge leveraged heat is producing profits to some extent on the other side. Amaranth blew up but what about the funds/IBs who took the other side of the time spreads? There was no one fund but plenty of people took the opposite side and made some cash. LTCM affect on the market was a structural one in the sense that they were highly leveraged with several IBs and these IBs were going to take huge losses. That is where the real threat was coming from, huge hits to several IBs and banks who extended leverage would hurt the U.S. markets. I would hope that banks learned from this and have better guidleines on how much leverage to extend. An Amaranth therefore becomes a more controlled oil spill. If we have a global crisis the markets will fall and derivitives could exaggerate the move but in the end the market moves towards an equilibrium of sorts, whatever that level is, in a MACRO sense. Some firms may take a hit but overall, new entrants jump in, pick apart the flesh and build up again. I am not sure the large notional value of derivatives will necessarily hurt the markets in a shit hitting the fan environment. What is more worrisome is IBs extended way too much leverage to any single entity which can have too great an influence over the market. I would like to think that derivative risk is spread out widely among the market such that you may see hits in a sector (energy futures-Amaranth) but overall the risk is spread around to mitigate any global effects beyond initial shocks.
SSP: Your interests and concerns are a topic that is best understood by looking at solutions that have been run quite a while back (before Grennwich crew as a matter of fact). Go to ISAGA and particulaly the gamers in New Hamshire for State and also the War College in PA. THe ISAGA meting in Berlin and the johns Hopkins meeting before that. After that you will be able to step several levels down underneath the surface games you are presently considering. Don't sweat the small stuff; get a grip on the underlying principles and concepts. The conventional orthodoxy is not where answers ly because the conventional orthodoxy is just the sales pitch of thefinancial industry. After you understand that the betting and protection stuff is just surface, then you can get down to business to understand how pools of captial and economics and econometrics works. Start with the idea that in a game the minority always controls. Also get straight that the minority is always wrong. Work from there for a change. I can't respond any further; just spending this month finishing first complete documentation and programing on the teams stuff.
You'd like to hope it's spread properly. But such a large, complex, interweaved, intricate, delicate, system of money and contracts tied up all over the world can cause total chaos if things start unraveling. If a hedge fund goes belly up and they have a large sum of derivative contracts that are no longer valid, where does that leave those on the other side of the trade? If a global crisis hits Asia, and it spreads to the rest of the world, and liquidity dries up, that means everyone lose right? It's the liquidity that can help bring things back to normal...if the market opens tomorrow and everyone realizes that AMZN isn't worth 100X earnings, the stock could instantly trade at $30/share because liquidity disappeared on the buy side. A natural disaster, series of them, or perhaps a market disaster could have the same effects. A huge amount of money/liquidity can instantly disappear and the markets can be sent tumbling. Derivatives can easily exaggerate such a move. The emerging markets are more susceptible to contagion and sickness and with Wall St. more and more dependent on these less stable instruments for returns, the street is playing with bigger fires in my opinion. We might not care anymore when the Chinese markets lose 5% in a night because that's how they operate and are rather disconnected from reality of the economic situation on the ground. But what happens if China become overbuilt, over-invested relative to their populations readiness to be a sustainable middle-class, India suffers a political upheaval, etc.? The markets can easily be sent into a tailspin because our dependence on these foreign markets(economically) makes us much more susceptible to their sickness. All that shit about the Chinese market tumbling so we should too was really just shit because of the disconnect between their markets and economy...but if/when their economy really does take a hit or slowdown largely, that impact can/will be felt with a lot of strength in our markets. All you need to do is look where large gains are being made in many of the Dow components...overseas, mostly in Asia. That's my concern. An unraveling can cause a global blues that lasts for a while and is deeply felt everywhere and reduces worldwide liquidity. One of the benefits of globalization is what we're seeing now in a global marketplace, but the effects go the other way too when there is a global slowdown which hasn't really been tested during this new age of globalization.
It will be interesting to see what happens in the CDO markets as the housing story continues to play out. It seems like there a ton of conflict of interests and the a lot of stuff is as buffet would say marked to myth.
With all due respect, I think that now we're in a market that hasn't existed in the past and LTCM was a starting point for my concern. We're in a much much much more complex web of globalized markets now, not just financial markets but economic, and the spread of a sickness can spread much faster than previously. Pools of liquidity can dry up like it never existed in times of crisis. Globalization means complex and dense markets that can affect all other markets without flinching. The tsunamis in SE Asia would likely have a much larger effect on the markets now than they did just 5 years ago because of the growth of Asia in the global community. My opinion perhaps, but I think in the not so distant future the global markets will get another test to see how strong the fibers(derivatives, liquidity, underlying balances) will be tested for strength and durability for the first time. In the last 10 years alone the market has changed dramatically...much of it due to computers and how do those computers react when there is a crisis of global proportion? If humans decide to shut down the computers, are they able to manage the complexities that the computers did? I don't know and I don't doubt that the humans who program the computers can find a solution if there were a huge liquidity crunch worldwide for whatever reason...but that doesn't mean liquidity can't dry up and disappear. It's the black swan without the philosophical aspect of there being a preventable/predictable event. There is always the unpredictability factor that sends things spinning in ways no one imagined...such as LTCM. Cheers.
SSP, This discussion can continue ad infinitum, simply because every well reasoned opinion is right in a sense and untested in it's entirety. Clever greedy minds have stitched the derivatives market together and clever greedy minds are going to have to fix it when it breaks. The trick is to position yourself so that you are in a position to profit whether it breaks or not.
good post, global correlation is here to stay. I like how the book shows Goldman squeezing LTCM. This is typical, when you're opponent is down squeeze them hard, ala Amaranth. Remember you can't really hedge against systemic risk, its never even really discussed. There is systemic, liquidity, and execution risk when taking any trade, maybe t-bills aren't so bad.
-------------------------------------------------------------------------------- Quote from fearless9: SSP, This discussion can continue ad infinitum, simply because every well reasoned opinion is right in a sense and untested in it's entirety. Clever greedy minds have stitched the derivatives market together and clever greedy minds are going to have to fix it when it breaks. The trick is to position yourself so that you are in a position to profit whether it breaks or not. -------------------------------------------------------------------------------- Good post and point and it's really the only answer one can come to. Cheers bro. Hey SSP: Here's a thought: There's no fixing or breaking going on in the adult community. We all know, as players, that the zero sum game is there for this and that. Also there is a lot of stuff outside of that game. Some people see this and some do not. Taleb doesn't as we recently found out. He does the Covell thingy with a subject. Just what do people do who are dealing with the Financial Industry? with Economics? with, etc? No one is fixing or breaking. People are participating. Some of them actually think it is a competitive thing. Look at a day. What does a person do each day? For derivatives, there are patsies all over the place. But there are others who use the derivatives as a pipeline during the day. What is the recent 27FEB07 called? It had to be videotaped for sure!!!!!!! It is called "the best trading day of my life". These days form a long series of events in people's scrap books. Who broke the 27th? Who fixed it? Go to Tsunami level Go to the next 100 years of terrorist incubation. Anything is a "the best trading day of my life". a tsunami is like blading a lot to build a milllion dollar house that costs 250K 100 years of terrorist incubation brings fantasitc improvement once the guys who are having "the best trading day of my life" get finished removing and rebuilding what once was a nest for creating terroists. There are patsies all over the place allowing the messes; they aren't breaking anything. They aren't fixing anything. You think fiancial industry derivatives "evaporation" is whatever. sudden or othewise. What it is is: "the best trading day of my life". And those profits you think evaporated are there and, in my case and for others like me, we just dump the money into solving community or regional or national or international problems. I trade leveraged. Why? I get more condensation. We need a "create a derivative week" every month. Some us do pool extraction by price change all of the time. It is taken OUT of the market. And it is PUT into something else more useful. There is nothing to fix and no one is breaking anything.