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Saturday, May 12, 2007

Systemic Risk and Group Behaviour

Two of my favorite quotes... "Pay no heed to the man behind the curtain." and "Human see, Human do"...

Naked Capitalism begs the question,
is the Fed out of control? and notes that

"The Fed is a close cousin to the Wizard of Oz. It hides its activities behind a veil, makes forceful and authoritative pronouncements, and is regarded with fear and awe."

Which led us to PGL at Angry Bear's questioning past
Fed policy actions and the expansion of the money supply.

Which led us to Dr. David Altig's fine offering of opinions on the Fed's intervention and
handling of the LTCM crisis...

Which led us to William Polley who notes that
hedge fund crisis risk is most worrisome, but he's not really worried because its different this time.

Which led us back to our own missive on how
debt market derivatives have replaced the trusts of the 1920's.

That's a long ho to road... I mean road to hoe... but we finally arrive...

We agree with Polley in that it is different this time. Yes, volatility and covariances are lower today than in 1997, however... as is usually the case, things are not what they seem.

In
a Bad Moon Risin we commented that since Q301...

"
The more money there is in search of higher yields, the higher those buyers will drive prices for high-yielding debt securities, and the lower those yields will fall.

The only way to make up for falling yields, of course, is to take on more risk
."

The debt markets have morphed into a
higher risk environment which is typified by a recent uncharacteristic lack of defaults in the aforementioned high risk debt instruments...

This is the "illusory" nature of today's lower volatility and covariances. So is it really any different? Or is it perhaps far, far worse. To make matters even worse...

Progressively similar capital pools employing similar risk management strategies are undermining the whole concept of risk diversification. (holding portfolios of assets with uncorrelated systematic sources of risk.)

Monkey see, Monkee do...

If asset and fund managers with similar goals, educations, backgrounds and modeling techniques all use similar risk management practices...

one can only assume that in a time of crisis, the models and they will all react in a similar manner.

Similar goals... Reduce total risk per unit of capital and/or raise cash to cover margin calls.

Similar reactions... First attempt to sell illiquid positions. After discovering "no bid" (huge spread widening on thin trading) for illiquid securities...

liquid positions have to be sold, regardless of which market they are in.

Abracadabra... This kind of group think or behaviour creates correlations amongst asset classes that were previously fundamentally uncorrelated.

and there goes the diversification baby out the window with the bathwater...

And a vicious vortex of liquidity magically appears as lenders increase "haircuts" on illiquid leveraged positions, thus forcing additional liquidations.

This leads to further depression of the value of illiquid positions, and, in turn, exacerbates margin calls.

At the same time, dealers become reluctant to take long or short positions of any significant size and this widens bid/ask spreads even further.

The truth is... the underlying "truths" of financial markets (as determined theoretically or empirically) regularly change as more market participants learn about them.

AKA shit happens, things change and where 10 fat guys could have gotten out the door 5 years ago... today, 1000 fat guys can't get out that door at the same time.

So is the light on? is anyone home? And has anyone checked the door lately?

All risk management practices require frequent "reality checks" to verify that the forecasts of risk models are still consistent with actual market participants potential behavior or misbehavior.

Human see, Human do... they did it, so can I... are these managers (many whom have never been through a serious market downturn) all too caught up in chasing yield and quickly replicating the success of others?

The firm got its money shuffling fees, I made my quota and bonus, deals done, commissions paid, debentures placed and risk layed off, time to move on to bigger fish. Wink, Wink, Nudge, Nudge...

Somehow, The Nattering One can clearly see the statue of three monkey's on Wall Street, all with both hands firmly planted on their heads...

speaking, seeing and hearing no evil...where it lurks in every corner and crevice with its filthy little consort... greed.

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