[FoRK] $30B a bargain for what it looks set to achieve?

Jeff Bone <jbone at place.org> on Wed Mar 19 15:58:28 PDT 2008

On Mar 19, 2008, at 2:20 PM, Adam L Beberg wrote:

> Jeff Bone wrote on 3/19/2008 11:11 AM:
>> One other bit...
> No disagreement here, I just play with money too ;)
> The problem is the leverage and how fast the whole system goes to  
> shit if there is even a small move.
> Lets assume that the leverage on that 500T is "only" 100:1 (it's way  
> higher, but anyway) That's still 5T. And a 1% move makes it  
> worthless. Now, of course you have a hedge to that, and a hedge to  
> _that_ hedge, etc, but eventually you get something unhedged and  
> some money was created from nothingness to do it all.

Even assuming the 500T figure in question and the 100:1 leverage, it's  
still possible --- indeed, it's likely --- that you might often have  
1% or greater moves in underlying prices with no adverse impact  
whatever.  (In fact that happens all the time.)  That's the nature of  
the hedges you mention;  a large part of that 500T is tied up in those  
offsetting bets such that a 1% move in something is offset by a 1%  
move in the other direction in something else, or several sub-1% moves  
in several other somethings else, and these things are structurally  
and inexorably tied together (e.g., bets on whether it's day or night  
--- it *will* be one or the other.)  Or, you've got a bet about the  
values of something at two different points in time, and you settle in  
some other instrument (usually "money" ;-) based only on the  
divergence between those things.

Some of that web of interlocking trades is quite robust, such that too  
great a divergence in the relative values of things from the  
assumptions that went into the trades is sufficient to create  
significant opportunities for those with the wherewithal to take  
advantage of the situation.

In any case, it's an almost sure bet that the 500T figure mentioned  
for derivatives "double-counts" both, or redundantly counts several,  
legs of the same complex trades.

The only real way to get the thing to completely unravel would be to  
*destroy* an amount of real, tangible underlying value approximate to  
the leverage ratio times the total notional value of all the trades  
that have that underlying thing or things on one side or the other.   
That's not, for example, what's going on right now.  The value that  
disappeared from the system overall during the weekend's reduction in  
a certain investment bank's share price was not actually destroyed;   
that asset was merely revalued due to a growing consensus in the  
market that its future prospects were discovered to be dimmer than  
expected.  THAT happened because of two things:  first, there was in  
essence a run on that bank, leaving it with less liquidity than it  
might need to make good on its trading obligations.  Second, it had  
bet heavily on a proposition  that has been considered increasingly  
risky for some time now.  And finally, I suppose that part of the  
ultimate valuation was really a function of "well, we can demand this  
given the situation."

In other words, aside from the temporary liquidity infusion of the  
Fed, this sort of valuation logic is all sort to be expected... the  
market functions well, given good information and rationality.  We had  
too little of either prior to the weekend, and after the weekend the  
price reflects more closely a rational consensus of the true value  
given improved information.

Note the need for transparency, and what happens when investors get  
surprised.  One could argue that the value that has disappeared was  
illusory in the first place, created by the market itself through  
incorrect valuation due to incomplete or incorrect information.  Enter  
regulation;  without what we've got, the system wouldn't even work as  
well as it does.  There's be lots of similar "surprises."

I have friends at said investment bank and this is unlikely to be much  
consolation for them, ditto many other shareholders;  there are many  
folks who were heavily concentrated in that firm, and whose financial  
futures are now much dimmer than they were a week ago.  Talking to  
them on Monday was no fun at all, believe me.  Yet that was their risk  
to take, in defiance of Rule #1 of being an investor:  always  
diversify.  Been bitten with that one myself, thanks a bunch  
CMGI. ;-) :-)

It's also worth noting apropos the present situation that JPM is in  
some sense "taking one for the team."  And that this is a role that  
JPM's played before...



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