Derivatives: Darth Vader's Revenge Message Board

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Non-Tech : Derivatives: Darth Vader's Revenge

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To: Merritt who wrote (977)	10/26/1999 4:38:00 PM
From: Henry Volquardsen	Read Replies (1) of 2794

Merritt, I do believe AG was manipulator and provider of the energy (liquidity) while the banks served as the tool. I don't recall the Fed providing any extra liquidity to the system just because of LTCM. They were already providing liquidity because of the emerging markets problems so it may be difficult to segregate the issues. But even if the Fed had I wouldn't have a problem with it. Afterall a big part of the Fed's job is to keep the banks out of trouble, regardless of how they got there. And whenever the banks get in trouble it is always because someone did something they probably shouldn't have. The point is that once the Fed has gotten the banks out of harms way do they make the proper regulatory adjustments to address the problem? So far the answer has been yes. It could be said that the derivatives provided the vehicle for the leverage exposure possibly but not definitely. A large part of what hit LTCM was the widening of credit spreads vs Treasuries. A lot of the position was through derivatives but a lot wasn't. If you own US corporate bonds and you hedge them by shorting US Treasuries you are not touching derivatives yet you are in the same boat as LTCM. And LTCM owned a lot of corporate bonds in various markets that they hedged by shorting Treasuries. But even the derivatives positions were problematic because of the leverage. If they had the same derivative positions but the banks hadn't let them use the amount of leverage they did they would have lost money but no where near enough to put them in danger of failure. So in my view there was nothing particularly toxic in the derivatives. It was the amount of derivatives they had with a relatively modest amount of capital, that is a leverage problem. I can see the benefits, but there's always someone on the other side who's experiencing the reverse not neceassarily. In the brewer example I mentioned earlier the market maker would attempt to find a counterparty with offsetting risk. If he finds one counterparty who needs to buy Euros and another who needs to sell he can offset the risk. The point about risk transference is not to find someone to take the risk unadulterated, that is the role of a speculator. Risk transference puts the risk in the hands of someone who can aggregate risk and thereby more efficiently manage it and fins offsets. Henry

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