Ref. a recent newspaper article.
..."Market sources said that some of the ways Long-Term Capital lost money included: losses related to the Russian bond market, the defaulting of ruble currency hedges by Russian banks, an incorrect bet on Danish mortgages and German bonds, a misguided bet that volatility in the American markets would drop off, and a wrong bet on the value of the British pound against the dollar. Stock and bond prices that were supposed to converge, diverged instead and liquidity dried up in many markets.
In a Sept. 3 letter to his shareholders, Meriwether said: "We expected that sooner or later . . . we as a firm would be tested. I did not anticipate, however, how severe the test would be." "
James to answer your querry: "....I have read(and tried, with my limited education in these matters) to understand the significance of the postings regarding derivatives on this thread. Could you explain the import of this situation, in that it seems most significant the a Federal Reserve President would intervene in behalf of a hedge fund, which I would think, would normally be allowed to fail".
James what the financial professionals do and have done at the moment is - with the advent of computer aided mathematical modeling - is to create a variety of financial instruments (derivatives) that are in turn hedges, puts, and calls on other instruments. These instruments are bets on market movements, in one way or another. Bascially, these instruments are so arcane that no one "understands" them, or rather if I can be somewhat less harsh...they have never been tested in a financial "blowout".
Where are we exactly and how did this begin to go wrong for the world's banks? Bascially, this (the derivative problem) is the most "challenging" thing that has ever faced the world banking authorities
What none of these financial professionals understand, at least from my own personal perception - perhaps they simply don't care being chased as they are by quarterly earnings contests between each other - is that no market can "hedge" against random risk. I am reminded of Nick Leeson's trades that went down because of the Kobe earthquake and the disappearance/dstruction/ vaporizing of Baring's Bank, a heretofore 233 year old British Bank with an impeccable reputation. Afterall: How could anyone predict the Kobe earthquake?
That being said, since we now have the world's financial framework in tatters - yes, Henry, it is in tatters - I suggest that the only analogy that fits this situation which we are now faced with is Dorothy's trips to the land of Oz. Or, rather our current trips to the land of Oz: Will Brazil go along with the world's bnks in the next two months and roll over her short term debts? Will the Japanese listen to reason and bite the bullet and do something about their banks, etc. etc.?
My god. I just finished reading Paul Volker's FDIC colloquium done last year about the soundness of the US banks. We are at the mercy of well informed people who are either totally liars, or fools. Read the report.... the high 5's are incredible.
Basically, James we are over the Desert of Death. We need Dorothy's magic belt to get us across the Desert of Death. Will we reach Oz this time???
...we now have responsible people saying, "Oh. I can take a 50% decline in the US stock market. That is easy. Please. Please.... I just hope to god the derivative exposure of X....Y....and Z doesn't totally crater the world's financial system."
Merriweather had $100 billion of derivatives exposure? Hell, that isn't anything ask Henry.
You and I and everyone, unfortunately, are going to be hearing more about this question of unwinding derivatives.... because it isn't just John Merriweather in Conneticut who has a little teething problem here.
With best wishes --
Clark
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