Fahrenheit 451
John Mackenzie
jrmfl@adelphia.net
May 18, 2004
Myron S. Scholes of Long Term
Capital Management, won one-half the 1997 Nobel Peace Prize in
Economic Sciences "for a new method to determine the value
of derivatives."
In September of 1998 LTCM ran into a glitch as their Laureate's
method began to run amok. At the beginning of 1998, LTCM held
capital of $4.8 billion, a portfolio of in excess of $200 billion
(credit facilities) and derivatives with a notional value (how
much capital a given derivative effectively controls) of $1.25
trillion.
The investors who dared to ask questions were told to "take
their money somewhere else."
On September 23, 1998 William J. McDonough, president of the
New York Federal Reserve Bank enlisted LTCM's counter parties
to bail out the fund which was for all intents and purposes bankrupt.
The counter parties provided $3.6 billion in return for a 90%
share in the fund and the promise a supervisory board would be
established.
Simply put, a Nobel Laureate's "derivative model" wrought
disaster, only to be bailed out by the very counter parties it
had "insured" against risk. The government's intervention
to save LTCM served to expand the "moral hazard" furthering
the expectation of bailouts among speculators with an appetite
for risk. I would suggest this type of intervention only serves
to further heighten the risks.
The leverage employed by LTCM indicates the firm was clearly
speculating upon convergence of interest rates, Alan Greenspan
and Bob Rubin's nod gave McDonough the go-ahead for an arranged
bailout as they, in their own words, believed it could very well
bring down the economy due to the magnitude of the "LTCM
shock."
LTCM's notional aggregate of $1.25 trillion implies extreme leverage
used in its pyramid of derivative positions against capital of
$4.8 billion.
I believe it is fair to assume the higher the leverage employed,
the higher degree of aggregate risk to a specific portfolio.
The leveraged speculators have recently exceeded $230 trillion
in aggregate.
Since the LTCM debacle, Chairman Greenspan has attempted to protect
the "real economy" with even less transparency in this
unregulated "over the counter" market.
Derivatives are financial products whose value is "derived"
from an perceived "underlying" asset value.
By example, stock options are based on the underlying value of
the stock that the option enables the purchaser to exercise their
"strike price" at a point in the future. Futures contracts
are used by "producers" to protect themselves from
various risks associated with price fluctuations in a specific
market. A commodity contract would be derived from the underlying
price of the good to be bought or sold at a specific date in
the future.
In addition to Stocks, Indices and other Market Indices, the
term "Asset,"in the derivatives sphere, also includes
Currencies and Interest Rates An important distinction
between "price" and "value" needs to be addressed
before venturing further into the derivative abyss:
Value: An amount, as of goods, services, or money, considered
to be a fair and suitable equivalent for something else; a fair
price or return.
Price: The amount as of money or goods, asked for or
given in exchange for something else.
Derivatives have intrinsic
value, meaning they are priced to derive the underlying value
of "something." Clearly we can assume "pricing
mechanisms" are subjective when unbound from the very markets
structure via "modeling" or perhaps in today's global
financial pyramid... by "intervention."
By example, derivatives allow investors to partition various
aspects of an asset, and trade those partitions separately, rather
than as a whole. The problem arises when Price / Value matrix
fails to conform.
Collateralized Debt Obligations have recently appeared as one
of the more popular types of derivatives. They are certainly
one of the most dangerous. Consider this straightforward exercise:
A mortgage is purchased and then sold with Overnight Rates at
historic lows. Then recognize in excess of 50% of the these mortgages
are adjustable. Real Rates, beyond the control of the Federal
Reserve without monetization of the long end, have risen dramatically,
putting many types of derivatives in peril. Understand that Commercial
Banks and Trusts make up the majority of this unregulated market
and then breath deeply.
These mortgage obligations have been purchased and sold, packaged,
securitized and then hedged using various derivative methodologies.
And what we have is a complete mess: grossly overvalued "assets"
trading as collateral in a negative real rate environment, levered
beyond reason to insure "safety" of the financial system.
I'll venture a guess... I would suggest this is nothing more
than a LTCM type speculation by orders of magnitude and
keep hearing Bob Rubin's "panic" when describing the
potential for disaster.
May 17, 2004
John Mackenzie
jrmfl@adelphia.net
John Mackenzie
manages private capital and hosts a gold
forum/investors exchange on Yahoo! groups.
321gold
Inc
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