I will be traveling over the next week or so and posts will be infrequent. For now, I leave you with the following excerpt from Financial Armageddon:
It is always hard to know ahead of time which catalyst will light the fuse. Past upheavals have been difficult to pin down to one cause. Often, an accumulation of little sparks suddenly causes eruption. Still, the trigger for a full-fledged systemic crisis will likely be the sudden and unexpected failure of an aggressive financial operator. That could mean a multibillion dollar hedge fund, with a large and highly leveraged exposure to certain illiquid markets or exotic securities, or a private equity firm, saddled with debt but with little in the way of marketable assets.
At that point, the wide-eyed delusions of yet another new era will be revealed as age-old fallacies.
Allegedly sophisticated operators will suddenly discover that swapping safe, liquid, and relatively straightforward investments for risky, illiquid, and utterly complex positions is not clever arbitrage but a value-destroying proposition. Many will also learn the hard way that accurate pricing, access to market liquidity, the cost and availability of credit, and the viability of the entire financial system ultimately depends on a kind of collective faith. They will realize that when risk is mixed and matched in unfamiliar combinations—traded, shifted or sliced and diced, or repackaged into bigger or smaller pieces and sold off—the potential for destructive blowback doesn’t leave the system. Nor does it create lots of extra room for everyone to take on more risk, a point that so many will have missed.
As for popular risk management theories, the smart money will recognize belatedly that it is not a good idea to be part of a large crowd holding similar positions looking for greater fools to sell to when the time comes to bail out, like those who relied on portfolio insurance prior to the 1987 stock market crash. Finally, many will fully understand what Nigel Jenkinson, a director of the Bank of England, meant when he said in the spring of 2006, “There is a dark side connected to financial integration. If shocks are large enough, the financial system becomes a risk transmitter rather than a risk disburser.”
These are dangerous times. Read the book and find out why.
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