Financial Market Turbulence 2008: Why and How? Lessons from the past

Protection from falling market values: Stay invested in different countries, understand risk, remember history, also remember that anyone can & will make mistakes and markets can be very humbling.


http://www.nytimes.com/2008/09/07/business/07ltcm.html?_r=2&ref=business&oref=slogin&oref=slogin

Roger Lowenstein wrote this article in The New York Times on Sept 6th 2008.

"AS striking as the parallel is to Bear, Long-Term Capital’s echo is far more profound. Its strategy was grounded in the notion that markets could be modeled. Thus, in August 1998, the hedge fund calculated that its daily “value at risk” — meaning the total it could lose — was only $35 million. Later that month, it dropped $550 million in a day.

How could the fund have been so far off? Such “risk management” calculations were and are a central tenet of modern finance. “Risk” is said to be a function of potential market movement, based on historical market data. But this conceit is false, since history is at best an imprecise guide.

Risk — say, in a card game — can be quantified, but financial markets are subject to uncertainty, which is far less precise. We can calculate that the odds of drawing the queen of spades are 1 in 52, because we know that each deck offers 52 choices. But the number of historical possibilities keeps changing.

Before 1929, a computer would have calculated very slim odds of a Great Depression; after it, considerably greater odds. Just so, before August 1998, Russia had never defaulted on its debt — or not since 1917, at any rate. When it did, credit markets behaved in ways that Long-Term didn’t predict and wasn’t prepared for."

"Long-Term Capital’s partners were shocked that their trades, spanning multiple asset classes, crashed in unison. But markets aren’t so random. In times of stress, the correlations rise. People in a panic sell stocks — all stocks. Lenders who are under pressure tighten credit to all."

It is interesting to note that despite similarities to the collapse of Long Term Capital Management in 1998, the regulators or the Government did not do anything to prevent another collapse such as that of Bear Stearns in Mar of 2008 or that of salvaging the remains of Freddie Mac and Fannie Mae of last weekend of Sept 7th 2008 with taxpayers funds. All of this done to protect a widespread collapse of the US financial system.

A good history reminder article. We need to wait and see what the US does over the next few months to prevent the occurrence of another 'large institution failure" that will be "too big to fail" hence requiring bailout by the middle class ordinary taxpayers to save the super class rich.

Warren Buffet is somehow prescient in saying that he does not buy what he does not understand and has stated several times that he does not understand derivatives and has/will never invest in them nor buy/invest in companies that invest in derivative instruments.

However, most of the recent US institution, various hedge fund and mortgage company failures have been directly linked to mainly to derivative exposures. Go figure!

With losses of over USD 500 billion and counting, I expect total losses to be between USD 1 trillion upto USD 1.5 trillion (yes that's a trillion dollars i.e. USD 1,000,000,000,000) before this bloodbath ends sometime in middle or end of next year.

Stay tuned....