Having gone almost totally unnoticed, there was NO ACTION in the repo market recently and the T bill on-the-run auction was completely mispriced – two events that have NEVER happened. Why no repos? Nobody wanted to lend governments and nobody wanted to borrow even at 1.8% compared to Fed Funds rates 4 points higher. The question to answer is, “What is going on?” In 1998 I was talking to a former Salomon Bros. derivatives trader. We were discussing the fact that the financial newspapers all but dismissed the near miss of calamity that came close to worldwide financial collapse. That is, unless the Nikkei had been supported, the barrier options acting similar to short straddles written by U.S. financial companies triggered.
The warning shot of financial disaster shot across the worldwide bow but we have not learned our lesson. The lesson was that we should not magnify short positions using derivatives on our financial institutions of these extreme events. This is the way insurance companies and reinsurers operate – by shorting extreme events. This is the way many HFs operate, by shorting extreme events on a hedged position and leveraging for return. So for the cost of a running spread (up-front fee) risk of mortgage extreme events are sold. This is very different from insurance companies selling P&C and Life insurance. All people don’t die at the same time and all properties in all geographies don’t get destroyed simultaneously, but an asset class can. It is important to note that Banks were able to weather the catastrophic failures by laying off risk to the tune of about $2.7 billion in the 2001 U.S. financial debacle. Banks account for about 51% of protection buyers and 38% sellers (2003,
British Banking Assoc). Insurance companies on the other hand account for % of buyers and 20% sellers with hedge funds balanced as sellers/buyers leading us to conclude that Bank risk is now Insurance company risk. But, there is more to the story, You may incorrectly read, for instance, that since HFs are balanced buyer/sellers they are not exposed. However, it is the magnitude of loss that is important, not the balance.
Natural barriers to overselling extreme events are the underlying securities – mortgages, corporate bonds, loans. To avert the sponsor’s involvement in the bankruptcy process on defaults the industry has created synthetics. Sounds like a good idea, except that synthetics remove natural barriers of supply/demand, akin to a gambler with an unlimited line of credit.
The problem is that financial models cannot truly determine the adverse impact of an outlier event that may cause correlations unforeseen and pushing second deviation events further into the tails and so on, and so on. A Quant is only as good as his/her data and great tools like SPSS/MathLab cannot forecast the point of the first falling domino. The first domino has fallen just like the proverbial Titanic hitting the iceberg. It’s just a matter of time, this is the “Beginning of the End” of financial collapse.
I write this article 15Sept2007, there is a U.S. presidential election next year, during that president’s administration there will be an unprecedented financial collapse that will even deteriorate the value of commodities. At that time the only answer will be to create a single currency or alternatively, an occidental, middle East/European, and oriental currencies and a grand nationalization of banking. I estimate this will happen 2011. P.J. de Marigny *.*