Remember Long Term Capital Management?
May 17, 2005 3:44 AM   Subscribe

Remember Long Term Capital Management? The hedge fund whose collapse threatened “a systemic crisis in the world financial system”? Most people in the investment industry claim that they have learned the lessons of LTCM, but what about the rise of synthetic CDOs, “complex structures that employ wads of credit derivatives to build leverage on top of leverage-what some skeptics call "imaginary" structures?" Investments in these financial instruments has exploded from under 1 trillion USD in 2001 to more than 5 trillion at the end of last year. Are problems with synthetic CDOs behind the recent rumors of "hedge fund frailty?" largely stolen from The Agonist
posted by afu (24 comments total) 1 user marked this as a favorite

 
I understand next to nothing about the markets but, when financial analysts and market experts talk about hedge funds with such palpable distaste, you know there are a few people in important jobs willing the schemes to implode.
posted by NinjaPirate at 3:53 AM on May 17, 2005


If you care what the world's second-richest guy thinks, Warren Buffett has been on top of this one for a couple of years.

And yet, and yet. It's another case of "We know the apocalypse is coming sometime, dammit, what we want to know is when."
posted by jfuller at 4:25 AM on May 17, 2005


On average if you throw a dart on a page of the WSJ to pick stocks you have the same average probability of picking stocks like "professionals" do...the other who cherry pick are either 1. brilliantly intuitive fews with a lot of insider knowledge 2. insider traders.

You ? You're the one who's going to take the risk for them with some cent of return.
posted by elpapacito at 5:29 AM on May 17, 2005


In Defense of Derivatives.

NinjaPirate-- your comment proves that you know more about the markets than most do.
posted by Kwantsar at 6:25 AM on May 17, 2005


Don't worry, these are all offshored monies and thus are the best examples of capitalism in the US. No taxes, no SEC controls, no protection for investors, who could ask for anything more unregulated by government? No way this could ever fail since it is guided solely by the Great Invisible Hand!
posted by nofundy at 6:45 AM on May 17, 2005


If you are going to criticize some endeavor for being largely imaginary then you have a lot of work on your hands.

I think I'm going to go read a Harry Potter book, watch the new Star Wars movie, buy a CD, oh, and I'm going to pay for all this with my paper money, and decide where to eat based on some billboard advertisements...

This is undoubtedly the work of Warren Buffet, or any other old money capitalist... The horror the horror, a zero sum game!
posted by nervousfritz at 6:47 AM on May 17, 2005


Hedge funds trade a small chance of catastrophic failure against a large chance of small gain. They don't eliminate risk, they just set up situations where people imagine it goes away.

And then you end up with the classic "imagination meets reality" scenario. People who imagine they can fly should stay away from high places.
posted by warbaby at 7:15 AM on May 17, 2005


So the question remains- where to put money now against the whirlwind to come? (Not real estate, surely? At these prices?)
posted by IndigoJones at 7:20 AM on May 17, 2005


Oh, yes, nofundy, those great invisible hands of Fannie Mae and Freddie Mac. What were you saying about private profits and public risks?
posted by Kwantsar at 7:51 AM on May 17, 2005


Paging mrfancypants.
posted by warbaby at 8:03 AM on May 17, 2005


So the question remains- where to put money now against the whirlwind to come?

If (like me) you're starting to shift assets out of the USA you might want to take a look at iShares MSCI South Korea. This is an Exchange Traded Fund (so you can trade it like a stock) that owns 70 of the leading South Korean stocks listed on the Morgan Stanley Korean Index. Samsung is its largest holding, followed by steelmaker Posco, Kookmin Bank and Hyundai Motor. The fund also owns shipbuilders, construction outfits and manufacturing firms.

Full Disclosure: I don't own any shares of this ETF, but I'm thinking of buying.. . this is the best way for small investors outside of Korea to invest in Samsung that I've seen yet.

I'm staying away from Real Estate at these levels. If you have to invest in Real Estate, I'd stay stick with shares of large homebuilders that can weather a downturn or Real Estate Investment Trusts that pay out large dividends.

As with any investment decision, do your own Due Diligence and come to your own conclusions. Good Luck!
posted by Fuzzy Monster at 8:27 AM on May 17, 2005


On average if you throw a dart on a page of the WSJ to pick stocks you have the same average probability of picking stocks like "professionals" do...the other who cherry pick are either 1. brilliantly intuitive fews with a lot of insider knowledge 2. insider traders.

not quite elpapacito. LTCM were riding high on the black-scholes options pricing model which is more than throwing darts, but far less than insider trading.

the black-scholes model predicted the future price of options using a complex set of differential equations similiar to the ones used to describe Brownian motion . apparently the random behaviour of investors produced a price fluctation sort of similar to that of cold cream swirling in a cup of chot offee. black and sholes modeled this price walk and won the 1997 nobel prize in economics for the discovery.

unfortunately, once it became commonly used, the "random" behaviour of investors was replaced by a more predictable behaviour and the model was no longer valid.

those who failed to understand how the model worked got burned by it and were said to be "fooled by randomness."
posted by three blind mice at 8:29 AM on May 17, 2005


Like Fuzzy Monster, I've been moving a lot of my money out of the US lately. It just doesn't seem like a good bet at the moment.

My choices are currently: VGTSX (Vanguard's International Stock Fund) and DODFX (Dodge and Cox international fund)

Both are holding firm in the recent downturns, so far.

What I worry about is the potential catalyst for the "perfect financial storm" that Greenspan's upcoming retirement may cause. At the least, there will be a sharp temporary panic in the US markets. The problem is that sharp shocks like that can really snowball.
posted by Invoke at 8:46 AM on May 17, 2005


three blind mice: that "fooled by randomness" link is gold. The Black Swan paper is exactly what I've been looking for.
posted by warbaby at 8:53 AM on May 17, 2005


taleb is a dynamite warbaby.

he argues to invest in the black swan: place yourself in the position to make a killing from the unexpected event - the perfect storm - instead of being wiped out by it.

of course, once everyone starts doing that then the rules change once again, but until the rest of the sheep start following the shephard, it does seem like the way to go.

but if taleb ever wins a nobel prize in economics run like hell in the opposite direction.
posted by three blind mice at 9:43 AM on May 17, 2005


Actually, I was thinking of risk in a slightly different sense. Taleb's "Black Swan" adds a great deal to Scott Atran's views here. And points out one of the errors in this analysis.

/derail
posted by warbaby at 9:53 AM on May 17, 2005


unfortunately, once it became commonly used, the "random" behaviour of investors was replaced by a more predictable behaviour and the model was no longer valid.

I'd just be interested in hearing why you think "the model was no longer valid".

As a fact check, Merton and Scholes won Nobel Prizes in 1997 for the model - Fischer Black died in 1995, Nobel Prizes are not awarded posthumously.
posted by milkrate at 10:01 AM on May 17, 2005


the thing that scares me is that the article on synthetic CDOs implies that there are huge knowledge gaps between the people setting up the CDOs and your average investor. This makes it easy for smart people with money to take advantage of "patient capital -- shareholders and lenders who believed that what mattered was fair value and not market value." That's what the case study of LCTM claimed was the ultimate problem, and it would be too easy for a similar thing not to be happening right now.
posted by afu at 10:18 AM on May 17, 2005 [1 favorite]


And, of course, what will happen is a catastrophic unwind. What this should do is beggar the richest companies on the planet, and thier officers as well.

What will happen is that they'll be declared to be "too big to fail", they'll get bailed out, and the cost of that will go to the taxpayer. Next up, another tax cut on the top tiers. The officers involved will rotate amongst the funds.

Get out your checkbooks, folks. If the hedge funds fail, the terrorist have already won.
posted by eriko at 10:38 AM on May 17, 2005 [1 favorite]


Investments in these financial instruments has exploded from under 1 trillion USD in 2001 to more than 5 trillion at the end of last year.

I wish there was a better way to quantify the size of a CDO besides notional value. The settlement required in the event of a default is almost never the entire value of the credit. And the actual cash value of these instruments is quite a bit lower, but that measure understates the amount of capital put at risk.

the thing that scares me is that the article on synthetic CDOs implies that there are huge knowledge gaps between the people setting up the CDOs and your average investor.

What is even scarier is that your average investor in CDOs and synthetic CDOs isn't an individual, but rather hedge funds, insurance companies and pension funds.
posted by mullacc at 11:32 AM on May 17, 2005


It's funny that you should post this. Last night I had a dream about the Yen carry. Weird.

Anyway, this is what hedges are all about, with stacked leverage and all. It's a grift game, sure, but the idea is that it's not supposed to be Joe Six-stock that's in these funds. We're talking accredited and institutional investors, right? From a risk regulation perspective, that makes the government more comfortable, mullacc, not less.

Fund managers know the score. To say that these are imaginary structures is to deny that there's a market. Where there's a market like this, someone is going to hedge. I don't believe fund managers are smart enough to pull it off indefinitely, nor eager enough to crash and burn completely.

But then, I have more faith than elpapacito. Sure, 80% of fund managers can't out-perform the S&P, but then, 20% can.
posted by rush at 3:02 PM on May 17, 2005


Thank you Fuzzy Monster and Invoke. For an interesting intro to Taleb, check out the New Yorker article. Made me buy the book.
posted by IndigoJones at 3:07 PM on May 17, 2005


rush: I wasn't making a point about government regulation. I'm not sure how you came to that conclusion. I think it's somewhat scary that, even with the field of investors limited by the government to accredited investors, there is a minority of market participants that don't understand the instrument in which they invest.

I think the biggest fear in synthetic CDOs is that they increase the amount of dominoes that will tumble if someone like GM blows up. Ultimately, the hedge funds and pension funds will probably be okay - but everyone will be spooked enough that the high yield/investment grade/ABS markets will tighten up. The subsequent liquidity crises caused by this credit crunch might push a few companies to bankruptcy (which is where Joe Six-stock gets screwed).
posted by mullacc at 4:37 PM on May 17, 2005


My boss is in the process of setting up a CDO, so this article is timely. High yield loan defaults are are at about 1%, with a similar rate forecast for the rest of the year. CDS spreads have widened tremendously in the auto sector with GM and Ford's recent downgrades. The investors that got burned the most by the downgrades, and Kerkorian's subsequent bid, were people who were long the bonds and short the stocks. If nothing else, money can be made (and lost) quickly in a volatile market vs. a flat one.
posted by Frank Grimes at 6:18 PM on May 18, 2005


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