Sunday, September 28, 2008

A point I've been making, although not here:


Maybe next time, we will listen more closely to financial theorists who think in abstract, general terms. Consider the Long-Term Capital Management debacle in 1998, when the Federal Reserve leaned on financial titans to rescue a massive hedge fund and stave off global fallout. Lots of people hold that the moral of the LCTM story was the failed thinking of two of the firm's founders, Robert Merton and Myron Scholes, both of whom were Nobel Prize-winning financial theorists. In fact, the collapse of LTCM was largely due to the overconfidence of bond trader John Meriwether and some of his other LTCM colleagues, who were gambling in the markets. The disgraced Merton has been working for the last decade trying to build better risk-management systems, mostly to little avail. Maybe he will be heard now. People still seem to want to trust businessmen who have made bundles and have a huge investment bank behind them, rather than listen to experts who are thinking about the fundamentals of risk management. We would have been better off this month if we'd been ignoring the former and listening to the latter.

There's nothing inherently wrong with derivative securities, constructing products that hedge, and so forth. They are like glass or knives: they can be very useful or very harmful. Used properly derivative securities can indeed reduce exposure to risk, provided all sides of the transaction are properly capitalized.

But use 'em for pure leverage, and therein may lie perdition.

But people will use them for better risk management, because they can be used that way.

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