Sunday, October 5, 2008

Deja vu

In one of my classes we are reading When Genius Failed by Roger Lowenstein, the story of the rise and fall of Long Term Capital Management. I had no idea when I planned the course this summer that it would be so relevant to current events. Below are some quotations from his chapter 8, "The Fall." With a few minor adjustments, they could be used to describe what has been happening in the financial markets for the past two weeks. They suggest that we have not learned much from past panics.

The default shattered the lazy but convenient assumptions of investors that the safety net would always be there. It "punctured a moral hazard bubble" that had been inflating expectations....

Investors now were running not just from emerging markets, but from investment risk wherever it lurked.

The bank wanted out. It was done with taking risk.

A few months before, they had not distinguished one risk from the next. Now it was all they thought of.

Despite the ballyhooed growth in derivatives, there was no liquidity in credit markets. There never is when everyone wants out at the same time.

It didn't matter what he sold; the point was, he had to sell something. At such a time, capital naturally flows from riskier assets to less risky ones, irrespective of their underlying value. To a tiny degree, Freidheim's own actions made it do so. Multiplied by a thousand other Freidheims all over Wall Street, the crisis of fear became a self-fulfilling prophecy.... A prices fell, banks backed ways from hedge funds. And as banks backed away, hedge funds had to keep selling.

Burned by foolish speculation in Russia, investors were rejecting risk in any guise, even reasonable risk.

The Main Street economy was sound, but financial markets were overleveraged and overextended. The entire Street has lost its nerve. The cool, unemotional traders of Merton's models no longer existed, if they ever had. Now they were in full-fledged panic.

...[A]lmost nothing in bond markets traded that day. The bond market had effectively closed; no one could trade out anything, or not without suffering horrendous losses.

The bond market collapse was caused by a panic not in the mainstream economy but on Wall Street itself, where too much optimism (and too much leverage) had suddenly come undone.

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