Sunday, March 16, 2008

One Hundred-Year Floods Every Ten Years
After Long Term Capital Management's financial melt down in 1998 I remember "experts" talking about the situation being a one hundred-year flood - i.e. so bad it could only happen every one hundred years. Talk then was of some risk measure called VAR (Value at Risk) that was supposed to measure risk and help prevent financial implosions. I did not understand VAR then and have not heard much of it since. VAR or not, Long Term Capital Management was a case of outsized leveraged bets that went wrong and it impacted the credit markets for a short, unpleasant period. Today's credit crisis is similar, outsized leveraged bets that went wrong - but its on a much bigger scale. From home owners to hedge funds to investment banks, leverage was cheap and easy for an extended period that led to complacency about ever increasing asset values that collateralized the debt. The de-leveraging of financial markets is painful and shows no signs of abating and has led the Fed to make moves it has not used since the Depression and to even invent new ways to add liquidity to markets.

The one hundred-year flood analogy needs to be modified to a ten-year flood, because significant market upheaval seems to happen every ten years. (The ten-year flood is as bad as the one hundred-year flood it's just occurring on a more frequent basis.) The flood of 2008 was preceded by the flood of 1998 caused by LTCM (the stock market declines of 2000 to 2003 were not a one hundred-year flood), the stock market crash of 1987, the hyper-inflation of the late 1970s and the market declines and financial upheaval of 1973 and 1974.

Markets recover after each flood and the brains on Wall Street concoct new products to prevent the next one hundred-year flood. The products getting stressed today are all the derivatives and securities (i.e. CDOs) designed after 1998 to take risk away from banks. I am sure Wall Street is working on the next wave of products that will "prevent" the next flood. Of course it will be impossible to test these products until 2018.


Anonymous said...

I am interested in hearing more about Wells Real Estate Timberland REIT. They have serious interest expense issues with their financing and I doubt they will be able to raise much more cash through additional stock sales. What's the scenario if they miss the rescheduled principal payment in June?

Rational Realist said...

I will make an additional post on Timberland's financing.