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Thread: weekend commentary - financial markets polluted with risk

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    Default weekend commentary - financial markets polluted with risk

    I missed this when it came out last month ... it's even more poignant given the economic developments of the past few weeks !



    (snip)"The most toxic financial market innovations today that have polluted the financial system with risk, and helped keep the housing bubble alive, are:
    - Credit derivatives
    - Asset-backed securities
    - Secondary-market syndicated loans
    - Home-equity lines of credit
    - Interest-only mortgages
    - Negative-amortization mortgages
    - Sub-prime mortgages and consumer loans

    Warren Buffet weighed in with a less sanguine assessment of this class of derivatives in his annual letter to shareholders, March 2003. Note that Buffet gets right to the point. The purpose of these innovations is to make money for the people who sell them, not to help society:

    “We view them as time bombs, both for the parties that deal in them and the economic system… Essentially, these instruments call for money to change hands at some future date, with the amount to be determined by one or more reference items, such as interest rates, stock prices or currency values… Unless derivatives contracts are collateralized or guaranteed, their ultimate value also depends on the creditworthiness of the counterparties to them. In the meantime, though, before a contract is settled, the counterparties record profits and losses -- often huge in amount -- in their current earnings statements without so much as a penny changing hands."(snip)
    ~
    Last edited by Melonie; 05-28-2006 at 06:41 AM.

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    Default Re: weekend commentary - financial markets polluted with risk

    part 2 ...



    (snip)"The way I see it, credit risk is always present to some degree, as is inflation risk. At times, it gets stored away like hazardous waste and forgotten like the drum in the illustration; risks are not discounted, such as in 1994, 1997-98, and 2000-02. When a financial market storm eventually arrives, the seas become so turbulent that the drum bursts. Gales and tides carry the poison far and wide, contaminating global markets.

    Recall the Peso Factor and the Asian Contagion. The former precipitated the Peso and Orange County crises and the bursting of the emerging and high-yield markets in 1994, the latter the Thai Baht Crisis, Russian Debt Default, and near collapse of Long Term Capital Management in 1997 and 1998. Both events were catalysts for severe emerging and high-yield market declines. We need only recall the 17%- 20% yields on low quality credit instruments in October 2002 to be reminded of the re-pricing of credit risk near the most severe domestic equity price trough since 1937."(snip)

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    Default Re: weekend commentary - financial markets polluted with risk

    part 3 -

    (snip) Some on the Street argue that such confidence is misplaced, and that the relative stability in the global markets since 2003 has lulled traders into a false sense of security. So much speculation has crept into commodities markets, for example, that in April they were trading at prices 50% higher than they would have been based only on fundamentals, estimated Merrill Lynch. A sharp sell-off followed in May. Are bank traders and hedge funds living on borrowed time? One senior bank executive thinks so. He worries that at any moment volatility could spike to levels never seen before.

    How the markets will respond to such an event "is up in the air," says Leslie Rahl, president and founder of Capital Market Risk Advisors Inc., a New York-based consultancy. That's because banks are dealing more with unpredictable clients like hedge funds and in less familiar financial products like derivatives of derivatives. They also use any number of risk models whose predictions vary wildly depending on the assumptions. For example, JPMorgan Chase & Co. (JPM ) estimates on page 76 of its annual report that in 2005 its trading portfolios were at risk of losing $88 million on any given day, a pittance compared with its annual profit of $8.5 billion. The figure it cited is called value at risk, or VAR, which describes the total losses across all positions, from pork bellies to Iraqi bonds, that could be sustained in any single day under normal trading conditions. On average, major investment banks report VAR of $56 million.

    But such backward-looking estimates don't capture the extent of the banks' risks. On the very next page of the JPMorgan report, the bank tells investors that losses could have soared to as much as $1.4 billion over, say, a four-week period last year if an abnormal event had occurred. That figure was based on a "stress test" it performed on its books, another kind of risk-modeling technique."(snip)

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