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Richard Brookstaber: Blowing up the Lab on Wall Street

Richard Bookstaber writes:

Blowing up the Lab on Wall Street -- Printout -- TIME: Looks like Wall Street's mad scientists have blown up the lab again... [by] the alchemy of creating collateralized debt obligations (CDOs) compounded by the enormous amount of leverage applied by big hedge funds.... Here's the recipe... you package a bunch of low-rated debt like subprime mortgages and then break the package into pieces, called tranches.... Some of the pieces are the first in line to get hit by any defaults, so they offer relatively high yields; others are last to get hit, with correspondingly lower yields. The alchemy begins when rating agencies... wave their magic wand over these top tranches and declare them to be a golden AAA rated.... The problem is that CDOs were untested; there was not much history to suggest CDOs would behave the same way as AAA corporate bonds. After all, the last few stress-free years have not exactly provided much of a testing ground.... t's not the first time this has happened.... One August day nine years ago, Russian bonds defaulted. A surprising result of this default was the spectacular failure of Long-Term Capital Management (LTCM), a hedge fund in Greenwich, Conn. Surprising because LTCM had nary a penny in Russian bonds....

A number of hedge funds are failing; others are seeing returns plunge. Among these is Goldman Sachs's flagship Global Alpha Fund, which burned a quarter of its $10 billion value.... Global Alpha was not a player in subprime junk. Indeed, Global Alpha's problems have not come from mortgages at all, but from a portfolio of stocks.

Why does this happen?.... [H]igh leverage. For example... every dollar of investor capital claimed six dollars of positions. This is the dry kindling for a market firestorm. When things go bad for a highly leveraged hedge fund, it gets a margin call and has to sell... prices drop. The falling prices mean a further decline in the fund's collateral.... And so goes the downward cycle.... It can be difficult to sell the stuff that's causing the problem.... So if you can't sell what you want to sell, you sell what you can sell....

As the subprime crisis propagates, it doesn't matter that some instruments are fundamentally strong and others are weak. What matters is who owns what, who is under pressure and what else they own.... A world in which highly leveraged hedge funds share similar strategies makes it inevitable that what we are seeing now will occur again. And the more complex the strategies, the more surprising the linkages that will emerge.... These funds hired the best and the brightest, yet they became embroiled in crises largely of their own making. If it could happen to them, it will happen again. And we'll all share in the consequences. Again.

Blowing up the lab strikes me as OK--as long as it doesn't blow up the economy. If people who took large leveraged positions without sufficient capital find that they have to sell at fire sale prices to those who do have sufficient capital, that is not necessarily a bad thing. It is a bad thing only if the consequences hit the prices of underlying assets, and thus hit spending flows. And so far that hasn't happened.