Monday, October 29, 2007

Never trust the sleeping markets

When oil went past $50/barrel, there were serious issues with the economy.

Now that oil is past $90/barrel, where does that put us?

Captial markets are melting up...

This bet is more akin to "The Fed loses control entirely and Effective Fed Funds trades radically higher irrespective of what Bernanke does, because nobody trusts anyone anymore - not even overnight."

Source: Market Ticker

So what does this mean?  If banks are borrowing at leg-breaking interest rates of 15% for overnight, they may as well just get an American Express Card.  At least they get the Air Miles or Cash Back points...

An asset is worth only what someone else will pay for it.  If CDOs or other credit derivatives have no market, or become too risky (aka costly) to finance, you end up with the Bell Curve of lending rates falling apart, and everyone taking what they can get just to get out of the burning building.

In statistics, normal distribution is measured out two standard deviations from the mean, where 95% of activity is considered to fall.  Anything outside this is considered outside the norm.

Three standard deviations is a fluke.

Four standard deviations is a mess.

Five standard deviations is a lotto ticket or a lightning strike.

Otherwise known as 5-Sigma.

In a standard normal distribution, an event that occurs five standard deviations or more from the mean has about a 1 in 3,488,555 chance in happening -- fairly unlikely, in other words. Yet plenty of stocks have seen more than their fair share of these lightning strikes.

Interesting thing about lighting, is that it can sometimes strike in the same place twice, can sometimes hit the same person twice, and many people are frightened simply by the ominous sound of thunder in the sky, when really there is nothing worth worrying about.  Except that doesn't matter - people will worry.

Chance & probabilities really don't mean much when you are dealing with irrational behaviour.  Or more specifically, Irrational Exuberance.

In the case of the real-estate bubble, quantity meant more than quality.  The more mortgages issued, the more money was made.  There was no fear of "risk" exposure, because these mortgages were bundled up and sold as packages, diluted like so much oil dumped in the ocean.  The "lead paint" in the asset only showed up after it has been consumed by the market, more specifically the credit markets, and found to be worthless, or at least rated far less than it once was determined.

If 10 of your friends told you something was garbage, would you want to get rid of it?  What if one of your friends offered you $0.10 on the dollar for it, the going rate for something sold in a pawn shop?  Would you trust that friend anymore, especially if he once told you it was worth much more?

With over $2.6 trillion in outstanding swaps (probably more like $4 trillion today), a 90% haircut would leave about $260 billion left over for whoever wanted to fight over it.

But really this is a worst-case scenario, isn't it?  Maybe not... what if there's no market at all for this $2.6 trillion dollars in swaps, or if there was a $0.10 on the dollar market that no one in their right mind would take?  The market for these CDOs would dry up until the next economic cycle makes them viable again....

I am not a market specialist or CDO specialist or even a financial specialist, so these are really just my thoughts on the whole matter of CDOs, Subprime, and the current state of the markets based on what I have read.  Chances are things will always revert back to the mean, and all of this stuff will disappear eventually.  People like a sense of normalcy...

"It's like a free lunch," said Gorgeon. "You're immune to default."

Guaranteed returns on your investment with no risk?  Where do I sign up?

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