Who next?
Lehman Brothers goes down in flames, leaving a very sanguinary scene on all the Streets around the world. How did this come about? Why did this happen? Weren't these guys supposed to be the geniuses who make the world go 'round? Sadly, this shouldn't be as shocking as it appears. The collapse of Long Term Capital Management (LTCM) should've been the wake up call for regulators and investors everywhere. Unfortunately, it was not. Roger Lowenstein, who's book - When Genius Failed - on the rise and precipitous fall of LTCM is a must read, has a very interesting article in the New York Times describing the fallacies and hubris that have lead us to the current situation. Also particularly prescient is this letter from the Oracle of Omaha, Warren Buffet, to Berkshire shareholders in 2002, describing derivatives and his rational for staying away from these, "financial weapons of mass destruction." (Note, you'll have to scroll to the end of the section titled "Derivatives").
My own two cents are this - there are many failures that are on display in the markets now. But of these, two stand out to me, both of which are at the heart of the problem. First up is the destruction of the basic moral predicates that modern finance and commerce are built upon. By lending to people who had no or limited means of repaying their loans, lenders, of all creed, jettisoned their moral obligation as bankers and became usurious loan sharks. By selling their loans on to other parties as derivative obligations, they hoped to rid themselves of the risk of being a lender, by any other name. But, when everyone is buying from everyone else, is there any doubt that we wouldn't have ended up here? The second failure is a more scientific one, and one that Roger Lowenstein states - that of an excessive, even servile, belief in models. Mathematical models by definition are predicated upon simplifying assumptions, that make the mathematics tractable. Thus a model is not an exact replica of the real world, but a noisy reflection of it, that is good within a bound (if a terribly loose one), and is convergent (if at all) only in an asymptotic sense. By forgetting this, banks have betted their existence away.
Having said this, I am still sanguine about the entire situation. By allowing Lehman to fail, the Fed has probably prevented a "moral hazard", where by market players assume that there is no risk that the government won't guarantee, thus encouraging even more risk-taking. Some blood-letting now should keep the world in good stead for the future. Further, the events of this weekend are probably cathartic and might provide relief from the state of suspended animation that the markets have been in for over a year now. However, these particular woods haven't been crossed yet, and it begs the question - who next?
My own two cents are this - there are many failures that are on display in the markets now. But of these, two stand out to me, both of which are at the heart of the problem. First up is the destruction of the basic moral predicates that modern finance and commerce are built upon. By lending to people who had no or limited means of repaying their loans, lenders, of all creed, jettisoned their moral obligation as bankers and became usurious loan sharks. By selling their loans on to other parties as derivative obligations, they hoped to rid themselves of the risk of being a lender, by any other name. But, when everyone is buying from everyone else, is there any doubt that we wouldn't have ended up here? The second failure is a more scientific one, and one that Roger Lowenstein states - that of an excessive, even servile, belief in models. Mathematical models by definition are predicated upon simplifying assumptions, that make the mathematics tractable. Thus a model is not an exact replica of the real world, but a noisy reflection of it, that is good within a bound (if a terribly loose one), and is convergent (if at all) only in an asymptotic sense. By forgetting this, banks have betted their existence away.
Having said this, I am still sanguine about the entire situation. By allowing Lehman to fail, the Fed has probably prevented a "moral hazard", where by market players assume that there is no risk that the government won't guarantee, thus encouraging even more risk-taking. Some blood-letting now should keep the world in good stead for the future. Further, the events of this weekend are probably cathartic and might provide relief from the state of suspended animation that the markets have been in for over a year now. However, these particular woods haven't been crossed yet, and it begs the question - who next?