Tuesday, July 10, 2007

Dancing? Shouldn't You Be Digging?


"We're still dancing," beams Chuck Prince, the CEO of Citigroup, in reference to the big bank's lending activities. The problems in the sub-prime mortgage market are not large enough to cause a problem for Citigroup, he says, much less for the financial markets as a whole.
"The depth of the pools of liquidity is so much larger than it used to be," Prince explains to the Financial Times, "that a disruptive event now needs to be much more disruptive than it used to be."
Hmmm...seems like a reasonable assessment. On the other hand, a bigger pool makes a bigger splash. In the context of today's gargantuan derivatives markets, for example, the LTCM debacle of the late 1990s seems like a storm in a teacup. The next storm, if and when it arrives, will likely produce ripples of much larger magnitude and much greater destructive force.
Back in the days when the Nobel prize winners at LTCM were devising news ways of losing billions of dollars, credit derivatives were little more than gleams in the eyes of investment bankers. The problems at LTCM, therefore, failed to trigger any enduring knock-on effect. But the financial markets of today feature an unprecedented quantity and variety of illiquid financial oddities that have never witnessed a financial crisis, nor even a garden-variety bear market.
What will happen, therefore, if the unexpected were to occur?
No one knows.
What we do know is that the notional value of credit derivatives outstanding has doubled five years in a row and now exceeds the value of the entire American GDP.

"At some point," Citigroup's Prince admits, "the disruptive event will be so significant that instead of liquidity filling in, the liquidity will go the other way...When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you've got to get up and dance."
...unless you don't mind leaving the party a little early.

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