The Subprime Situation Report II

As I mentioned earlier, the coming reset of outstanding mortgages will definitely put tremendous pressure on the overall US economy and the financial markets all around the world. Justification for this madness was the dispersal of risk. What do I mean by that?

As you will have probably read elsewhere, these loans were sliced and diced and repackaged and sold as mortgage-backed bonds. They were rated by Moody’s and Standard & Poor’s, often as high as AAA. These CDOs, as they are called, were then sold to investors such as hedge funds. These toxic investments are now spread throughout the world causing immeasurable contamination. But that's not all. What has made the whole situation so much worse is the excessive leverage!

Leverages are everywhere. To give an example of this, the Goldman Sachs funds that have been in great difficulty were leveraged by a factor of eight to ten times and therein lies the rub. Goldman Sachs, who deny bailing the fund out, have nonetheless injected $2 billion of their own money and persuaded outsiders to contribute a further billion, in so doing, have reduced the gearing to 3.5 times – still very rich!

What astounds us is that so many of the participants have been surprised at what has happened. They have the brightest brains and the most modern of computer systems. These computer systems were mentioned in a recent article in the Financial Times by GillianTett and Anuj Gangahar; they said that Goldman Sachs, renowned as one of the savviest players on Wall Street, had to admit that their flagship global equity fund lost over 30% of its value in just one week because of problems with its trading strategies created by computer models. In particular, the computers had failed to foresee recent market movements to such a degree that they labelled them a “25 – standard deviation event”; something that only happens once every 100,000 years or more, yet very recently several occurred on consecutive days!

The conclusion one must draw is that in some fashion or another this extraordinarily, but predictable, chain of events that could only end in disaster are like alchemy, transformed when fed into complicated mathematical equations and crunched by computers to a one in 100,000 years or more probability of collapse. The fact that these computer programs have control over such huge amounts of money should send shivers through the system and bring a smile to Nassim Taleb’s face. Who is he?

Nassim Taleb makes a living out of betting on such rare events. He is famous for his books “Fooled by Randomness” and subsequently “The Black Swan”. He uses the symbolic “black swan” as an example of a rare event and explains that just because you haven’t seen a black swan doesn’t mean that one does not exist, as indeed they do!

So, don't say I never say okay. Prepare to meet Ms Black Swan...soon.