By John Reizner |
It seems that with every significant market swoon, commentators come out of the woodwork on financial television and speak of the risk of systemic risk to the financial markets, more recently from hedge fund or complex derivative blow ups, or events from China. I think there is always the risk, however small, that such an event could occur and cause a large scale meltdown, and we would be foolhardy to say this would never happen.
But really, what is the likelihood of such a catalyst now for a catastrophic market event? I think the catalyst could be either caused by one or more of four factors: hedge fund (s) seizing up, a massive derivatives transaction or series of transactions gone seriously awry, the level of our public and private debt, or events from Asia, specifically China.
The first risk factor to the soundness of the financial markets is excessive debt. Sir John Templeton, perhaps the greatest global investor of our time, has said that never before has our financial system been so mired in both public and private debt, and further he has stated that never before has any civilization in history escaped from such levels of debt without dire consequences for its citizens and the society. It is my view that we will be faced with a lower standard of living for all our people if we do not soon effectively address the budget deficit and reform the level of future Medicare and Social Security obligations.
Sir John was alive and I imagine he was vividly impressed with the catastrophic stock market crash of 1929 and the deflationary unwinding that occurred for more than a decade afterward. He has said that another Crash will certainly happen, but that we cannot know when it will strike. Chairman Bernanke, a student of the Great Depression, that era's moniker, has been reported to believe that the Fed could drop money from helicopters in order to stem off a deflationary spiral such as what happened during the collapse of the 1930's (which would be a rather interesting spectacle). A deflationary collapse such as happened in the thirties is possibly the most devastating economic blow that can happen to a society's economic system.
The second risk factor is the behavior of hedge funds in the market. I have spoken about hedge funds in my article, "Four Reasons Why You Should Not Invest in Hedge Funds". There are now over 8,000 hedge funds reportedly managing hundreds of billions of dollars. Hedge funds provide a valuable service to the market by providing liquidity to the market so the rest of us can reliably execute our trades. But many funds use a great deal of leverage in an attempt to achieve higher returns. The hedge fund Long Term Capital Management, begun by John Meriwether in 1994, a former Salomon Brothers bond trader, achieved wonderful returns in its early years, but ran into trouble in 1998 when the Russian government defaulted on its debt. Returns afterward went negative as a result of the consequences of the default. As the firm was using an extraordinarily high level of leverage, their results were severely impacted. A multi billion dollar bailout of the fund had to be organized to prevent a contagion and collapse in the financial markets.
The third risk factor to the markets is derivatives. Derivatives are investment instruments based on underlying assets such as stocks, bonds, commodities, indexes, interest rates, and so on. The derivative can include put and call options, commodity futures, or interest rate swaps, etc. There are opportunities in these instruments to reap large reward or great loss. There are both publicly traded derivatives and ones traded by private agreement. Warren Buffett was quoted from his March 2003 annual letter about the danger of a miscalculation in complex derivatives transactions. He stated, "we view them as time bombs, both for the parties that deal in them and the financial system." see http://www.forbes.com/home_asia/2003/05/09/cx_aw_0509derivatives.html. Both Alan Greenspan and Warren Buffet are concerned that fewer economic institutions are handling derivative transactions, and Buffett has called them "weapons of mass destruction." Id.
The fourth risk to the financial markets is adverse market and economic events from China. The February 2007 Shanghai market swoon shook the confidence of investors worldwide. We do not yet know how this will play out. The record of U.S. markets over the last twenty seven years in relation to similar events is in my estimation good. The market has recovered ground lost from sudden market downturns in 1987, 1989, and 1998. If you want to hunker down it may make sense to seek diversification of assets and to keep enough assets to cover your debt should the unthinkable occur.