Wall Street Crisis, Risk Calculation, and Moral Hazard

And so the story continues, as we find out that as many had expected, Lehman Brothers was in such horrible financial shape that nobody was willing to buy them. This, of course, was exacerbated by that fact that the U.S. Government refused to back-stop this deal, as they agreed to do in the case of Bear Stearns, Freddie Mac, and Fanny Mae. Why would they refuse? There was no other option. Behind closed doors, for weeks, many people spoke secretly on Wall Street about the potential that Leman Brothers was in such bad shape that even the government would not be willing to back-stop something that was inevitably a losing deal for tax payers. Then, minutes after the news that Lehman Brothers wouldn't survive, Bank of America and Merrill Lynch announced a buy-out deal that values Merill Lynch at around $29/share, or approximately $44 billion. This is a 70% premium to Friday's close. The interesting caveat to this scenario is that rumors are being floated around that federal regulators forced Merrill to begin shopping itself, culminating in a deal this weekend. It really doesn't matter, but what does is how this is going to effect world-wide financial markets going forward, and especially U.S. government credit around the world. We are now left with WaMu, AIG, and Citigroup as the 'ugly-red-headed-step-children' of Wall Street. Many have speculated that those in the bear camp will attempt to raid AIG and Citigroup even further this week, as they did Bear Stearns, Lehman Brothers, Merrill Lynch, IndyMac, Freddie Mac, Fannie Mae, and Washington Mutual. To help in anyway possible, the Fed now says it will now accept 'low quality' assets in return for government loans, or in other words they will take horribly effected equity positions and other no-bid, no promise 'assets' in order to execute emergency capital exchanges. At some point, the U.S. government becomes a serious issue in regards to its own credit, its own balance sheet, and world-wide worthiness as a financial business partner going forward.

Calculations of risk obviously failed, but it is important to look at these issues in combination with moral hazards going forward. It is impossible to plan for every and anything, but to be leveraged 100:1, 75:1, or even 50:1 is just INSANE. What is even more insane, is the fact that many, if not all Wall Street firms use and or used this type of leverage on a regular basis. Great when things are going your way, almost so great that the potential for disaster seems to become a distant worry, but in the event that anything turns against you, things happen so quickly that being so highly levered makes getting out of the way impossible. Interestingly enough, a great many quantitative models designed to run millions of scenarios based upon investing inputs decided upon by these firms when testing, came up with these exact scenarios, yet the degrees to which models showed them as 'possible', really didn't even make a blip on the radar. Obviously, firms do these tests in order to design protocol and risk management strategies for situations more likely to occurr, but there MUST be a plan for the worst case scenario, and in my opinion, many of these firms did not adhere to this fundamental investing rule. ALWAYS HAVE A PLAN, and especially, ALWAYS HAVE A PLAN FOR THE WORST. It is not clear yet (it very well may never be clear) whether these firms saw themselves as 'too big to fail', 'too intelligent' to fail, or just took the very humanistic approach of 'this cannot happen to me/us', but ultimately there was a disconnect between percieved risk, regulation, and internal firm responsibility to clients, employees, and the financial system as a whole. Ultimately, leverage ratios reached such enormous levels that when these disaster scenarios came to pass, what was created was such an intense gearing to the downside that when rumors began or clients wanted their money, the chain of events did not allow time for any planning, adjustments, or capital preservation. Admitedly, this period will go undoubtedly go down as one of the most infamous Wall Street implosions, so I do not speak on these issues as though they truly could have been altered to any great degree, but I simply want everyone to learn that for their OWN trading, having a disaster plan is always of great importance. So, plan or no plan, over confident or not confident enough, this is what happened to the firms experiencing disaster scenarios right now. Many of them, even if they had wanted to (and they did!), could not have avoided this end game, greatly coming as a result of poor planning and continuing to pretend as though everything was okay. Do you remember how many times Lehman, Merrill, Bear Stearns, Citigroup, WaMu, AIG,etc, came out and said things like 'we are well capitalized, our balance sheet is strong, things look good going forward, and on and on? There was this idea that financial firms simply needed just a little more time to get out of the woods. The entire 'mark-to-market' debacle in which these firms finally had to value many of their assets (which had inflated, old valuations) at true, real market value (most of the time this was pennies on the dollar), finally put a nail in the coffin for the 'wait out the storm' idea. And so, alas, this passing moment never came, and although this 'hide your head in the sand strategy' has worked many times in the past, just as in trading, bad decisions that are rewarded at times, end up creating the potential for major disasters at some point in the future. Well, that time is now, and at some point as Americans we must hope for the best of our financial system. As a trader, I will do whatever I can to exploit the situation for profits, but that's because it is my job....I have some out of the money put contracts on the NDX 100 that I expect to sell on the open, but depending on the action, I may keep them for further downside later into this week. It is OptionsExpiration as well, so on top of everything going on right now, this only helps to contribute to the volatility and potential nastiness of the markets.

Good Luck This Week Traders! Be careful, lots of head fakes, expect the unexpected, and trade as though you expect the completely 'impossible' to happen at all times. "Think like a criminal". What would hurt the most people, most of the time? This is something I ask myself on a regular basis, and although you cannot trade solely based on this idea, it helps to keep proper perspective. Nothing is for sure, and nothing is promised. Discipline, discipline, discipline. This is not a bad time to take a break from trading if you are worried about what to do. Being in cash is NEVER wrong, don't let anyone tell you that it is.
Aloha, and talk to you tomorrow!