Sneak Preview - Part 4: Helicopter Commander by Jim Puplava www.financialsense.com Storm Watch Update: Part 1 Part 2 Part 3 November 18, 2005
There would come a day that would be unlike any other day. There would be an event unlike any other event. It would precipitate a crisis unlike any other crisis before it. It would emerge out of nowhere at a time no one would expect. It would be an event that no one anticipated—a crisis the experts didn’t foresee. It would be an exogenous event—a rogue wave.
When the crisis arrived it caught market participants by surprise. Its arrival was swift and unexpected. Losses hit every sector. The devastation was encyclopedic in its breadth and utterly cataclysmic in its destruction. A financial nuclear chain reaction had been set in motion that rippled across every market and reached into every corner of the globe. It shook the very foundations of the global financial system leaving fear and destruction in its wake.
At the epicenter of this storm was the titanic hedge fund, WedgeBook Partners, and its captain J. Gordon Grecko. WedgeBook had $20 billion in equity, of which two-fifths belonged to Grecko and his partners. At the core of the storm was the firm’s $150 billion in debt and its asset book of $1.5 trillion. In Wall Street terms $20 billion in equity was big money, yet it was absolutely insignificant when sized against the firm’s debt of $150 billion and leveraged assets of $1.5 trillion. It took less than six weeks to lose it all. In the final stages of its demise WedgeBook was losing a billion dollars a day. WedgeBook’s leverage of 75:1 was too dangerously high. In good times and in stable markets that leverage had magnified the fund’s legendary returns. In unstable and declining markets that leverage proved to be fatal.
In times of extreme duress markets can seize up, liquidity can dry up, and panic can overwhelm the whole financial system. When crises erupt, investors eject out of every market with alarming speed. They abandon exotic and emerging markets and run from risk wherever it lurks. Like fire in a movie theater, everyone runs for the exits simultaneously. When everyone is selling at the same time, sellers can overwhelm markets. When a firm has to sell in a market that has been seized by panic, there are no buyers. When there are more sellers than buyers, market prices plunge to extreme lows—far below what investors ever anticipated. This is what happened to WedgeBook Partners. In the final days of WedgeBook’s demise, leverage and lack of liquidity unleashed hell on the world’s markets.
What transpired in the end was beyond anyone’s comprehension. There was a flaw in the system that all the models had missed. The probability of systemic risk, ever present, lying invisible in the background, was considered a once-in-a-lifetime occurrence and a statistical impossibility. These were the "fat tails" that lingered at the end of the bell-shaped curve, waiting patiently to explode. Although statistically possible, they were considered improbable and therefore they were kept out of sight and out of mind. The problem was that they reappeared more often than was acknowledged. The notion that relying on any formulaic model posed inescapable systemic risk eluded the financial elite. This was true of J. Gordon Grecko whose belief in himself and the predictability of his models bordered on conceit. The fact that one day, without warning, trades would leap off the charts was considered by the best minds to be an unlikely statistical freak.
The hubris of men like Grecko and others like him who worked on the Street and the financial capitals around the globe was rooted in their belief in the infallibility of their models. They assumed each roll of the dice or every trade would be governed by the same statistical model and the gods of chance would continue to smile upon them. There are reasons why financial markets can run to extremes. Markets are more random than certain. It is this arbitrariness that catches the markets by surprise. Each day’s closing price is not a complete sample from which long-term trends can be projected into infinity, as if each trade or coin toss will come out the same. The only problem with this assumption is that more often than not, the patterns change. When they do, they became disruptive events. They turn into a one-hundred-year or perfect financial storm.
This was one of those times. The events as they unfolded had a beginning as they would have an end. The clues warning of the coming storm were there for all to see. They were simply ignored. However, before the storm, there was a beginning and it is to that beginning that we must now return. It is here that we find the clues that foretold this series of most unfortunate of events.
My final installment, “The Day After Tomorrow, Part 4: Helicopter Commander” is coming next week. Here's a sneak preview of my main characters...
