Comments on Rick Bookstaber: Can high liquidity + low volatility = high risk?

I was speaking historically; up until this crisis ...

2009-05-21T07:49:54.829-04:00

I was speaking historically; up until this crisis default risk was never the big concern with mortgages. Rather, issues related to the prepayment option were the biggest risk and concern.

There had been cases of localized high default, but not anything like this. So was this a "Black Swan"? I would not call it that -- the term Black Swan is the same as what we call Knightian uncertainty -- risks that cannot be considered or measured. In the case of default, this is a risk that was known and is measured. The problem is that we mismeasured it. We were in a game of roulette and got the odds of a 00 wrong.

Putting it another way, if someone had asked those who are knowledgeable about modeling default risk if they thought it possible for sub-prime mortgages to have a default rate like what we are seeing they would have conceded it to be possible, but put the odds of the event as being very low. But our dumb luck is that this low probability event occurred.

Just starting your book on Deamon, and am enjoying...

2009-05-21T03:15:42.067-04:00

Just starting your book on Deamon, and am enjoying it. Hope there will be a followup on how the Demon destroyed the economy. Struck by sentence on p 54 that "mortages have little in the way of default risk". Was this a Black Swan that even you didn't see? How important was the the Li Copula? Is financial engineering the breeding pond of Black Swans?

there hasn't been much discussion about the gr...

2007-09-01T01:32:00.000-04:00

there hasn't been much discussion about the growth of futures in the investment world. with the same amount of equity, an investor can buy S&P futures contracts which are inherently 20x more levered that the equivalent amount put on in SPY's.

moreover, the growth of levered ETF's is also affected everyday accounts -- even IRA's.

leverage is everywhere.

Is an issue with leverage amplified by the lack of...

2007-08-31T09:20:00.000-04:00

Is an issue with leverage amplified by the lack of transparency among hedge fund credit providers? Stated another way, one hedge fund could have multiple lines of credit from different banks thus obscuring the true amount of leverage (or credit outstanding) any one bank is aware of. I'm about 60 pages into your book, already a classic in my opinion, so if you discussed this already feel free to ignore.

I believe that Rick meant that, by borrowing (leve...

2007-08-31T01:04:00.000-04:00

I believe that Rick meant that, by borrowing (leveraging) to juice their returns, hedge funds are creating additional funds that have to be invested. This increases the amount of liquid assets seeking a home, forcing returns down as there is more money than there are places to invest (liquidity demanders).

The lower returns reinforce the need to lever so that the returns on invested capital provide the hedge fund's investors with attractive returns (without which the investors might redeem their interests and invest through other managers).

Hi Rick,

one point is still not too clear t...

2007-08-30T16:48:00.000-04:00

Hi Rick,

one point is still not too clear to me: why does higher leverage brings more liquidity?

I understand that higher liquidity (whose cause might be, say, an increase in corporate profits, or more credit opportunities, etc.) brings to lower volatility, which in turn brings to higher leverage. But it sounds to me that higher leverage means that you try to buy 20$ on the back of, say 5$ of assets you own, instead of 10$. So the leverage has increased form 2x to 4x (you still own 5, but now you pretend to buy more). So, if my view is correct, higher leverage doesn't have to increase liquidity, it should just increase the risk of the Hedge Fund. This I know so far, but I hope to learn more from you.

Thanks,

Bernardo.

Rick:

I understand what you are saying, and...

2007-08-23T21:34:00.000-04:00

Rick:

I understand what you are saying, and you made that point very well in the book. Leverage can kill.

Leverage killed LTCM and many other funds and investors before, and since.

From what I've seen over the last few weeks, volatility has been on the upswing (although certainly not at an unprecedented level).

There have been some liquidity shortages, at least in the banking system (you only have to see the reserves versus required reserves and the volume at the discount rate window in today's numbers to see that).

Over the last two weeks, there had been some liquidity issues in the corporate markets (and a rush to government bonds that was unusual).

Do you feel that the increased volatility and reduced liquidity are at a point where we are nearing a crash?

Thanks.