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Fed's Tall "Tail"


Government intervention inherently destabilizing.

After this week's much publicized run-up in financial stocks like Citigroup (C), Merrill Lynch (MER) and Lehman Brothers (LEH), officials at the Federal Reserve and the Treasury would have us believe they exert a calming influence on the raging emotions of irrational markets.

Unfortunately, math isn't on their side.

Rather than submerging markets in the tepid bath of government security, the Fannie Mae (FNM) and Freddie Mac (FRE) bailouts and the restriction of short-selling on 19 key financial stocks created a violent move in the intended direction: Up.

Tuesday's whoosh and reversal in the equity markets -- particularly the financials -- was truly phenomenal. The world all but ended in the morning, only to be triumphantly resurrected by the afternoon's close. Wells Fargo (WFC) took the baton and announced earnings that outpaced tempered expectations, and we were off to the races again the very next morning.

It was a rally for the ages. In fact, according to Doug Kass, Tuesday's 13% move in the financial services exchange traded fund, the XLF, was an 11-standard deviation event. Kass pointed out the odds of such an occurrence are roughly the same as the world ending - three or four times.

The last time we saw moves of this magnitude was nearly a year ago, just before the Fed "surprised" the markets by cutting the Discount Rate. Goldman Sachs (GS) CEO David Viniar said jittery markets experienced staggering gyrations -- to the tune of 25 standard deviations -- just days before Bernanke sought to calm them.

Such brazen manipulation shouldn't inspire us to relax into the soothing embrace of the Plunge Protection Team. Rather, government intervention in financial markets is inherently destabilizing, as evidenced by the unprecedentedly rare events of a few days ago.

Financial market risk management is based on math, specifically on statistical models. Traders calculate the odds of an event happening, the potential loss if it does, and then invest accordingly.

Extremely rare events, sometimes called "tail events" (in reference to their position on the normal distribution), break those models and can cause huge losses. In fact, economic theorist Nassim Nicholas Taleb dedicated an entire book to Wall Street's inability to cope with such highly improbable events, which he called "Black Swans."

It used to be that most of these occurrences were caused by acts of nature, geopolitical shocks or long-term structural shifts in the way a certain market or group of peopled acted. Now, with alarming frequency, Washington creates these tail events under the guise of stabilization.

Nothing could be further from the truth.

As the market comes to rely on the Fed and the Treasury to heal its ills, traditional risk management is rendered useless. Investment banks are far better served by spending millions on crafty Washington lobbyists than on teams of expert statisticians and experienced traders to protect the firm's capital.

Irrespective of one's opionion on the economy or the stock market, this isn't a welcome development.
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