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Who Is the Next Long-Term Capital Management?

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With over $500 trillion in derivatives tying together the global economy, it only takes a grain of sand in the financial machination to smoke the system.

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"One dog goes one way, the other dog goes the other way and this guy's sayin', "Whadda ya want from me?'"
- Tommy DeVito, Goodfellas

Yesterday we noted that 10-year swap spreads turned negative for the first time ever as risk premiums plummeted, and pointed to the fine folks at Bloomberg for further color.

There are a handful of interpretations floating around the street this morning, at least among those who monitor such things. Some are saying the action was effectively the unwinding of a bad bet; perhaps those banking on higher Treasury yields, or a reversal in the corporate bond or mortgage markets. Others suggest scared bears are scrambling for risk, a capitulation of sorts as the market refused to blow a fuse.

What's the right read? The honest answer is, "I don't know." Perhaps it's a combination of the above, or maybe something that will only show itself with the benefit of hindsight. What's clear is that it's a piece of the puzzle. Our job is to interpret how it fits into the big picture.

I was speaking with Professor Peter Atwater last night and we noodled something that isn't currently being discussed in the media sphere -- the unintended consequences of the Fed Policies as it relates to quant models.

Does anyone remember the Nobel Prize winners at Long-Term Capital Management? Its fixed income arbitrage, statistical arbitrage and pairs trading, coupled with high leverage almost toppled the capital market system when it failed spectacularly.

Why did it fail? One of the inputs "zigged" when it was supposed to "zag."

With all eyes on financial institutions, sovereign defaults, state bankruptcies and pension shortfalls, I'll humbly submit reason #11 to be wary of this scary bull-unforeseen systemic risk emanating from quant models gone awry. This is the first time in history 10-year interest rate swap spreads turned negative. I would venture to guess it wasn't "modeled' that way by the quant geeks.

With upwards of $500 trillion in derivatives tying together our finance-based global economy, including institutions, central banks and the taxpaying public, it only takes a grain of sand in the financial machination to smoke the system.

That's not saying it will happen. It's simply stating that it could. That's a worthy nugget of information as we collectively shape our risk profiles

R.P.
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