A Demon Of Our Own Design

For those who enjoyed 'When Genius Failed' -- the book about LTCM -- this book will be of great interest.

The author, Richard Bookstaber, is actually the author that I had to read when I was going through the CFA (Chartered Financial Analyst) program -- he wrote chapters on 'risk management' that were required reading in order to pass the Level 3 exam and earn the Charter. He is very well qualified to speak on this subject and this topic is extremely pertinent to what is going on in the fixed-income market currently.

The basic theme of the book is that financial market accidents need not be related to actual serious economic problems. The 'structure' of the market itself is set up to spiral out of control at times.

His concluding paragraph is entitled "Built To Crash?"

[due to innovation in the derivatives market] "when a market dislocation arises, it is difficult to know how the prices of these instruments will react. Innovation and mechanical efficiency have also increased complexity by pushing markets to become more interconnected... The combination of tight coupling and complexity is a formula for normal accidents.... In all of these cases disaster was triggered by simple and apparently innocent actions that initiated a chain of compounding problems because of the complex nature of the system..."

"as we have seen time and time again, in the instances where it really matters the liquidity that is supposed to justify the [increased] leverage will disappear with a resulting spiral into crisis."

end quote

Look how this fixed-income market is acting. Look how the broker stocks are acting. Does this look eerily similar to you?

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