My 1st Million At 33 - yes, you can do it too

Back on October 13, 2007, when I tried to address Wharton’s article on “Financial Innovations: A Double-Edged Sword” via BillCara’s blog, I left the following comment on his site (back in October 2007):

Wharton’s article has touched most of the important topics related to financial innovative products. There are three other things that are not addressed however:
1. Counter-party risk: the solvency of the counter-party must be considered and must be evaluated under some three-sigma events. When the tsunami comes, you don’t want to be right but still be left with the baggage from your counter-party.

2. Cross-correlation of the financial instruments: this needs to be addressed for your own portfolio and your counter-party’s portfolio if possible. The correlation and its potential variation range must be carefully considered. Using efficient frontier, one can potentially absorb high volatility and balance it (through some other negatively correlated instrument) in an entire portfolio.

3. Market efficiency: The risk of a financial product is always proportional to the return. Even if there is a temporary market inefficiency that allows one to arbitrage, such inefficiency (and therefore opportunity) is bound to disappear as the capital that participates in such opportunity expands dramatically. Such process of exploiting market inefficiency is itself making the market efficient again. So no matter how innovative the financial instruments or strategies are, one should not delude oneself into thinking that such edge can last forever.

I put counter-party risk as the most important thing. Obviously, now with Ambak and MBIA monoline insurance companies effectively bankrupt, you would have to wonder how these “prestigious” bankers and financial engineers compared to someone (me) who only took a single macro-economic class for ALL of his economics/finance training.

Well, #2 is to address over-concentration in your own portfolio and also in combination of your counter-party. This is going to be a serious problem for all banks going forward, since most of them are highly concentrated in real estate loans, whose performance is highly correlated to all sorts of credit instruments including commercial real estate loans, corporate bonds, and municipal bonds.

#3 is obviously where all the greedy wallstreet/hedge fund people have failed to even consider. The total amount of real estate loans is simply too big for a potentially safe arbitrage of interest rates between the short and long term bonds. Well, yes, certainly that short term bonds almost always pay less interest on the long term bonds. But with too many people leveraged up 10X or 20X doing the same trade, the efficient market is bound to give you a zero, if not negative return.

Now of course, the reason that I bring up these comments again is that they don’t just apply to subprime loans but to all things financial. The reason for buying physical gold and silver instead of through ETF is exactly due to #1. I’ve looked into GLD, and it seemed to be pretty safe (especially with the gold bar serial number provided). However, the same thing cannot be said for SLV, the silver ETF, which is an even thinly capitalized market. Possibly one day down the road, SLV will trade at a hefty discount to the actual silver spot price, due to counter-party blowup. The the party that’s going to be in trouble is most likely the guys with the biggest derivative books: Citibank and JP Morgan.

I don’t know how Citibank in the future will be, but it has fallen two thirds of its value, and still falling, and it still needs cash infusion. All the big banks and brokerage houses have been simply too greedy and too confident. If you simply look at their account books on Yahoo, all of them (such as Goldman Sachs, Citibank, JP Morgan) are leveraged to hilt, with LOTS of borrowed cash on their book. The total amount of cash is close to a trillion. Now, for example in Citibank, when significant percentage of the portfolio is betting on the same thing: mortgages, then everything easily come crashing down.

Financial leverage always works both ways: up and also down. In a highly leveraged portfolio, it is usually difficult if not impossible to prevent three-sigma events when sufficient number of things come crashing down. Such long term leveraged bets can only rely upon continual expansion of the credit market in saving their ass. Unfortunately, it appears that 2007 is the peak year for credit markets, which won’t recover anytime soon.