A rare perspective from someone who knows

Kelso’s Nuts was kind enough to share his thoughts on this blog about the inner workings of Wall Street. He has an intimate knowledge of some of these things that most of us can’t begin to understand.

Kelso is an Editor for “Editorials from Hell’s leading daily newspaper” and he posts there daily.

The following comment I find to be extremely interesting and enlightening.

ICHABOD: The concept in financial engineering you’re referring to is called “FAT TAILS” or to be more precise “FAT RIGHT TAILS.” Most securities are distributed log-normally meaning the natural logs of their daily changes pertain to a Bell Curve. The non-stationarity of time-series securities data means that there’s tons of errors in the parameters for one and the error that is most often missed is the “act of god” — a devastating loss because of an occurrence much more likely than the Bell Curve would predict.

The 1998 Long-Term Capital Management crisis was more surprising because it really hung on an unexpected world event. Everybody knew there was a Russian debt and currency crisis coming. Everybody had hedged for a chance of a default on debt or a devaluation of the Ruble. The freak-out scenario happened. They defaulted on all debt. They devalued the Ruble sharply. And they imposed very strict bank and currency controls such that people who had hedged with GKO, MinFin and Ruble put-options could not collect their winners from Russia but had to pay off their losers. Meanwhile, in the crisis mode there was this fast flight to quality as the USD, EEU, CHF and JPY skyrocketed and every exotic security in the world correlated as they ever had before. That was an “act of God.”

The results of the popping of the real estate bubble were worse because the bubble’s pop fell well within the bounds of what all the math guys like me had predicted just using normal math. We saw the debt. We saw the deficit. We saw the wars. We saw the commodity boom and huge economic expansion in Europe, Canada, Oceania, South Africa, Russia, the FSU, and South America. But we also saw that the Fed was determined to keep cutting interest rates despite all those factors so as to preserve the housing boom and all the reckless betting by banks that were just greedy johnny-come-latelys and didn’t have the trading experience of either the hedge funds or the trading houses like JP, Goldilocks, Citi, BT, Deutsche, Swissbank/O’Connor, ING, etc.

You’re seeing a terrible immorality play happening here. LONG-TERM CAPITAL MANAGEMENT was made to work at slave wages, with all the General Partners deep in the hole so as to try to pay back the Fed and a Summers-organized consortium of banks who had “bailed out” LTCM but not bailed out either the General of Limited Partners. LTCM took their losses and responsibilities like men and dealt with it despite personal hardship.

Meanwhile, the losers in the far more predictable crisis — the bursting of the housing bubble — are being given Willy Wonka golden tickets!

GROTESQUE!