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The global credit crisis has its indelible effect on the stock markets around the world as they are suffering terrible loses. The US housing market has collapsed as loans were handed out to people without income, jobs or assets. But when the interest rates are low the poor credit histories can relax as the banks have the option to repossess and make a profit on the property. But now when the market is heading towards a recession, it happens to be all about thriving in the depression market.

The bad mortgages are the prime reason on why the building societies are going kaput. The financial engineering and the globalization of the finance market has actually aggravated and spread the crisis. To counter this problem, the ‘collateral debt obligation’ was ideated, and this bond was thought to be a good investment option as the mortgages were backed by property. But as the mortgage saga happened to be faulty itself, the bond never yielded positive results and a whole lot of banks in the US, France and Germany have refused to value funds which are backed by these debt instruments.

This has led to a slump in the interest rates and if the stock market further slumps, it will chip away the possibility of any probable rise in the rates. So, naturally it is not a high time for the stock market shareholders. Every fall will make them cumulatively poorer. The fundamentals have always been the same, which is to buy low and sell high. Therefore, the investors must not panic and start selling their shares. Stock market investment on a particular medium should always be on a long term basis. But if the investor has touched the burning pie called the high risk investment, in the form of hedge funds, contracts for difference and spread betting, it is casualty guaranteed.

With the housing market grinding to a halt aided with the stock market slump, there will be a severe cut down on the expensive mortgages. Even if a low single digit growth in the housing prices can be achieved, that can be the ‘best’ possible accomplishment.

But with respect to the shares, it will be wrong to predict a total meltdown. According to the International Monetary Fund, this current crisis is manageable, since the world’s Central banks are squeezing in funds into the stock market. But the stock market cannot cease to be apprehensive.

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Months after the auction rate securities (ARS) market collapsed following a broker-dealer pullout, investors across the United States are still waiting for liquidity to return to investments they once thought were safe places to park their funds. Though some issuers of municipal bonds have made efforts to refinance their debt, holders of student loan backed auction rate securities have only a 99% auction failure rate to look forward to.

The story of the ARS market collapse, like many others involving the finance industry, is one mired in conflict of interest.

For much of the ARS market’s history, broker-dealers like UBS, Merrill Lynch, and Lehman Brothers had “shored up” their auctions by submitting bids on their own behalf. These bids ‘of last resort’ provided extra demand for auction rate stocks and bonds, ensuring that there was a buyer for all shares exposed for sale at auction. For years, this practice appeared immensely successful; the market thrived and investors were attracted by the liquidity of the ARS system.

But by late 2007, major investment firms and broker-dealers were well aware that the ARS market bubble was about to burst, as internal e-mails and reports to state governments show. This was a serious concern to broker-dealers, many of whom had accumulated billions of dollars in auction rate paper. These concerns were swiftly conveyed to several state governments, encouraging municipal borrowers to refinance their debt - a gesture not of broker-dealer goodwill, but of self-interested survival, as evidenced by the fact that such a warning was never given to the countless investors who also held ARS.

However, even such a move was not enough to satisfy executives at major financial institutions; they needed some way to quickly unload ARS that they knew were doomed. But who in their right mind would want to purchase the securities in the months before a market crash?

Faced with a conflict of interest between preserving immediate profits and ensuring the well-being of their customers, broker-dealers predictably chose to save their own money. Though they knew that auction rate securities were soon to become illiquid, they aggressively marketed the securities to unsuspecting investors as “safe, liquid, cash-equivalent” investments.

What investors didn’t know:

- The securities they were purchasing were held by broker-dealers who were eager to unload paper whose value and liquidity were due for a fall.

- The liquidity of the ARS market was dependent on the same broker-dealers who were trying hard to exit the market.

For more information about the ongoing auction rate securities crisis, visit the website of ARS lawyers at http://www.auctionratesecuritieslawsuit.com.

Joseph Devine

Back in 1997 major financial slump rocked number of countries in Asia, an event that became known as “Asian currency crisis”. Effected countries included Taiwan, Thailand South Korea and others. One of the memorable comments of the time came from one of leading Thai politicians. He blamed this whole mess on speculators, with George Soros being the main culprit. The remarks went so far as to public statement of “not being able to guarantee his safety if he visited Thailand”. Quite ominous.

The fallout in South Korea was brutal. The US Dollar has about doubled in value against the Won, with USD-KRW moving from just above 800 in early 1997, to 1600 by the year’s end. Local stock market suffered similar fate, as did all areas of economy. Perhaps most telling was an enormous spike in unemployment, as the jobless rate soared to almost double digits, with about 9 million people out of work.

This author observed the aftermath first hand, during one of his business trips to South Korea at that time. Collapse of once high flying conglomerate Daewoo under burden of debt. The sight of many construction projects suspended or stopped all over Seoul and Pusan. Daily failure of scores of small business. It was good time to visit South Korea, due to low prices, but very difficult period for residents.

The country has rebounded nicely since then and became one of Asia’s most dynamic economies. KRW strengthen considerably reaching level 900 against USD in 2007. The stock market has recorded double digit gains in four of the last five years, gaining 32% in last year alone. Korean companies like Samsung Electronics Co, and Hyundai Motors Co, have established themselves as some of the world’s leading corporations.

Things have changed in 2008. Challenges like high oil prices, inflation, external debt and account deficit have shaken investors confidence. While many countries have seen outflow of funds into the dollar, this process became especially painful in South Korea. The Won has become the Asia’s worst performing currency, loosing 20% to date. Stock market was no better, falling 25%, with farther sell off of equities expected.

These developments created widely spread comparisons to situation from 1997 and were quick to be picked by the press. International Monetary Fund disagrees with this assessment and expressed confidence by saying that South Korea is a mature and resilient economy with country’s fundamentals much stronger than a decade ago. Korean financial authorities, however, felt obligated to act by intervention on Wons behalf in the open market. This seemed to stop the bleeding for now.

What can be expected next? In all reality, 1997 type sell off is extremely unlikely. As South Korean economy is cooling down together with the rest of the world, Seoul might not be able to stop bleeding of the stock market but there is one thing they can do- keep intervening on behalf of its currency. Unlike before, there are huge foreign reserves, about 250 billion dollars worth of, and they can be used to support Won.

Very likely scenario, as of this writing, is continued fall of Korean equities, in tune with broader stock declines. The Won should also keep dropping, but in much more measured and steady pace. Central Bank has not mentioned what the comfortable level for USD-KRW is, but as we noticed over last few years, major trends are very powerful and can go through any “line in the sand’ drawn by anybody.

Current rate is around 1150. Even with expected interventions, Won can easily weaken to 1300 and maybe 1400, but far short of the previous low of 1600. Also, one shouldn’t look for a fast move, but rather steady depreciation, lasting a year or two. This is not a situation for active traders, but for those who prefer longer term positions current development might present good opportunity for farther selling of KRW.

Mike P. Kulej is a Chief Forex Strategist for Spectrum Forex LLC. He specializes in mechanical trading systems as explained on http://www.spectrumforex.com . Spectrum Forex LLC offers numerous services to individual traders. He also publishes trading blog http://www.fxmadness.com. With questions and comments e-mail him at kulej@spectrumforex.com

Denial is a ubiquitous psychological defense mechanism. It involves the repression of bad news, unpleasant information, and anxiety-inducing experiences. Judging by the German press, the country is in a state of denial regarding the waning health of its economy and the dwindling fortunes of its financial system.

Commerzbank, Germany’s fourth largest lender, saw its shares decimated by more than 80 percent to a 19-year low, having increased its loan-loss provisions to cover flood-submerged east German debts. Faced with a precipitous drop in net profit, it reacted reflexively by sacking yet more staff. The shares of many other German banks trade below book value.

Dresdner Bank - Germany’s third largest private establishment - already trimmed an unprecedented one fifth of its workforce this year alone. Other leading German banks - such as Deutsche Bank and Hypovereinsbank - resorted to panic selling of equity portfolios, real-estate, non-core activities, and securitized assets to patch up their ailing income statements. Deutsche Bank, for instance, unloaded its US leasing and custody businesses.

On September 19, Moody’s changed its outlook for Germany’s largest banks from “stable” to “negative”. In a scathing remark, it said:

“The rating agency stated several times already that current difficult economic conditions that are hurting the banking business in Germany come on top of the legacy of past strategies that were less focused on strengthening the banks’ recurring earning power. Indeed, the German private-sector banks, as a group, remain among the lowest-performing large European banks.”

Last week, Fitch Ratings, the international agency, followed suit and downgraded the long-term , short- term, and individual ratings of Dresdner Bank and of Bayerische Hypo- und Vereinsbank (HVB).

These were only the last in a series of negative outlooks pertaining to German insurers and banks. It is ironic that Fitch cited the “bear equity markets (that) have taken their toll not only on trading results but also on sales to private customers, the fund management business and on corporate finance.”

Germans used to be immune to the stock exchange and its lures until they were caught in the frenzied global equities bubble. Moody’s observes wryly that “a material and stable retail franchise in its home market, even if more modestly profitable, can and does represent a reliable line of defence against temporary difficulties in financial and wholesale markets.”

The technology-laden and scandal-ridden Neuer Markt - Europe’s answer to America’s NASDAQ - as well as the SMAX exchange for small-caps were shut down last week, the former having lost a staggering 96 percent of its value since March 2000. This compared to Britain’s AIM, which lost “only” half its worth. Even Britain’s infamous FTSE-TechMARK faded by a “mere” 88 percent.

Only 1 company floated on the Neuer Markt this year - compared to more than 130 two years ago. In an unprecedented show of “no-confidence”, more than 40 companies withdrew their listings last year. The Duetsche Boerse promised to create two new classes of shares on the Frankfurt Stock Exchange. It belatedly vowed to introduce more transparency and openness to foreign investors.

Banks have been accused by irate customers of helping to list inappropriate firms and providing fraudulent advisory services. Court cases are pending against the likes of Commerzbank. These proceedings may dash the bank’s hopes to move from retail into private banking.

To further compound matters, Germany is in the throes of a tsunami of corporate insolvencies. This long-overdue restructuring, though beneficial in the long run, couldn’t have transpired at a worse time, as far as the banks go. Massive provisions and write-downs have voraciously consumed their capital base even as operating profits have plummeted. This double whammy more than eroded the benefits of their painful cost-cutting measures.

German banks - not unlike Japanese ones - maintain incestuous relationships with their clients. When it finally collapsed in April, Philip Holzmann AG owed billions to Deutsche Bank with whom it had a cordial working relationship for more than a century. But the bank also owned 19.6 percent of the ailing construction behemoth and chaired its supervisory board - the relics of previous shambolic rescue packages.

Germany competes with Austria in over-branching, with Japan in souring assets, and with Russia in overhead. According to the German daily, Frankfurter Allgemeine Zeitung, the cost to income ratio of German banks is 90 percent. Mass bankruptcies and consolidation - voluntary or enforced - are unavoidable, especially in the cooperative, mortgage, and savings banks sectors, concludes the paper. The process is a decade-old. More than 1500 banks vanished from the German landscape in this period. Another 2500 remain making Germany still one of the most over-banked countries in the world.

Moody’s don’t put much stock in the cost-cutting measures of the German banks. Added competition and a “more realistic pricing” of loans and services are far more important to their shriveling bottom line. But “that light is not yet visible at the end of the tunnel … and challenging market conditions are likely to persist for the time being.”

The woeful state of Germany’s financial system reflects not only Germany’s economic malaise - “The Economist” called it the “sick man” of Europe - but its failed attempt to imitate and emulate the inimitable financial centers of London and New-York. It is a rebuke to the misguided belief that capitalistic models - and institutions - can be transplanted in their entirety across cultural barriers. It is incontrovertible proof that history - and the core competencies it spawns - still matter.

When German insurers and banks, for instance, branched into faddish businesses - such as the Internet and mobile telephony - they did so in vacuum. Germany has few venture capitalists and American-style entrepreneurs. This misguided strategy resulted in a frightening erosion of the strength and capital base of the intrepid investors.

In a sense, Germany - and definitely its eastern Lander - is a country in transition. Risk-aversion is giving way to risk-seeking in the forms of investments in equities and derivatives and venture capital. Family ownership is gradually supplanted by stock exchange listings, imported management, and mergers, acquisitions, and takeovers - both friendly and hostile. The social contracts regarding employment, pensions, the role of the trade unions, the balance between human and pecuniary capital, and the carving up of monopoly market niches - are being re-written.

Global integration means that, as sovereignty is transferred to supranational entities, the cozy relationship between the banks and the German government on all levels is over. Last October, Hans Eichel, the German finance minister, announced OECD-inspired anti-money laundering measures that are likely to compromise bank secrecy and client anonymity and, thus, hurt the German - sometimes murky - banking business. Erstwhile rampant government intervention is now mitigated or outright prohibited by the European Union.

Thus, German Laender are forced, by the European Commission, to partly abolish, three years hence, their guarantees to the Landesbanken (regional development banks) and Sparkassen (thrifts). German diversification to Austria and central and east Europe will provide only temporary respite. As the EU enlarges and digests, at the very least, the Czech Republic, Hungary, and Poland in 2004-5 - German franchises there will come under the uncompromising remit of the Commission once more.

In general, Germans fared worse than Austrians in their extraterritorial banking ventures. Less cosmopolitan, with less exposure to the parts of the former Habsburg Empire, and struggling with a stagnant domestic economy - German banks found it difficult to turn central European banks around as successfully as the likes of the Austrian Erste Bank did. They did make inroads into niche structured financing markets in north Europe and the USA - but these seem to be random excursions rather a studied shift of business emphasis.

On the bright side, Moody’s - though it maintains a negative outlook on German banking - noted, in November 2001, the banks’ “intrinsic financial strength and diversified operating base”. Tax reform and the hesitant introduction of private pensions are also cause for restrained optimism.

Pursuant to the purchase of Drsedner Bank by Allianz, Moody’s welcome the emergence of bancassurance and Allfinanz models - financial services one stop shops. German banks are also positioned to reap the benefits of their considerable investments in e-commerce, technology, and the restructuring of their branch networks.

The Depression on 1929-1936 may have started with the meltdown of capital markets, especially that of Wall Street - but it was exacerbated by the collapse of the concatenated international banking system. The world today is even more integrated. The collapse of one or more major German banks can result in dire consequences and not only in the euro zone. The IMF says as much in its “World Economic Outlook” published on September 25.

The Germans deny this prognosis - and the diagnosis - vehemently. Bundesbank President Ernst Welteke - a board member of the European Central Bank - spent the better part of last week implausibly denying any crisis in German banking. These are mere “structural problems in the weak phase”, he told a press conference. Nothing consolidation can’t solve.

It is this consistent refusal to confront reality that is the most worrisome. In the short to medium term, German banks are likely to outlive the storm. In the process, they will lose their iron grip on the domestic market as customer loyalty dissipates and foreign competition increases. If they do not confront their plight with honesty and open-mindedness, they may well be reduced to glorified back-office extensions of the global giants.

About The Author

Sam Vaknin is the author of Malignant Self Love - Narcissism Revisited and After the Rain - How the West Lost the East. He is a columnist for Central Europe Review, PopMatters, and eBookWeb , a United Press International (UPI) Senior Business Correspondent, and the editor of mental health and Central East Europe categories in The Open Directory Bellaonline, and Suite101 .

Until recently, he served as the Economic Advisor to the Government of Macedonia.

Visit Sam’s Web site at http://samvak.tripod.com; palma@unet.com.mk

Let me tell you something simple. If you can catch the wave of a non-farm payroll release, you can make a lot of money quickly.

If fact you know it’s a gold mine, because the brokers don’t like you doing it. I guarantee you, if the average broker doesn’t like you doing something, then you’re doing something right.

So, that said, it’s still dangerous. If you get on the wrong side, you’ll get hammered. So how do you trade the NFP report?

Simple. Just simplicity itself. You wait for a bit after the release to let the whipsaws work themselves out of the market.

After they’ve worked themselves out, you enter.

Okay, it’s granted that not all fx brokers will let you do this. You will need to hunt around for one who will let you.

So, if the price is racing up, and has been for the past 3 to 5 minutes, enter a long order. Exit on weakness. In other words, when the price looks like it’s going to come back down and collapse, then exit.

You trade only on strength.

Now, what if you enter and the price immediately goes against you?

Don’t give the price more than 17 pips against you. At the 17 pip loss point, exit. You’ll make so much more than that on winning trades that the risk/reward ratio is well in your favor.

Don’t worry about that.

If the price has only gone up several pips (like say 9 or so) and then comes back down, just exit at entry.

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The price of gold per ounce is exploding!

• Gold has gone up forty-six dollars in the last couple of days alone.
• Gold is now up eleven percent year-to-date.
• Gold has also broken above the critical $900 level.

I’m going to explain the reasoning behind the recent explosive move in gold. I’m also going to explain why I feel that the price of gold per ounce is going to rise even higher in the coming weeks and months.

Let’s go back to a couple of weeks ago -

• Federal Reserve Chairman Ben Bernanke, along with several other Fed governors began talking tough about inflation.
• The financial markets wrongly got the impression that the Fed would begin to raise interest rates, possibly as soon as August.
• The dollar began to rise in response and gold sold off.

However, it soon became clear, after the most recent Federal Reserve Open Market Committee meeting that all the talk about the importance of a strong dollar and the concern about rising inflation was just that - TALK! In actuality, the Fed is more concerned about the state of the economy than they are about saving the dollar. As soon as it became clear that the Fed wasn’t likely to raise interest rates any time soon, gold began exploding to the upside!

If you think last week’s action in the gold market was exciting, just wait. Over the long-term, the price of gold per ounce is going to move even HIGHER.

You see, the Fed is in a bit of a predicament -

• If they raise interest rates, the weakened financial system could collapse.
• If they don’t raise rates, the dollar will continue to weaken.

Sadly, the Fed’s inability to raise rates will cause everyone to lose. The dollar will continue to fall and the economy will suffer because of higher inflation.

The best way to protect your hard-earned money from the falling dollar and the ravages of high inflation is with pure silver and gold bullion coins. You can find a huge selection of discount gold bullion coins at: http://bullionbargains.com

For people who are not familiar with Forex trading and all that it entails, it really can seem like a secret world that offers great wealth to all those who participate in it. In order to develop a meaningful understanding of what Forex trading is and what makes it possible, you are going to need to have a firm grasp on what money is, and how money functions.

Everyone knows the basics when it comes to money, but are you aware of what exchange rates are, or how governments determine what money is really worth? In the past, goods were traded in exchange for other goods, so anything of value could be traded as a means of currency. This system worked extremely well for a long time, but there were drawbacks that had to be addressed eventually.

The hardest part of switching over to a real money system had to do with learning how to equate items of value with something that had no inherent value at all. Placing a determinate value on goods was also a difficulty that had to be faced. It became apparent that numerous parties had to be involved to turn many trades into beneficial and profitable ventures. The modern system of money was born out of this problem, and from the modern money system came the Forex trading market.

Simply put, Forex trading involves exchanging two currencies, and it is something that absolutely anybody can participate in despite it seeming like a secret world of sorts. The point behind trading foreign exchange currencies is to make money, which means that some planning is absolutely vital in order to be successful. The ability to predict how the world’s economy will function is what separates the best investors from those who slowly go broke, because it is important for good investors to recognize that the value of foreign currency is going to go up at some point, in the near or distant future.

Finding a stable standard of the value of a currency is what is going to determine profitability in Forex trading. If one nation is suddenly going to decide that their currency holds absolutely no value, then the market around it is simply going to collapse. This may be why the Forex market trades the most in the six largest nations holding most of the world’s money. People have agreed that currency does hold value of some kind, and this alone makes it well worth having. This truly is the most basic principle for operating and finance, and it is the strongest driving force determining what makes Forex trading such a profitable venture.

The secret world of Forex trading does not have to be a secret. Once you understand the history and the value of money, and what makes the Forex foreign exchange market as profitable as it is, you too can seek significant profits from this form of investing. Forex investors are finding incredible profits in this lucrative market, and all it really takes is an understanding of what drives the Forex market, and ultimately what gives money its value.

If you are new to the Forex Market and want more information then get your free copy of the Complete Newbies Guide to Forex Trading Online.

Or if you want to start trading in the Forex see my Top Pick Forex Trading Programs.

There are lot of forex robots for sale but most will soon wipe your equity out but there is a tiny minority which win and we will look at a checklist you should follow, to find them and get the right one for you…

Here is your checklist for finding the best forex robots.

1. Get a Real Track Record

Most of the forex trading systems online fail on this basic point - they don’t have one! All they have is back tested simulations on data and of course we can all make money doing this. You will normally see the words “simulated”, “hypothetical” and in “hindsight”. Lets be clear you are buying a trading system on the basis that it will make you money and if has never been traded why would you trust it?

If you pass by the simulated systems you already have got rid of 90% +. When looking for a real time track record two or three years is the minimum period you should consider remember, anyone can fluke a few weeks or a month and this time period means nothing.

2. Risk Tolerance

You will normally find that a system will lose for weeks on end, that’s just the way forex trading is so make sure you prepared for this and look at the biggest loss and time to recovery - i.e. if you joined the system on the worst possible day.

3. You Need to Know The Logic

Never by a system which doesn’t have the logic disclosed. Ideally, it should tell you the exact rules and parameters used and the logic behind them. This will give you the confidence to keep executing the trading system through periods of losses until you hit a home run.

You need to maintain discipline of execution and make sure the trades are placed exactly as the system dictates. If you can’t do this with confidence and discipline you don’t have a system.

4. Curve Fitting

The reason most simulated trading systems fail is because they are curve fitted. This means the rules are bent to fit the data. As no two pieces of data ever come around in the same price sequence again the system collapses in real time trading. Even proven systems get curve fitted. The system makes money, so the vendor offers new improved rules but don’t fall for this, use the original ones, curve fitting sees systems fail.

5. Best Time Periods

The idea of an automated trading system is to save time and you should really use a swing trading or long term trend following system - never a day trading system. Day trading is based on logic that doesn’t work and anyway, you will never find a real track record so steer clear.

Follow the above 5 points and you will find the best forex robots and then you can choose one that fits your risk criteria. Forex robots do work but don’t forget they will lose for long periods to so you must have the confidence and the discipline to take these loses, until profits come.

There are some good automated forex trading systems and the above information will help you to find one which will lead you to currency trading success.

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There may be dozens of strategies in Forex trading. Let’s just talk about the roots.

Background

Long Term Capital Management(LTCM) was a hedge fund established in 1994 by John Meriwether, a very successful bond trader at Salomon Brothers. At Salomon, Meriwether was one of the first on wall street to hire top academics and professors. Meriwether established a team of academics who applied models based on financial theories to trading. At Salomon, Meriwether’s group of geniuses generated amazing returns and demonstrated an unparalleled ability to precisely calculate risk and other market factors.

In 1994, Meriwether left Salomon and established LTCM. The partners included two Nobel Price-winning economists, a former vice chairman of the Board of Governors of the Federal Reserve, a professor from Harvard University, and other successful bond traders. This elite group of traders and academics attracted initial investment of about $1.3 billion from many large institutional clients.

Strategy

The strategy of LTCM was simple in concept but difficult to implement. LTCM utilized computer models to find arbitrage opportunities between markets. LTCM’s central strategy was convergence trades where securities were incorrectly priced relative to one another. LTCM would take long positions on the under priced security and short positions on the overpriced security.

LTCM engaged in this strategy in international bond markets, emerging markets, US Government bonds, and other markets. LTCM would make money when these spreads shrunk and returned to the fair value. Later, when LTCM’s capital base increased the fund engaged in strategies outside their expertise such as merger arbitrage and S&P 500 volatility.

These strategies, however, focused on tiny price differences. Myron Scholes, one of the partners, stated that “LTCM would function like a giant vacuum cleaner sucking up nickels that everyone else had overlooked.” To make a significant profit on small differences in value, the hedge fund took high-leveraged positions. At the start of 1998, the fund had assets of about $5 billion and had borrowed about $125 billion.

Results

LTCM achieved outstanding returns initially. Before fees, the fund earned 28% in 1994, 59% in 1995, 57% in 1996, and 27% in 1997. LTCM earned these returns with surprisingly little downside volatility. Through April 1998, the value of one dollar initially invested increased to $4.11.

However, in mid 1998 the fund began to experience losses. These losses were further compounded when Salomon Brothers exited the arbitrage business. Later in the year, Russia defaulted on government bonds, a LTCM holding. Investors panicked and sold Japanese and European bonds and bought U.S. treasury bonds. Thus, spreads between LTCM’s holding increased, causing the arbitrage trades to lose huge amounts. LTCM lost $1.85 billion in capital by the end of August 1998.

Spreads between LTCM’s arbitrage trades continued to widen and the fund experienced a flight to liquidity causing assets to shrink in the first 3 weeks of September from $2.3 billion to $600 million. Although assets decreased, because of the use of leverage the portfolio value did not shrink. However, the decrease in assets elevated the the fund’s leverage. Ultimately, the Federal Reserve Bank of New York catalyzed a $3.625 billion bail-out by the major institutional creditors in order to avoid a wider collapse in the financial markets caused LTCM’s dramatic leverage and huge derivatives positions. At the end of September 1998, the value of one dollar initially invested decreased to $.33 before fees.

Lessons from LTCM’s Failure

1.Limitation of Excess Leverage Use

When engaging in investment strategies based on securities converging from market price to an estimated fair price, managers must be able to have a long term time frame and be able to withstand unfavorable price changes. When using dramatic leverage, the ability of capital to be invested long term during unfavorable price changes is limited by the patience of the creditors. Normally, lenders lose patience during market crisis, when borrowers need the capital. If forced to securities during an illiquid market crisis, the fund will fail.

LTCM’s use of leverage also highlighted the lack of regulation in the over-the-counter (OTC) derivatives market. Many of the lending and reporting requirements established in other markets, such as futures, were not present in the OTC derivatives market. This lack of transparency caused the risks of LTCM’s dramatic leverage to not be completely recognized.

The failure of LTCM does not mean that any use of leverage is bad, but highlights the potential negative consequences of using excessive leverage.

2.Importance of Risk Management

LTCM failed to manage multiple aspects of risk internally. Managers mostly focused on theoretical models and not enough on liquid risk, gap risk, and stress-testing.

With such large positions, LTCM should have focused more on liquidity risk. LTCM’s model’s underestimated the probability of a market crisis and potential for a flight to liquidity.

LTCM’s models also assumed that long and short positions were highly correlated. This assumption was historically based. Past results do not guarantee future results. By stress testing the model for the potential of lower correlations, risk could have been better managed.

In addition to LTCM, the hedge fund’s large institutional creditors failed to properly manage risk. Impressed by the fund’s all star traders and large amount of assets, many creditors provided very generous credit terms, even though the creditors engaged in significant risk. Also, many creditors failed to understand their total exposure to specific markets. During a crisis, exposure in multiple areas of a business to specific risks can cause dramatic damage.

3.Supervision

LTCM failed to have a truly independent check on traders. Without this supervision, traders were able to create positions that were too risky.

LTCM demonstrates an interesting case of the limitations of predictions based on historical information, and the importance of recognizing potential failure of models. In addition, the story of LTCM illustrates the risk of limited transparency in OTC derivatives market.

To learn more about finance and investing, please visit the Sharpe Investing blog.

Matt Golberg is a finance major and attending a well regarded business school.