The size of the banks’ bets is rising rapidly the world over. This is because potential returns have fallen as fast as markets have risen, so banks have had to bet more in order to continue generating huge profits.
The present situation “is not dissimilar” to the one that preceded the collapse of LTCM … banks are walking themselves to the edge of the cliff. This is because—as all past financial crises have shown—the risk management models they use woefully underestimate the savage effects of big shocks, when everybody is trying to wriggle out of their positions at the same time … By regulatory fiat, when banks’ positions sour they must either stump up more capital or reduce their exposures.
Invariably, when markets are panicking, they do the latter. Since everyone else is heading for the exits at the same time, these become more than a little crowded, moving prices against those trying to get out, and requiring still more unwinding of positions. It has happened many times before with more or less calamitous consequences … It could well happen again.
There are a number of potential flashpoints: a rout in the dollar, say, or a huge spike in the oil price, or a big emerging market getting in trouble again. If it does happen, the chain reaction could be particularly devastating this time.
This article is right on with its observations and could have been written a few months ago. Actually, it was published exactly 4 years ago, in February 2004. Talk about somebody reading the handwriting on the wall…