irondoor91

The Hedge Fund Hustle

Re: Instability

The longer a market is stable, the greater the risk (opportunity?) for that market to become destabilzed. Many instituional investors, being human and looking to avoid employment risk, seek out stable markets and stable markets and stable returns because they know it is an easy sell to their constituents and clients. But, in order to distinguish themselves in the marketplace they use ever-greater degress of leverage. Great strategy when there is virtually unlimited liquidity available from the IB's and no real limits on ratios. Additionally, the creation of more exotic levered illiquid instruments introduces additional profit opportunity, which can only be enhanced with more leverage.

Eventually, the market becomes just a little bit unstable because it is actually resting its stability on the back of the least capable managers. Then, it becomes a bit more unstable as those few of the other managers who are holding the same instruments obtain the shaky information coming from the bottom-dwellers. Ultimately, there is nothing to stabilize the market when everyone is heading for the same illiquid exit.

That's where we are today, and it would be much worse if the Fed had not recognized the enormous risk to the entire world financial system inherent in the leverage. Their problem is that they cannot gather all the players into the same room to identify the sacrificial lambs. All those mortgages have been sliced and diced into too much "diversification".