When I worked on the trading floor at Salomon Brothers in 1990 and 1991, there was a group of reclusive traders that were different from others at the company. All around them from the government bond, foreign exchange, gold and other market trading desks, there was lots of noise. Traders with two phones in their ears bought and sold screaming as markets moved. It was an electric atmosphere. In the middle of the football field size-trading room sat the quiet cerebral group - the arb desk. No noise came from the arb desk; they were traders but you would never see them with two phones in their ears. They were almost invisible. However, this small and select group made all the money at the firm. Arb is short for arbitrage. Arbitrage is the term used to describe simultaneously buying and selling in two markets to lock in a risk-free profit. Arb was a misnomer for this group. They did not look for risk-free profits; rather they spread risk in one market against another. As an example, they might buy mortgage-backed securities and sell US government bonds on spread - hardly a risk-free trade. The traders on the arb desk made hundreds of millions if not billions in profits for Salomon and tens of millions for themselves. Eventually they moved out of Salomon and started a hedge fund; they named it Long Term Capital Management (LTCM). In 1998, their arb trades blew up because of the 1997 Asian financial crisis and the 1998 Russian financial crisis. LTCM had bought foreign bonds, sold US bonds as an "arb" trade, and leveraged it to the hilt. Many funds blow up, however, this one was different. LTCM positions were so big and so leveraged that the Federal Reserve Bank of New York, fearing a contagious collapse of financial markets, bailed the fund out of their positions to the tune of $3.625 billion. It was a huge bailout of a financial entity but the bailout of financial institutions in 2008 dwarfed the LTCM debacle. In both cases, huge leverage and risk positions led to financial meltdown. In both cases, huge leverage and the systemic risk of contagion made the US government step in to save the day.
Oil and sanctions push Russians to the brink
Fast forward to today. The Russian government under President Vladimir Putin has been under sanctions from the United States and Europe for months. The Russian annexation of Crimea and support for rebels in Ukraine has put international pressure on the Putin government. The sanctions alone have hurt the Russian economy. As the world's largest producer and exporter of crude oil, the collapse of oil prices has added insult to injury. The Russians now face an economic crisis of epic proportions. The value of the ruble has declined dramatically.
There has been a lot of investment in Russia over recent years. The oil boom that sent prices north of $100 per barrel has resulted in capital projects in the country. A bull market in raw material prices has also attracted capital to Russia, a significant producer of many raw materials.
Sanctions and lower commodity prices have pushed the Russian economy to the brink of disaster and have isolated the Russian leader. In the meantime, billions of dollars have poured into the country over recent years - invested by companies in the countries that have leveled sanctions against Russia.
Putin's press conference
As the Russian economy falters, Mr. Putin gave a marathon press conference on Thursday, December 18. During the press conference, the Russian leader pointed fingers at the nations that imposed sanctions. He compared Russia to a bear and said that the West is seeking to chain the bear and remove its claws and teeth. Putin said that the bear refuses to "sit quietly and eat honey." Putin called the current economic conditions in his country a "difficult period" and denied that Russia faces a crisis. He stoked nationalistic zeal by blaming all economic woes on the evil West.
Managing Expectations - "Mr. Valentine has set the price"
One of my favorite movies of all-time is Trading Places. In the film the main character, Billy Ray Valentine, transforms from a street beggar into a senior executive at a fictional commodity brokerage company, Duke and Duke. The owners, Randolph and Mortimer Duke, teach Valentine the commodity business. One day Billy Ray tells the Dukes that he believes the price of pork bellies, which have fallen, will rise. Randolph then says, "Advise our clients interested in bellies to buy at 64... Mr. Valentine has set the price."
During his press conference, and like Mr. Valentine, it is possible that Putin set the price for crude oil and that price is far lower than today's. The commodity has fallen from $107.73 per barrel in June to under $60. In an attempt to manage the expectations of Russians and prepare them for further economic woes, Mr. Putin said that the Russian economy must adapt to the reality of oil prices that could fall as low as $40 a barrel. At $40 per barrel, Russia's suffering will intensify.
A rough road for Russia
The ruble was trading at 31-1 against the US dollar at the beginning of 2014. Recently, the ruble has halved in value. Oil and energy accounts for a lion's share Russia's cash flow. Sanctions continue to choke the Russian economy. Recently, Russia did a series of deals with China. Russia will supply China with commodities and they will exchange technology - the two countries set up a bilateral currency agreement to exchange payments in their local currencies. However, this is not enough to stem Russia's economic problems. Prices will skyrocket in coming weeks and months due to the devaluation of the ruble. Trade with many traditional European counterparts has stopped due to sanctions. Individual Russians will experience a long cold Russian winter of discontent possibly followed by a prolonged period of economic hardship.
More casualties to come
Contagion is a danger given current Russian economic woes. Up until recently, investment capital flowed into the country in astonishing amounts. The sudden downturn in oil prices presents another problem. Crude oil prices remained above the $80 for the better part of four years. Investment capital steadily flowed into the energy sector.
The financial turmoil caused by LTCM in 1998 and the crisis of 2008 were each triggered by market events. LTCM by the Asian and Russian financial crises, 2008 by issues of leverage in the subprime mortgage-backed securities markets and European sovereign debt issues. Today the world faces another Russian crisis and a rapidly falling oil price in a sector that has attracted a lot of investment capital over past years. Add to that a weak European economy and sovereign debt issues that are not yet resolved.
The fall in oil and Russian economic crisis are fresh issues as 2014 draws to a close. The true effects will surface in 2015 and they could be ugly. It is possible, maybe even probable that we will see contagion across global financial markets in coming months. There are bound to be leveraged positions out there given the current low interest rate environment. As I watch the deterioration of the Russian economy while oil prices fall, I wonder whether the ghosts of LTCM and the 2008 financial crisis will collide in 2015 with many more casualties in the days ahead the result of contagion and systemic risk.
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