Is Technology Destroying the Markets?
An even bigger risk is the combination of technology and mathematics used to create the exotic mortgage-backed derivatives that caused the "Great Credit Crunch" that began at the end of 2007. In this case, we learned nothing from the demise of Long-Term Capital and the bailout of this hedge fund in 1998.
If you recall, among the Board of Directors of Long-Term Capital were Myron Scholes and Robert C. Merton, who shared the 1997 Nobel Prize in Economic Sciences for a "new method to determine the value of derivatives." They "helped" LTCM make several unsound, esoteric bets, including investments in interest rate derivatives, which are similar to the mortgage derivatives of the current "Great Credit Crunch."
The problem with these derivative structures is there is no way to anticipate all possible combinations of variables that make them tick. You can't even mark them to market. This is why I believe that time bombs continue to tick among the $232.2 trillion notional derivative contacts that were reported in the Q1 FDIC Quarterly Banking Profile.
Isn't it interesting that some say the Libor scandal goes all the way back to 1998? Fudging the Libor rate alters how the derivatives are evaluated, and as we know the valuations have been wrong.
At JP Morgan(JPM) , CEO Jamie Dimon did not understand the risk of the "London Whale" big bet on a derivative structure. Eventually the loss was pegged at $2 billion, but when earnings were reported a few weeks later the loss ballooned to $5 billion. I read a story recently that stated that the mark to market was inaccurate, but within the bounds of the risk manager.
It's hard enough to mark an exotic derivative, but when you mark the long side of a strategy at the mythical offering price, and the short side at the mythical bid price, significant loses can be masked.
Will the financial regulators ever learn?
This article is commentary by an independent contributor, separate from TheStreet's regular news coverage.