Capitalism Without Consequences
Christopher Aiello
Centurion Global Capital, Hong Kong
Dec 13, 2007

Last November, I had the pleasure to enjoy a coffee with Dr. Paul Wilmott, who is considered to be one of the leading experts in the pricing of complex derivatives in the world today. In addition to being an accomplished mathematician and master teacher of derivatives pricing, Dr. Wilmott has also run a successful hedge fund focused on options volatility arbitrage. So he understands both the theory and practice of derivatives risk.

One of the key aspects of my discussion with Dr. Wilmott focused on the immense growth of the credit derivatives market. In my own trading, I incorporate both sentiment analysis and statistical analysis on top of my core fundamental views.

During the discussion with Dr. Wilmott, we both agreed that the very low risk premiums that were being priced into the credit market at that time and all the way up until June of this year (2007), as well as the very low levels of the VIX were abnormal and that sooner or later credit spreads and equity volatility had to expand and revert to more normalized historical levels.

At the end of the day, when it comes to financial markets and financial instruments, common sense has to rule over complexity since all markets are an amalgamation of human participants and as much as we would like to pride ourselves for being logical economic animals, once money is on the line and positions are in the market, emotions tend to ride high and it takes a strong sense of self-discipline and emotional strength to admit one is wrong and take a loss, once a position is clearly not working out.

Given the fact that sooner or later, credit spreads and equity volatility and the appropriate pricing of risk had to normalize, no one should be surprised by the significant volatility that has hit the credit and equity markets since July of this year when the first tremors of losses started appearing in the credit derivatives market in earnest.

The magnitude of the losses is significant and my own gut instinct is that the losses will tally north of US$300 billion, perhaps as high as $500 billion due to the significant amount of leverage that has been applied to the credit derivatives market.

When one considers the history of market cycles, it seems that every 7-10 years the repeated cycle of easy credit leading to massive over speculation in a given asset class, fuelled by greed and excess leads to significant losses. While the market is freaking out about the fall out in the credit derivatives market, haven't we seen this film before in the '98-99 period of the Asian financial crises, and the Russian debt default, and before that the S&L crises?

What is fairly amazing about this cycle of easy credit, leading to excessive speculation, fuelled by greed and then leading to ever bigger losses, is that rather than take it on the chin, "fess up" and say, "we were greedy and pushed it beyond the limit", certain players in the market want to find a way to avoid the pain of losses (i.e. The Super SIV scheme) rather than take the hit all the way to the bottom line.

This past week, I was in Vietnam on a due diligence trip to source real estate for a new Asian real estate fund I will be launching in 2008. After spending the day visiting various real estate sites in and around Ho Chi Minh City, I wanted to do some additional "market research" and check out the local night clubs. Needless to say, Ho Chi Minh City boasts of some excellent opportunities to apply the motto of working hard in the day with playing hard at night. However due to an early morning breakfast meeting with a local Developer and the need to have my brain synapses working lucidly, I chose to head back to my hotel room rather than continue on with the evening foray into the more demure and curvaceous geometric dimensions on offer in Saigon.

Upon returning to my hotel room, I turned on Bloomberg TV to check the US markets and was greeted by H. Paulson pushing his "share the love and avoid the foreclosure HOPE program". I don't know if anyone else saw that news cast but the way that H. Paulson kept exhorting homeowners on the verge of bankruptcy to call 1-800-HOPE to work out a mortgage relief plan, I felt like I was watching a religious revival.

As I sat there listening to a former heavy weight Goldman Sachs banker essentially saying, that it was OK for marginal borrowers to take out dubious loans that were more than likely going to default at some point, and that the US government and the banking system was going to stop marginal borrowers from feeling the pain of having their homes taken away, I couldn't stop but think, when does excess and greed get punished?

We live in a crazy era when it is OK for a mortgage borrower to take out a loan with out having to provide proof of income or asset strength (i.e. no documentation sub-prime mortgages) and bankers can turn toxic-waste sub-prime loans into AAA rated paper which then goes up in flames, and everyone is bailing everyone else out with the nifty new pain avoidance mechanisms such as the SUPER SIV and HOPE programs.

Delaying the inevitable of having to write down to true values, nearly worthless structured debt positions, or not forcing a whole slew of ARM sub-prime mortgage loans to re-set to higher levels, in an economic sense will distort once again the pricing of risk in the market. Worse, in the long-term delaying the inevitable will only reinforce the bad habit and mentality that there are no consequences for excess, greed and over-reaching in today's complex global markets.

Important Disclaimer:

The views and issues expressed in this article are those of the author's and not that of Risk Latte Company Limited ("the Company") or any of its employees and members. The Company is not responsible for any factual or conceptual errors contained in the body of the content of this article and shall not be responsible and liable for any losses, direct or otherwise, incurred by anyone, individual or partnerships or body corporate, by making direct or indirect use of any of strategies, ideas and points mentioned in this article. The Company is not a stockbroker or investment advisor and is not registered with the SFC in Hong Kong or with any other regulatory body anywhere in the world. Buying and selling stocks, securities and other financial assets could be extremely risky and investors should consult their brokers, investment advisors and banks before making any investments.

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