Eric Rosenfeld, the one-time Harvard professor who became a trader at Long-Term Capital Management in the 1990s, explains how a portfolio balanced in a way so that it appears “riskless” because it has so many diversified positions can be made very risky when too many people holding similar positions decide to exit at the same time. In short, trades that don’t seem to be correlated at a fundamental economic level or according to history can nonetheless become correlated through trading activity.
What’s more, he explains how the attempt to mirror the Solomon Brothers trading desk was a mistake for LTCM because it failed to take into account what might be called “business model risk management.” Solomon’s trading desk was less risky for the firm because if trading had an epic failure, the other business lines could take up the slack. This could not only prevent the business as a whole from failing, it could also provide additional liquidity support to the trading operations if the failure was only temporary. LTCM was basically a monoline trading operation, with nothing to fall back on when trading went kaput. And, yes, there are lessons we should be applying from this to the current mess on Wall Street.
It’s a long way to go–nearly an hour an a half. But if you are sitting in the air conditioning somewhere, waiting out the mid-day heat, it’s highly informative. If you want to cheat, fast forward to about the 57 minute mark and listen to the discussion about “endogenous risk” and “risk management.” (Via ZeroHedge)