Wednesday, February 28, 2007

The risk shell game...

It is convenient to blame yesterday's market turmoil on the Chinese. After all, they are inscrutable, ya know. And to be sure the decision by their "Fed" to curtail irrational exuberance was a key factor. There are also plenty of other factors.

But for those who view things from Greenspan's perspective, there are worrisome indicators. Orders for durable goods — covering everything from jet engines to computers, as well as washing machines and other household appliances — fell more than forecast last month, the Commerce Department announced, a sign of ongoing weakness in manufacturing. The 7.8% decline was the biggest since October. Another important indicator of business spending, orders for nondefense capital goods not including aircraft, fell 6%, the third drop in four months.

Even though a new report from the National Association of Realtors showed that sales of previously owned homes rose 3% in January, the median price of those homes fell to $210,600, down 3% from the same period last year. Inventories of unsold homes also remain high. [More]

But the rest of the story is perhaps better understood by trying to figure out who is actually at risk now and how much.

Not an easy job.

One concern is that the heavy wiring in the markets could not keep up with the rapid changes. Another is the rapid growth of derivatives. The problems in the subprime mortgage sector have focused attention on the slicing and dicing of risk using sophisticated instrument such as collateralised debt obligations and credit default swaps. Banks have used these to shed credit risk, but it is not clear where all that risk now lies. Financial shares were hit particularly hard on Tuesday, suggesting that nerves are starting to jangle over this uncertainty. Shares in Goldman Sachs, perhaps the smartest of the financial alchemists, ended down 6.6%. This was partly due to its Asian exposure (it owns a stake in a big Chinese bank). But its role in conjuring up and trading exotic financial instruments was probably also a factor. [More]

While farmers are struggling to cope with options strategies, guys in suits worth more than my pickup are devising exotic financial instruments to hand risk around like a hot potato. Tuesday, somebody ended up holding it.

To be honest, I have trouble with options strategies. It's easy to misplace what success looks like. Moreover, I am comfortable with the production and price risks as they occur in the real world.

While I doubtless could make some money being more aggressive in the use of risk instruments, my guess is it would take utilize time that I can be doing something else more personally or financially rewarding. Just because an action makes money doesn't mean it doesn't have to compete with other choices that offer different or even better rewards.

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