Catch the Falling Knife in the Dark

Photograph by Jessica Ebelhar/The New York Times via Redux

In the wake of the LTCM episode, the large banks and securities firms that were counterparties to hedge funds strengthened their management of hedge fund risk significantly. Those improvements were motivated by their self-interest, which was reinforced by recommendations from their prudential supervisors and from the Counterparty Risk Management Policy Group (CRMPG), made up of 12 banks and securities firms that were among the most significant counterparties to hedge funds. However, recently there have been reports that competitive pressures have resulted in some weakening of risk-management practices.

Remarks by then-Chairman Alan Greenspan, Risk Transfer and Financial Stability, to the Federal Reserve Bank of Chicago’s 41st Annual Conference on Bank Structure, Chicago, Illinois, (via satellite), May 5, 2005.

“Recently” was different in 2005. In recent days “recently” is, well, more recent, and since August of 2007, more often.

What is remarkable of the chairman’s balanced 2005 assessment is if, and when, you only read his cautions, his too-be-sures. Then, and only then, can you understand the latent fear the confident class had, and still has, in derivative screw-up.

Time marches on. We, ever less and less confident, grope forward in a new more dim quantitative light.

Do not let your knees buckle with the egregiousness of Fortress Whale even as your and my confidence exhibits “some weakening.” As in 2005, 2007, 2009, and now 2012, we must stand confident and catch the falling knife in the dark. Discuss.