Phorgy Phynance

The word is out… it’s NOT about subprime

with 4 comments

Whenever I read about “subprime contagion”, I feel frustrated. When you get the flu, does the runny nose cause the muscle aches? No. Just because the runny nose came first doesn’t mean the flu can be described as “runny nose contagion”. The subprime mess was just the first symptom to appear in the bursting of a general credit bubble. The corporate high yield market saw very similar aggressive loan covenants. Commercial real estate. Emerging markets. You name it. We’ve been in the midst of a general fixed-income bubble since our friends at the Fed decided to keep rates far too low for far too long.

Think about this. Back in 2005, we were worried about the CDS market reaching $17 TRILLION notional. That is a HUGE number. But the notional amount is not indicative of overall exposure because of hedging, right?

If you want to see a perfect hedge, visit a Zen garden.

What is that number today? More like $45 TRILLION. That is insane. An entire new insurance industry has basically assumed that corporate defaults do not exist anymore. Not only that, a “hedge” can turn into naked exposure at the flip of a switch, i.e. what happens when the entity you bought insurance from no longer exists?

When I get a chance, I hope to start posting some more mathematical analysis of what’s going on (since that’s what I’m good at). For example, a primer on Leverage Mathematics 101 (which is partially complete) followed by Hedge Mathematics 101 would be a good start. In risk management, “hedging” basically means “let’s buy(sell) some similar securities so that we have more capital to buy other stuff.” In other words, hedging allows you to leverage yourself more.

Here is an article that may help spread the word, i.e. it’s not about subprime:

Straight Talk on the Mortgage Mess from an Insider

However, I would go even further. The truth is the current mess is not even about mortgages. Here is the word we should all be thinking about, “Fixed Income Bubble”.

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Written by Eric

December 9, 2007 at 10:16 pm

4 Responses

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  1. please do post your mathematical stuff.. I would be interested and since just found your blog will follow it more regularly

    polysena

    January 16, 2008 at 7:42 am

  2. For example, a primer on Leverage Mathematics 101 (which is partially complete) followed by Hedge Mathematics 101 would be a good start.

    why 101?

    polysena

    January 16, 2008 at 11:48 am

  3. In risk management, “hedging” basically means “let’s buy(sell) some similar securities so that we have more capital to buy other stuff.” In other words, hedging allows you to leverage yourself more.

    well thought!

    polysena

    January 16, 2008 at 11:48 am

  4. Hi polysena,

    Thanks for your interest. I’ll try to add some more math kung fu soon, but with the market turmoil right now, it is taking some extra effort just to ensure that I remain employed. That’s part of the “fun” of working in phynance though is the prospect of managing through uncertainty 🙂

    Best wishes!

    phorgyphynance

    January 16, 2008 at 12:36 pm


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