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Where Will Risk Erupt This Time?

Tyler Durden's picture




 

Submitted by Charles Hugh-Smith of OfTwoMinds blog,

So where has all the risk pooled up in the system? In foreign exchange (FX) markets, that's where.

One of the precepts of this blog is that risk cannot be disappeared, it can only be transferred or temporarily hidden from view. This runs counter to modern portfolio management, which holds that all risks can be hedged with counterparty-issued securities, i.e. options, futures contracts, derivatives, etc.
 
This also runs counter to the Central Banking Cargo Cult, which holds that any eruption of risk can be smothered by the unlimited liquidity spewed by omnipotent central banks.
 
 
There are several problems with the notion that risk can always be neutralized with counterparty securities and/or central bank liquidity. The first is fundamental. As mathematician Benoit Mandelbrot showed in his seminal book The (Mis)behavior of Markets, risk is a feature of all markets. As a result of their fractal nature, risk cannot be eliminated, and claims that risk has been eliminated will fail catastrophically.
In other words, precisely what happened in 2008-2009, when all the "low-risk" trades blew up and nearly took the global financial system down.
 
The second reason has to do with the failure of conventional models to assess tail risk. As former Federal Reserve chairman Alan Greenspan confessed in Foreign AffairsWhy I Didn't See the Crisis Coming, the Fed's models failed to accurately account for tail risk (otherwise known as things that supposedly happen only rarely but when they do happen, they're a doozy), because guess what--they happen far more often than statistical models predict.
 
If Greenspan had read Mandelbrot's book, he would have known that.
 
The third reason is human nature. As Greenspan observed, conventional models assume markets will remain liquid during crises. But in the real world, when panic takes hold, sellers/bids completely disappear and markets freeze up. Assets that cannot be sold are rendered worthless.
 
Risk, which has supposedly been disappeared by hedging, erupts and what is supposed to be permanent--liquidity--disappears.
 
This leads to the fourth problem, which is counterparty hedging is only as good as the liquidity of the market and the solvency of the counterparty.
 
It's all well and good to hedge a position with a counterparty-issued security, but if the counterparty can't pay off the hedge when things go south, the hedge disappears and the loss must be swallowed whole.
 
That leads to the fifth problem, which is in highly leveraged bets, a modest loss leads to insolvency. To quote Marx, "All that is solid melts into air."
 
The sixth problem is systemic. Risk, by its very nature, flows to where it is least expected--into the parts of the system that are perceived as "safe."
 
Thus risk in 2002 to 2007 flowed into home mortgages, the part of the financial system that was widely viewed as low-risk.
 
So where is all the systemic risk now? Like generals preparing to fight the last war, the Fed and other central banks are focused on protecting the mortgage market, Too Big to Fail/Jail (TBTF/J) banks and sovereign bonds, as those were the sectors where risk erupted last time.
 
(Note that the Fed has bought about $2 trillion of U.S. mortgages since 2009, about 20% of the entire market. That's one way to soak up risk: just put a bid under the market and buy, buy, buy, burying it all in central bank balance sheets and government pension funds.)
 
But risk can't be disappeared; it can only be transferred or temporarily cloaked. So where has all the risk pooled up in the system? In foreign exchange (FX) markets, that's where. The $11 trillion in carry trades the central banks have funded are being deleveraged in a rapidly destabilizing environment of Japan devaluing its currency, the yen, by 40% since late 2012, and the withdrawal of the Fed's $1 trillion-a-year QE programs.
 
I'll give you two examples of risk piling up in the FX market. The consensus is that the Fed ending $1 trillion/year in QE money issuance is no big deal because the Bank of Japan (BoJ) and the European Central Bank (ECB) are printing more money, which is taking the place of the Fed's QE issuance.
 
Not so fast, Slick. Roughly two-thirds of the emerging-market debt that must be liquidated or rolled over is denominated in dollars, which means the borrowers still need dollars, not yen or euros or yuan. So the strengthening dollar will still bite all these emerging-market borrowers with very sharp teeth.
 
Printing yen and euros is not a direct substitute for the dollars that have ceased flowing.
 
Then there's all the high-fiving when trade deals are announced between China and whomever. Nice, but everyone crowing about a de-dollarized trade has forgotten that China's RMB (yuan) is pegged to the U.S. dollar. That means that the rising dollar is dragging the RMB higher in relation to rubles, yen, euros, pesos, quatloos, etc.
 

The risks unleashed by central bank funding of massive carry trades, policy-driven devaluations and currency crises have yet to manifest. When they do, we'll rediscover why traders consider the FX market the 800-pound gorilla that stomps on the stock and bond markets without even noticing the squishing sound.

 

 

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Mon, 11/10/2014 - 09:45 | 5431893 LawsofPhysics
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Risk?  What risk?  All risk is now been eliminated by an implicit guaranty by the government to steal from every citizen and bailout oligarchs.  Can't pay your tax, go to prison...

Humanity has been here before, the end will be no different this time around.

Mon, 11/10/2014 - 09:53 | 5431919 philipat
philipat's picture

Yup, The Fed has your back. Until it doesn't...

Mon, 11/10/2014 - 10:01 | 5431936 Tao 4 the Show
Tao 4 the Show's picture

I think they have you by more than your back.

And BTW, the whole concept of "risk" exists within the context of the current system - it only makes sense relative to system functioning more or less the way it is now. Given that its continued existence is assuredly limited, the whole article is more or less meaningless.

Mon, 11/10/2014 - 10:02 | 5431958 Cognitive Dissonance
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"Risk" is the juice Wall Street lives off of. If risk appears to be absent it is because WS, via the Fed, wishes it to be obscured.

Mon, 11/10/2014 - 10:09 | 5431966 Tao 4 the Show
Tao 4 the Show's picture

Yes, the whole thing is fake. Simplest way to understand that is just to realize that there is far more "money" (cash, electronic savings, stocks, bonds, derivatives, etc) in existence than there are goods and services in the world.

And to take it a step further, most of what current "money" can buy depends completely on the system functioning well. If it stops functioning or diminishes in functioning, the money becomes meaningless or at least less meaningful.

Mon, 11/10/2014 - 10:09 | 5431980 Headbanger
Headbanger's picture

"The Feral Reserve is now the ultimate power in the Universe"

 

Fixed it..

Mon, 11/10/2014 - 09:58 | 5431938 slaughterer
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This article is very vague and cannot name the next specific event that will trigger a market collapse. 

Mon, 11/10/2014 - 10:04 | 5431964 Cognitive Dissonance
Cognitive Dissonance's picture

Too funny.

Answers dammit, I want answers. Specific answers in fact or you're just a useless slob.

Mon, 11/10/2014 - 10:47 | 5432111 Calmyourself
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She is obviously new here, nice to see you Cog..

Mon, 11/10/2014 - 10:11 | 5431989 TeamDepends
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Black revolutionary group puts $5K bounty on Officer Darren Wilsons' head @ gatewaypundit.com. Perhaps ebola is not cooperating and they are rolling out the race war. Can you imagine what would happen if a white militia put a bounty (on social media!) on a black head? It is going to be a hot winter. Not sure why somebody junked you.

Mon, 11/10/2014 - 10:27 | 5432040 LawsofPhysics
LawsofPhysics's picture

Irrelevant really as you can't "fix" stupid, regardless of the color of stupid.

Once the Chicoms are in control of places like detroit, stupid white folks will be the last of the negro's problems.

The asian oligarchs have dealt with minority uprising for centuries, mostly through direct or indirect extermination.

You are already seeing this in the Bay Area.

Fuck em.

Mon, 11/10/2014 - 09:47 | 5431904 buzzsaw99
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Mandelbrot never met Old Yeller.

Mon, 11/10/2014 - 09:51 | 5431913 IANAE
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microprudential regulation that ensures structures/derivatives that are currently OBS are instead collateralized/haircut/accounted for on regulated entity b/s thereby trapping cash and capital at the legal entity level would resolve most of this nonsense.

 

Mon, 11/10/2014 - 11:05 | 5432182 IANAE
IANAE's picture

junked...now that's funny

Mon, 11/10/2014 - 11:06 | 5432189 IANAE
IANAE's picture

.

Mon, 11/10/2014 - 09:51 | 5431916 gatorengineer
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Risk is not tolerated anymore.  Dont like Ebola stories, the media stops covering them.  Dont like ISIS the media stops covering it.  Dont like war in the Ukraine.....  well you get the idea.

The only question is how long have they bought 5 hours, 5 days, 5 months 5 years, 50 years.....

My guess is the slide in earnest will be about 5 months out, but I have never been right....  Maybe retail will have a great christmas, and alot of $12 a pound roast beef will be eaten by all.

 

Mon, 11/10/2014 - 10:24 | 5432037 Calculus99
Calculus99's picture

I don't think it's because people don't like those stories, rather media blows them out of all proportion then moves on to a different story to blow out of all proprtion. Media are like the little kid that quickly gets bored with every new toy bough so always needs a new one.

Ebola never was a risk, it just made a good story that we humans lap up - We're all going to die in a plague that will devastate half the world etc. No different from SARS a few years back. Personally I don't know one person who got SARS but at the time we were repeatdly told it was a disaster in the making. 

Media basically does a good job in all of this because ultimatly their job is to make money via advertising sales. Nothing boosts those sales like a good old scare story. If you want the truth don't listen to 95% of the media. 

Mon, 11/10/2014 - 10:29 | 5432047 gatorengineer
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The problem is where do you find that 5% you are talking about that reports the truth....?  

Mon, 11/10/2014 - 11:02 | 5432181 Galactic Superwave
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The media overreaction will, most of the time, create a negative feedback loop that motivates those who can have some control in the crisis to react to mitigate the crisis. The Ebola outbreak could of been much worse if the media hadn't exposed the incompetence of the Dallas hospital. The same thing happened with the Y2K phenomena. Y2K was a non-event because the media made it such a big deal. These negative feedback loops are driven by fear.

But, the overaction of the media can also trigger a positive feedback loop in the affected populance. For example, Fergeson. Positive feedback loops are driven by anger.

It's best to personally just be(come) aware of the possible affects and choose not to participate in the fear/anger.

Mon, 11/10/2014 - 10:32 | 5431925 falak pema
falak pema's picture

What CHS does not emphasise enough is that the whole tenet of capitalism is that there are choices in this world for generating FUTURE profits from current investment.

That's what capitalism is : a TOOL for generating future profits from current wealth, by judicious investment based on RISK/RETURN OPTIONS. The notion of risk is as endemic to investment as the notion of evil is to human moral/ethical choices in life. There is always a downside to human activity.

Depending on the amount of accumulated savings (wealth), the capitalist can make a choice depending on the fundamentals of the economic climate: aka : active labour utilisation rate, savings/consumption ratio, current industrial capacity utlilsation, debt/equity, debt/GDP ratios etc; what risk-return profile best suits the environment of investment vs consumption at any given moment in the investment cycle. 

Assuming that risk has been eliminated is like assuming that good has prevailed over evil in the human world. 

Just contrary to all human history. 

Our world leaders, by their own acts, have decreed capitalism is now a useless tool.

And we are now a race of fools living in their shadows.

One who is not a fool as he is progeny of those who saw 1929 coming is this guy :  Jerome Levy (not the guy who invented the Levi-Strauss jeans !)

http://www.businessinsider.com/jerome-levy-1929-crash-recession-2014-11

Mon, 11/10/2014 - 10:28 | 5432027 Son of Captain Nemo
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 "As former Federal Reserve chairman Alan Greenspan confessed in Foreign Affairs, Why I Didn't See the Crisis Coming, the Fed's models failed to accurately account for tail risk (otherwise known as things that supposedly happen only rarely but when they do happen, they're a doozy), because guess what--they happen far more often than statistical models predict."...

What a steaming "crock of shit" that he didn't see it coming!

When the market(s) were on life support in '02 Greenspan had "Mandelbrot's book" memorized well before the crash in 2008 when he stated without hesitation to George Bush Jr.  right before the second invasion of Iraq in 2003 to "Give me a war"!  Saddam was in the process of securing deals with Europe to sell his oil in Euros instead of $$$ which would have given us '08 in '03!...

The bailouts were the "coup de grace" and the last rail to string the parties responsible up for the blatant promotion of the last and greatest theft of all. And what did the American people do?... Just looked the other way!

America you can pick up your trophy here!

 

Mon, 11/10/2014 - 11:10 | 5432222 loveyajimbo
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That is not a very flattering pic of Mooch Obongo...

Tue, 11/11/2014 - 23:20 | 5433140 Radical Marijuana
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The most important FRACTAL is the repeating pattern of the methods of organized crime controlling civilization, and the most important RISK is that everything was built on that foundation of enforced frauds. The way that society is directed by systems of legalized lies, backed by legalized violence, is the SOURCE OF SYSTEMIC RISK! The assessments of markets WITHIN their own frame of reference is extremely misleading, since everything that human beings are doing is more and more dominated by lies backed by violence, enabled to deliberately ignore any rational evidence or logical arguments OUTSIDE of the social systems built on those lies backed by violence.

It is practically IMPOSSIBLE for human societies to assess risks, since the greatest of all risks is that governments are the biggest form of organized crime, controlled by the best organized gangs of criminals, who are so dominant thereby that there can NOT be any rational discussions of real risks. That situation is profoundly worse than we can fully imagine, due to the degree that most of us take almost everything about our own culture for granted.

There is a growing grand canyon chasm between progress in sciences and engineering, EXCEPT NOT social sciences and engineering, because of the degree to which that would require adopting a more scientific attitude towards society, that there IS "800-pound gorilla" in the room, that human societies were always dominated by systems of lies backed by violence, which are being pumped up and UP, to extremely absurd, and impossible to sustain, King Kong proportions, by technologies becoming trillions of times more powerful and capable, while the political world adapts to that by manifesting even Bigger Lies, backed up with More Violence, which sort of systems are able to continue to deliberately ignore THAT IS THE GREATEST RISK!

We have become apes with atomic bombs, backing up electronic monkey money. The runaway triumphs of civilization controlled by systems of legalized lies, backed by legalized violence, through which means the foundation of the entire political economy became ENFORCED FRAUDS, make it practically impossible for human beings to assess any other risks more rationally, since the ULTIMATE "800-POUND GORILLA" IS "HUMAN NATURE" ... after things like advancing biological science and technology makes it theoretically possible for us to sufficiently understand how to deliberately change our own nature. It was "human nature" to be able to create systems of artificial selection, driven by the original pressures of natural selection, to end up being based on backing up lies with violence, which operates as our DELIBERATE BLIND SPOT!

The contradictions between human beings developing better science and technology, BUT, which reaches a dead-end in political science, because that is where the combined money/murder systems operate on the basis of the maximum possible frauds and deceits, which get away with dong that more and more, because nothing within those human systems can stop that, MEANS it is practically impossible to adequately assess any risks to human beings, outside of the risks that they present to themselves. The degree to which our entire civilization is dominated by professional liars and immaculate hypocrites, operating through systems of legalized lies backed by legalized violence, enabling almost universal attitudes of evil deliberate ignorance towards everything OUTSIDE of that ability, WITHIN that society, to continue to control things by backing up lies with violence, MEANS THAT, COLLECTIVELY, WE BECOME MORE CRIMINALLY INSANE!

The ancient paradoxes regarding the dominance of the "800-pound gorilla" in the social system, channeled through the long history of successful warfare based on deceits and spies, becoming the foundation of economics based on enforced frauds, are all being pumped up and UP, at exponential rates, towards COLLECTIVE, RUNAWAY CRIMINAL INSANITIES ... Discussions of human economic systems continue to almost totally take place WITHIN the biggest bullies' bullshit world view, in which the basic social facts that governments are necessarily the biggest form of organized crime, controlled by the best organized gangs of criminals, are NOT ALLOWED to be significantly debated in the public spaces, since those public spaces continue to be almost totally dominated by the biggest bullies, the "800-pound gorillas."

At the present time, it appears impossible for our political processes to avoid going through psychotic breakdowns, and severe social storms, because it is impossible for our kind of politics to have an overall rational assessment of real risks. Rather, everything we are doing is based on grossly disproportional and irrational risk assessments. For instance, the "war on drugs" and the "war on terror," which were based on deceits, in order to advance the debt slavery systems. Overall, the ruling classes have been successfully engaging in a war on consciousness for thousands of years. The "800-pound gorilla" of backing up lies with violence never went away, but rather was able to transform into global systems of electronic frauds, backed by atomic bombs.

It is impossible for human beings to survive the consequences of advancing science and technology, as long as those are NOT ALLOWED WITHIN POLITICAL SCIENCE AND TECHNOLOGY, other than still through that being dominated by the biggest bullies bullshit social stories, where everything is presented in as backward of ways as possible, while those attitudes of evil deliberate ignorance continue to be enforced, so that the frauds can continue to get BIGGER! Due to the degree that our society is almost totally dominated by systems based on backing up lies with violence, NONE OF THE ECONOMIC STATISTICS ACTUALLY MAKE MUCH SENSE, SINCE THOSE ARE ALL MEASURED AND CALCULATED WITHIN A FUNDAMENTALLY FRAUDULENT FRAME OF REFERENCE.

Most of the articles and comments on Zero Hedge are still operating within that frame of reference, somewhat attempting to provide "actionable intelligence." However, it appears to me that a growing minority of the people who comment on Zero Hedge have approached understanding the degree to which THE GREATEST RISKS THAT WE FACE ARE THE WAYS THAT EVERYTHING WE DO IS BEING DIRECTED BY SYSTEMS OF ENFORCED FRAUDS, WHICH ENABLE ATTITUDES OF EVIL DELIBERATE IGNORANCE. Anyone with practically relevant "actionable intelligence" is still stuck INSIDE of the established systems of enforced frauds, which are the greatest of all RISKS, regarding which nothing can be done, WITHIN those systems. It remains to be seen whether or not the "800-pound gorillas" that develop abilities like mathematical physics, which enable making their frauds become electronic, while their force becomes atomic, are going to be able to survive having done that!

I believe that appears to be theoretically possible, however, that would require our paradigms regarding political science to go through greater shifts than our physics already did! More than anything else, it would require enough people understanding the basics, that the most important FRACTAL is the repeating pattern of the methods of organized crime controlling civilization, and the most important RISK is that everything was built on that foundation of enforced frauds.

Mon, 11/10/2014 - 20:03 | 5434542 RMolineaux
RMolineaux's picture

Hugh-Smith has not made it clear that the expansion of risk occurrs when new liquidity is used to leverage up the bets of third parties.  Leverage levels in FX are astonishingly high, practically guaranteeing the bankruptcy of participants with only small changes in exchange rates.

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