Rational Advisor

The leading candidate is a major geopolitical shock. A U.S. attack on Iran, for instance, could drive oil prices past $100 a barrel, lead to wholesale liquidation of dollar assets by Middle Eastern investors and destabilize the region by drawing powers like Russia into the conflict. That, in turn, could set off a financial crisis by prompting wholesale liquidation of stocks by leveraged hedge funds and other investors, while putting enormous stress on the leveraged balance sheets of major banks and securities firms. Such a catastrophe could be worsened by the trillions of dollars of derivatives that Berkshire Hathaway CEO Warren Buffett has called “financial weapons of mass destruction.”

Meanwhile, top executives at Goldman Sachs and elsewhere have referred to August’s market setback as a 100-year flood or a 20-standard-deviations event - a fancy way of implying that it was a statistical fluke unlikely to recur. Dislocations in the mortgage and leveraged-finance markets emerged, hammering stocks by nearly 10% over a few weeks and battering a group of big quantitative equity funds that suffered declines of as much as 30%.

What happened in August, however, was no extreme event. The setback in the junk-bond market was mild compared with what happened in 2002. If a geopolitical shock erupted in a period of market instability, the Street would have to deal with some real financial trouble.

IT’S WORRISOME THAT THE BEST and brightest on Wall Street consistently underestimate the odds of market-jarring events because this suggests that the financial community isn’t well-prepared for a true 100-year flood.

Why is it every year or two, we seem to experience 100-year events? When people talk about a 100-year flood, it’s another way of saying that something bad happened and they didn’t expect it.

As the markets get more complex, leveraged and interconnected, they become more crisis-prones. Advances in engineering have made the physical world a safer place, but financial engineering has increased dangers for investors.

Then and Now for instance, the leverage used by hedge funds and financial institutions can create the potential for a cascading decline, because price drops can lead to forced selling. The selling then can feed on itself and infect unrelated markets. That’s just what happened when the Long-Term Capital Management hedge fund collapsed in 1998. And despite the often-heard theory that the major stock markets are decoupling, there seems to be a growing correlation among them when prices drop. The growing influence of hedge funds and other leveraged investors may account for that.

Wall Street firms like to talk about their tolerance for risk and their willingness to provide liquidity. But these financial behemoths are highly leveraged, sometimes having just one dollar in equity capital backing every $30 of assets. Their holdings include tens of billions of dollars of illiquid securities. In reality, if disaster strikes, the financial giants might be sellers of assets and seekers of liquidity.

A BIG PROBLEM WITH LEVERAGE is that it can force investors to sell just when markets are most depressed and opportunities are greatest. The U.S. mortgage market arguably is as attractive as it has been in several years, but a leveraged investor like Thornburg Mortgage can’t take advantage of it. It was a forced seller of mortgages in August because lenders wanted their money back.

GEOPOLITICAL RISK, ESPECIALLY the danger posed by Iran, has been discussed

Given the hawkish view toward Iran by some officials in the Bush administration and the unpredictability of the Iranian regime, the odds of a U.S.-Iran conflict aren’t trivial — although the ability to wage war against Iran is questionable, given the U.S. armed forces’ deep involvement in Iraq. Iran has long been an irritant to America. In fact, one factor in the 1987 crash was the uncertainty caused by a U.S. attack on Iranian oil platforms that Washington said had been used to attack an American tanker.

The repercussions of a U.S.-Iran conflict could cause a repeat of what happened after the onset of World War I – an extended shutdown of major equity markets. The World War I situation shows just how fragile liquidity can be. Financial markets were blind to the coming of war in 1914 until it had virtually begun. The markets now might be ignoring the growing danger in the Middle East.

Another obvious risk is a Chinese economic slowdown or financial crisis. It’s notable that the biggest decline in the Dow this year — 416 points on Feb. 27 — was a direct response to a sharp sell off in the Shanghai market. While China still probably isn’t big enough in the world economy to prompt a market crash, it certainly could contribute to one.

There are several parallels between the economic and financial backdrop in 1987 and now, including a weakening dollar, rising oil and commodity prices, inflation fears, a long-standing economic expansion, an elevated stock market, a relatively new Fed chairman, rising protectionist sentiment and a lengthy span since the last 10% market correction.

Perhaps the most alarming similarity bears on the dollar, which has been under pressure against the euro, pound and Canadian dollar.

Prices of key commodities have surged this year, with gold hitting $750 an ounce, its highest level since 1980. U.S. financial authorities aren’t publicly talking down the dollar, as Treasury Secretary James Baker did to harmful effect just before the 1987 crash. Henry Paulson, the current
Treasury secretary, keeps reiterating that a strong dollar is in the national interest, but few in the currency markets think he means what he’s saying. Instead, they see Washington tolerating a weak greenback because it stimulates exports and should help trim America’s record trade deficit.

THE U.S. MAY BE PLAYING a dangerous game, because the depreciating currency might be taxing the patience of world central banks that are seeing the value of their huge dollar-denominated holdings erode. While a run on the buck — and a sharp market setback — are possible, it doesn’t appear to be in the interest of big dollar-holders like China, Russia or the Middle East nations to precipitate a collapse in the currency.

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