Wednesday, May 24, 2006

America’s gross domestic product (GDP) is $10 trillion a year. A staggering amount when you realize 1 trillion seconds ago was 29,000 years before Jesus Christ. A billion hours ago, human beings and their ancestors were in the Middle Paleolithic Age, or the Stone Age. And now there are supercomputers that can handle several trillion moves per second (e.g., Google’s search engines)

IBM’s latest speed demon handles 180 teraflops (180 trillion calculations in a single second — machines that can go back in time when the first multicellular organisms appeared on Earth about 1 billion years ago, or go forward and extrapolate from the ever-faster biotech breakthroughs that will extend the human lifespan to 150, 200, even 250 years in the 22nd century, by which time predict some inventor scientists the bio brain will have fused with mechanical teraflops.

Sandia National Laboratories “Red Storm” computer has already modeled how much explosive power it would take to destroy an asteroid hurtling toward Earth.

Increasingly these teraflop capabilities also help some hedge funds place ever larger bets on the future of anything and everything — a total now of about $300 trillion in the derivatives market from how nanotechnology will affect biotechnology and the human lifespan to how hostilities against Iraq will drive up oil prices.

Some speculative bets are predicated on Israel striking Iran first and Iran’s retaliatory operations in the Persian Gulf propelling oil up to $200 a barrel — by this time next year. Will Israel hit Iran’s nuclear facilities before next November’s Congressional elections — or after? The United States will be blamed either way, but if before November, the Republicans could lose both houses of Congress? How would this, in turn, affect the global chessboard?

Regulatory bodies on both sides of the Atlantic are increasingly concerned about a derivatives meltdown. Experts see a 15 to 20 percent chance of a global financial tsunami. The time frame is vague but clearly the foreseeable future is in mind.

In 1998, the Long-Term Capital Management (LTCM), with “miracle” worker John Meriwether of Salomon Brothers fame at the helm — backed up by two Nobel-prize winning economists, and a former vice chairman of the Federal Reserve — hit the proverbial iceberg. The 80 founding members had ponied up $10 million apiece — almost $1 billion out of the starting gate.

To head off a total hedge fund eclipse in 1998, Merrill Lynch’s William J. McDonough, then president of the New York Fed, quickly corralled 14 mega firms — e.g., Goldman Sachs, Merrill Lynch, UBS, J.P. Morgan — to each kick in between $100 million and $350 million to bail out LTCM with $3.7 billion. If Mr. McDonough hadn’t launched the lifeboats, the collapse of the Russian boom in 1998, that triggered two weeks later LTCM’s one-bad-bet-too-many, would have produced a global depression.

Last week the Senate Banking Committee held hearings on hedge funds and derivatives. The immigration and U.S. border crisis and Gen. Michael Hayden’s hearings as the new head of the CIA demoted major news about what was said to minor news briefs that made some inside pages. Television demonstrated yet again it is to news what bumper stickers are to philosophy; networks ignored the story.

Government interference with a regulatory regime in the largely unregulated hedge funds was rejected by all present as a cure that might precipitate the very events the hearings were designed to defuse. But if the industry wasn’t dancing with wolves, the mixed metaphor had it skating on thin ice.

Hall of Fame investor Warren Buffett has warned derivatives are “weapons of mass destruction time bombs both for the parties that deal in them and the economic system.” The dangers, says Mr. Buffett, “while now latent are potentially lethal.” Everything from futures, forwards and options to calls, leaps and swaps are potential detonators.

There is a Derivatives Strategy Hall of Fame, the Fixed Income Analysts Society Hall of Fame and the Risk Hall of Fame. One of the few math geniuses to belong to all three is Oldrich Vasicek, a founding partner of Moody’s KMV, He was this year’s presenter at the 12th Annual Global Derivatives Trading & Risk conference on May 9 in Paris. Only mavens could understand the dialectology that was so much gobbledygook to the layman.

Backwardation anyone? That’s Futures markets where shorter-dated contracts trade higher than longer-dated ones. Black-Scholes? An equation for valuing plain “vanilla” options for which Fischer Black and Myron Scholes shared the 1973 Nobel Prize. Convexity? A financial instrument has convexity if its price increases (or decreases) faster (or slower) than “corresponding changes in the underlying price.” The “Put-Call Parity Theorem” or the “Quanto Option” are but two expressions in the language spoken by the real masters of the universe. LTCM’s masters got their “swaptions” wrong and the universe almost tanked.

Richard McCormack, a former undersecretary of state for economics, and senior adviser at the Center for Strategic and International Studies, testified last week, “The challenge we have now … is to correct, if we can, any structural or technical problems that could increase the likelihood of systemic risk in the event of future shock. … History suggests we may not be totally successful in this effort of prevention, and that future financial market turmoil is likely to resonate in the derivative area.” Moreover, Mr. McCormack said there is no such thing as a permanent fix to problems in derivatives.

A year ago, Mr. McCormack wrote: “The global economy today resembles a large truck racing down the highway at 70 miles an hour, with four or five bald tires. The odds are the truck will make it to its destination intact. But a major accident is always possible.”

For years, those wealthy enough to hedge their bets and ante up between $1 million and $10 million and higher for a hedge fund ride have told this reporter they were averaging 30 percent a year for five consecutive years before losing “a little” in the last year.

Linda Davies’ “Into the Fire” says the derivatives trader is like “a bookie once removed taking bets on people making bets.” But the bookies are now mathematicians and physicists who design ever more sophisticated financial instruments. The two principals of H.C. Wainright Economics, an investment-strategy firm, raised the speculative bar by writing in the Wall Street Journal this week, “the dollar, the world’s mightiest currency, has lost more than 60 percent of its gold value in the past four years.” And you thought we had gone off the gold standard in 1971.

Think again. Bone up on the asymmetrical correlation of Latin America’s neo-Marxist resurgency and the half-trillion-dollar Iraq/Afghan war tab. And fasten your seat belt.

Arnaud de Borchgrave is editor at large of The Washington Times and of United Press International.

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