Trying To Define Liquidity

What is about math that makes us feel comforted? Numbers are objective, of course, but the using of numbers is not. Even in the hard sciences calculations are not strictly calculations for their own sake, they are interpreted and therefore given subjective meaning. I don’t intend to detour this argument into a teleological one, but in some ways that just can’t be helped.

We know about statistics in econometrics, but its parallel and really in many ways the inspiration for the use of math in economics derived from its long-standing application in finance. For as long as humans have wondered they have tried to predict the future. Almost every system invented for that task has tried to do so by searching the past for recognizable patterns. It is here where algorithms and regressions may be so alluring.

But to get from that to a robust forecasting paradigm requires truly more computational skills than are available even today, let alone ten or twenty years ago. That hasn’t stopped people from trying, of course, and it likely never will. The Spanish once scoured the Americas for El Dorado, the mythical lost city of gold; to a modern shadow bank, untold riches aren’t found in some far flung rainforest, they are found instead on a balance sheet governed by the secret black box formula.

The first outfit believed to have found it was LTCM. Its rise and fall have largely been lost to history, surpassed in every way by what happened in 2008. But what went on ten years earlier told us everything we needed to know about the crisis, including the idea of liquidity in the mathematical, modern wholesale sense; the system that was driven by far more derivatives as money than money as money.

In September 1998, the Federal Open Market Committee of the Federal Reserve sat around the table to discuss the intricate problems created by the prospect of LTCM’s complete demise, at times marveling at its feats while also being terrified by what that might represent of a future far different than the arrangements they all knew and understood.

CHAIRMAN GREENSPAN. Somebody mentioned to me that Bankers Trust had an August balance sheet for LTCM. Is that true?

VICE CHAIRMAN MCDONOUGH. Yes, but the balance sheet is a relatively small piece of the whole action because so much of the latter is off-balance-sheet.

Traditional accounting systems are no match for this forward way of thinking. I don’t mean “forward” in the sense of LTCM representing progress, rather everything they did was modeled into the future, brought back into present values and then recorded from those. Obviously in such a situation there is a great emphasis on those calculations, which was, to be frank, LTCM’s game. They were the first to do it so extensively and so they had an enormous asymmetry of information, not the least of which was their roster of financial gods, those men who pioneered all this stuff.

That gave them a tremendous advantage, at least in the beginning.

MR. FISHER. It was something of a signature for this firm to insist that if a counterparty wanted to deal with them, there would be no initial margin. Not many other firms have gotten away with that.

MR. GRAMLICH. It goes to your bedazzlement effect.

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Disclosure: This material has been distributed fo or informational purposes only. It is the opinion of the author and should not be considered as investment advice or a recommendation of any particular security, strategy, or investment product. Investments involve risk and you can lose money. Past investing and economic performance is not indicative of future performance. Alhambra Investment Partners, LLC expressly disclaims all liability in respect to actions taken based on all of the information in this writing. If an investor does not understand the risks associated with certain securities, he/she should seek the advice of an independent adviser.

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