Washington Post – The financial world has been suffering lately from Post-Greenspan Stress Disorder. The new chairman of the Federal Reserve, Ben Bernanke, has been accident-prone, and some investorshave gotten the jitters. They might be reassured if they paid more attention to the country’s second most powerful monetary official, New York Fed President Timothy Geithner.
Geithner watches for the big, scary meltdowns that could threaten the entire financial system. Like his mentor, former Treasury secretary Robert Rubin, he’s a worrier — always looking for the “systemic risks,” the cascading events that can trigger a panicky rush for the exits. He’s in a constant dialogue with the nation’s biggest banks and investment firms about how they manage risk.
As with globalization itself, the good news and the bad news in these markets is the same — greater interdependence. Financial markets appear to be better protected today thanks to complicated products, known as derivatives, that allow different kinds of financial risk to be shared and traded around the world. You can hedge against almost anything these days, from hurricanes to interest rate hikes. The danger is that if this complex protective scaffolding ever failed, it could bring some of the global financial architecture down with it.
The past six weeks have been an interesting period for Geithner and his fellow central bankers. Some of the world’s smartest investors, who run the exotic portfolios known as “hedge funds,” got caught in a sudden, unexpected downdraft in May. The investments that had proved most profitable — in emerging markets, commodities and other alternatives to large-cap stocks — all took nose dives. Investment strategies that supposedly were well hedged, so that losses in one sector would be offset by gains in another, turned out to be “correlated,” so that they all went down together.
The hedge fund industry prides itself on its “value at risk” (VAR) models. But last month, traders say, some markets moved “six standard deviations” — in other words, six times the expected range of volatility. The fancy VAR models, based on past experience, failed to predict the actual damage.
