THE DAY AFTER TOMORROW

Web Note
The following short story is hypothetical in nature, but is based on what was, what is, and what will be.

Meet John and Terry Wheeler, January 2003

For John and Terry Wheeler it was a dream come true. The opportunity had finally arrived. It was a chance to move out of their small apartment and finally own a home of their own. They had always dreamed of owning a home, but there was never enough money. Terry’s tips from waitressing at an upscale steakhouse had enabled the couple to build a small kitty of $5,000, but that didn’t cut it. Homes were expensive in southern California and it seemed no matter how much John and Terry brought home, housing prices moved further out of reach. That is until Terry’s aunt passed away leaving her a small inheritance. The $20,000 bequest wasn’t much, but with the drop in interest rates their realtor said that with the right financing package, they would be able to swing the deal.

In March of 2003 their dream became a reality. They purchased a small home in the suburbs for $515,000. The yard was small and the homes were close together, but they didn’t seem to care. After living in a 1,000 square foot apartment since they got married, Terry thought their new home was a palace. Thanks to the realtor’s advice of taking out a variable rate mortgage, they were able to get a 3% starter loan, which brought the payments on their $490,000 mortgage down to $2,100 a month. With property taxes and insurance, their combined incomes were able to handle the $2,500 a month outgo. Besides, John’s job as an electrician paid well and with all of the new homes being built, John was getting time and half for working overtime. Business began to pick up at the local steakhouse and on weekends Terry took home more than $500 in tips. By working three lunches a week in addition to her five nights, Terry’s income was beginning to catch up with John’s.

These were good times. With John’s overtime and the extra money Terry made working lunches, the Wheelers had enough money to buy Terry a new car. They were able to buy a brand new Ford Explorer for less than $400 a month thanks to zero percent financing. Times were so good that they even had enough money at the end of the month to put a little extra aside into savings. Terry wanted to buy furniture for the living and dining rooms with their extra earnings and the tax refund they received from the President’s tax cuts. John had his eye on a new 52 inch LCD TV for the family room. With their cash savings they were able to pay cash for the LCD TV. But the furniture was too expensive. Terry didn’t want to wait. The furniture store offered them an attractive financing package that made the purchase tempting. John was hesitant, but he found it hard to say no. After all he had gotten the new TV. How could he say no to Terry’s desire to furnish an empty living and dining room? The furniture payments wouldn’t start for another two years. When they kicked in, it would add another $360 to the monthly budget. By then they hoped they would have enough cash in the till to pay down the loan and reduce their payments.

If the overtime kept up and business at the restaurant remained strong, they would still be able to handle the additional payments when they were due. However, the overtime and weekend tips were now a necessity. Without them there would be very little left over in the budget at the end of the month. But that was a worry for another day. Right now times were good and 2003 ended up as a memorable year. A new home, a new car, new furniture, a new LCD TV – what else could a couple ask for? This was living the American dream. John felt good enough about his new job. With a major new development going in, the overtime pay would continue. That Christmas he bought Terry a set of diamond earrings on credit. Terry wanted to make this Christmas special for John. She had her eye on the home entertainment system that would be the perfect compliment to the new TV. The system cost more than $2,500, so she charged it. Terry figured that her tips would enable her to pay off the credit card within a year. That year's Christmas was one they would never forget. The $4,000 in new credit card debt would be a monthly reminder.

The Wheelers Feel the "Pinch" in 2004

2003 ended well and the couple was hopeful that 2004 would bring more of the same. John’s overtime continued and Terry still made $500 or more in tips on weekends. But in March they got a bit of a shock. Last October their mortgage payment went up by $100 a month after the bank raised their mortgage interest rate from 3% to 3.5%. They had expected an increase, but were a bit troubled after the mortgage company raised the rate another half a point. Their adjustable rate mortgage adjusted every six months, but they were assured by their realtor at the time of purchase that interest rates would remain low. They were now paying 4%, which was still less than a fixed rate mortgage, but the rate hikes had increased their monthly payments by more than $240 a month. Terry was also beginning to complain about the cost of groceries and the price of gasoline. It now cost more than $56 a week to fill the tank of her new Ford Explorer and the weekly grocery bill had risen by more than $20. Their property tax bill went up in April and they also were paying more on monthly utilities. These were all small things, but they were starting to add up. John and Terry still managed to put aside $150 a month, but it wasn’t as much as they hoped for.

The monthly credit card payments were now over $120 a month and over the last year they found themselves buying more things on credit. They bought a portable barbeque and new patio furniture in the spring. Terry really wanted a spa for the backyard. The backyard was too small for a swimming pool, but the pool company could build a nice spa and waterfall in the corner of the yard for $15,000. Their credit card balance was now over $8,000, so charging it was out of the question.

John called their realtor who suggested a home equity loan. Houses in their neighborhood had been appreciating by more than 2% a month. The realtor told John their home had appreciated by more than $100,000 over the last 15 months. John took the realtor’s advice. Their home's appreciation made John and Terry feel richer. They now had more than $125,000 in equity, which was hard for them to believe. Terry wanted to put in the spa by summer. Besides the new spa, Terry also had her eye on a new bedroom set. The furniture store had been running sales every weekend. A new bedroom set would cost more than $12,000 and John wanted another TV to fit in the armoire. John called the mortgage company, figuring they would need about $35,000 to pay for the spa, bedroom set, new plasma TV and pay off their credit cards. John found it absolutely amazing how easy it was to get credit now that they had become homeowners. Getting credit had never been this easy. Buying their new home had been the best financial decision they ever made.

During that summer John and Terry took their first vacation since their honeymoon. Carnival Cruise line was offering a package tour of the Mexican Riviera for only $2,500. It was bit expensive, but with their credit card debt paid off and their home continuing to appreciate, John felt they could afford to charge it. They came back from their vacation refreshed. Terry was pleased with some of the purchases they had made in Mexico. There were new pots for the back yard, nic nacs for the family room and beautiful silver jewelry for Terry. The purchases had set them back another $1,000, which they also put on their credit cards.

It all seemed affordable especially now since their home kept appreciating. Their combined mortgages was $525,000. That was more than the original purchase of their home. But the way John figured things, they were still ahead. A call to his realtor had reassured John that things were okay financially. Their home was now worth more than $625,000. Even though their debt balances were larger, they were still ahead by almost $100,000!

They were living the good life. John’s overtime continued and Terry still made good money at the steakhouse. The couple were thrilled with their new home. Terry loved all of her new furnishings and John was considering adding a covered patio off their family room. It would provide the shade they needed to cool the house down from the summer heat. A call to their mortgage company provided the needed cash. John got the $7,000 he needed to put in the new patio cover and Terry wanted to replace the family room Venetian blinds with wooden shutters. John asked his mortgage broker for a $22,000 loan. That would give him enough money to build the new patio cover, put in the family room shutters and pay off their credit cards.

At summer's end, their credit card balance was back over $5,000. There was always something that came up each month and there never seemed to be the extra cash around to pay for things. It became easier to charge things. John and Terry had not realized it, but charging things each month had now become a way of life. Terry complained about their grocery bills. Costs seemed to be going up everywhere and their grocery bill had gone up by more than 40% over the last three years. Her last office visit to her gynecologist cost her $80. A trip to the dentist to get her teeth cleaned cost $58. Prices were going up everywhere and it was beginning to pinch their budget. In October of 2004 the mortgage company raised their mortgage rate by another half a point to 4.5%. John complained to his mortgage company, but the broker told him that his variable rate mortgage was still cheaper than a fixed rate loan.

John was getting worried. Their mortgage payment was now over $2,500 a month. Property taxes on their new home were going up along with their mortgage payment. Taxes and insurance now added up to $600 a month. In addition to their regular mortgage, they now had a $47,000 home equity loan. This cost them an additional $200 a month. Add in the $75 minimum payment for their credit cards and it all was starting to take its toll. Making matters worse was the fact that their home equity payment went up almost every month. Not by much, but enough to irritate John. The bank told him it was because the Fed was raising interest rates. The home equity loan was tied to the prime rate. When the prime rate went up, so did John’s monthly payment. John didn’t understand economics, but he began to understand that every time he saw Alan Greenspan on TV, it meant his mortgage payments were going up.

Although John and Terry were still happy, they found themselves arguing more over money. The end of each month left them in a tight spot. They stopped going out to movies every Sunday. Out of necessity they both decided it was best to stay away from the shopping malls. Terry tried to save money on groceries by using coupons and buying more household cleaning supplies at Wal-Mart. These were small changes, but they helped to balance their budget. John’s union had negotiated a pay raise and his boss still needed John to put in the overtime. They were thankful for their new home and good fortune, but by year-end they both agreed to pull in their horns at Christmas. They managed to get through the Christmas season by adding only $1,500 a new credit card debt. There wasn’t enough in checking at the end of the month to pay for discretionary luxuries. The difference was made up with credit cards. The cutbacks that John and Terry had initiated made the budget balance each month, but there was very little left for unexpected expenses – a trip to the dentist, new tires for John’s truck or simple repairs around the house or birthday, anniversary or Christmas presents.

When John and Terry added up assets and liabilities at the end of 2004 they were still on the plus side. One of their neighbors had sold their home for $650,000. It was the same model as John and Terry’s. Their realtor told them that their home might be worth a little more with the patio and spa addition. Although their mortgage and credit card balances had increased in 2004, they were able to upgrade their home with new shutters, a spa and patio. Terry was happy with the way the house looked, so John anticipated no new expenditures for 2005. If the house continued to appreciate like it had the last two years, it would more than make up for the difference in mounting credit card bills. They looked forward to the new year with all of their major expenditures now behind them. The new home construction market was still strong in San Diego. John’s only worry was Alan Greenspan’s frequent appearance on the evening news. That meant higher interest rates and John worried what would happen in March when it was time for another mortgage adjustment.

J. Gordon Grecko – Fortune's Friend

What John and Terry could not know as they began 2005 is that approaching financial and political storms would soon impact them in a personal way. Events in Washington, a crisis on Wall Street and an escalation of the war in the Middle East would push them to the brink of insolvency. John knew that when Mr. Greenspan spoke, bad things happened to his monthly budget. He and Terry were about to find out about another man – J. Gordon Grecko – who would have an even deeper impact on their mortgage payments. Terry knew of Gordon Grecko from watching entertainment programs. Terry knew he was fabulously rich and had had many glamorous wives and well publicized divorces. Heir to a publishing fortune, Grecko had made his own fortune on Wall Street by running one of its most successful hedge funds. John and Terry knew little about what Grecko did for a living other than he was very rich and had a beautiful wife.

The only reason Terry knew his name was because Grecko was a publicity hound. Grecko found that his patrician background and the publicity helped to open doors – especially when it came to obtaining credit from investment banks. Grecko was a bright star on Wall Street and everyone wanted to rub shoulders or be in business with Grecko. Grecko made money as easily as the Fed expanded credit. Grecko could have been another trust fund brat, but he had inherited his father’s brains and ambition. He had gone to Yale and then on to Harvard for graduate school. Grecko found he had a gift with numbers and finance. After graduation there was only one outlet for his ambition and that was Wall Street.

The senior Grecko had sold the family publishing business, which freed him to pursue another ambition in politics. When the senior senator from New York retired, Grecko senior stepped into his shoes. It had been an expensive election, but easily handled by a family fortune that numbered in the billions. Grecko’s political connections were helpful in opening doors, but Grecko junior’s talent and smarts were what landed him a job on Salomon’s bond desk. By the time Grecko arrived on Wall Street, the staid and predictable bond world was pulsating with change and opportunity. There he found a man who would change his life forever. John Meriwether was a rising star at Solomon and Grecko was only too happy to become one of Meriwether’s protégés. Under Meriwether’s tutelage, Grecko learned the intricacies of bond arbitrage. Bonds trade on mathematical spreads. The riskier the bond, the wider the spread – hence the greater the difference between a bond’s yield and a similar yield on risk free Treasuries. These rules are the bible of bond trading. They are responsible for creating a matrix of different yields and spreads on debt securities around the globe.

What Grecko learned at Solomon and from Meriwether is that bond spreads would occasionally widen in a time of crisis. But if you had the staying power to ride out the storm, spreads eventually narrowed and reverted to the mean. The key was staying power and that meant having plenty of access to credit. Access to credit was what allowed you to stay in the game. Credit was also what enabled you to turn nickels into dimes, dimes into quarters, and quarters into dollar bills.

Grecko had always been comfortable with numbers, but he learned to not trust them completely. The difference between him and the other quants on the bond desk is he had developed a knack for reading the economic tea leaves better than anyone else. It was what made Grecko's calls stand out and stand far above all of his peers. Grecko was developing his own style of trading. He preferred to make large macro bets. Once he understood the big picture, he relied on his models to refine his position. The success he was having at Solomon was also giving him the confidence to go out on his own. Eventually the bond dream team at Solomon split up. Meriwether set up his own shop at Long Term Capital Management. With his mentor gone, it was time to set sail on a new course and begin a journey that would make him both famous and infamous at its end.

Wall Street was changing rapidly during the 1990s. The Fed was creating vast sums of credit and much of it was making its way to Wall Street. Large sums of money were pouring into mutual funds. The public was coming into the market in a very big way. The catalyst had been lower interest rates, which made the returns on fixed income investments seem less attractive. Deregulation was in the air, making it easy to get into competitive businesses. Banks were becoming brokerage firms and brokerage firms were becoming banks. With governments borrowing vast sums of money, the debt markets exploded exponentially.

Grecko Makes It Big

There was also a technology and communication revolution taking place and it was revolutionizing the street. Better information, faster data feeds, and instantaneous communication moved markets at lighting speeds. There was talk of a new era and Grecko was capitalizing on it. His family name and reputation put Grecko on a first name basis with many of Silicon Valley’s CEOs. He was connected with all of the movers and shakers in the markets, whether it New York, Washington, or California. While his mentor at Solomon focused his fund on debt markets, Grecko was consumed by technology. To Grecko technology was the big picture. His hedge fund stayed focused and concentrated its holdings in the technology sector. Being well connected provided him with access to the numerous technology and Internet IPOs. His fund was making a fortune. His own net worth and reputation grew as he added additional zeros to his net worth.

Grecko was glad he stayed focused on technology. Too much money and credit were making the bond market unstable. Signs of stress were visible in Asia. Grecko unwound his bond positions at the beginning of the year and concentrated his positions mainly in technology with smaller bets in healthcare and financials. He was glad he did. The Asian tsunami finally hit the credit markets in the summer of 1997. Grecko was relieved he was out. The next year he noticed that credit spreads continued to widen and remained mostly out of the debt markets. That single decision saved his fund. Instead of debt, he had loaded up on Internets taking a sizable position in Amazon.com and AOL.

By 1999 Grecko’s own fortune made the Forbes 400 list making him one of America’s wealthiest individuals. But the market was getting too frothy for his own comfort. Some of his technology holdings would double in a month only to double again the following quarter. He began to see that the party was soon coming to an end. That summer the Fed had embarked on a series of interest rate hikes. Grecko knew that would eventually mean pain for the markets and the economy. That summer he began to quietly unload the fund's technology holdings and moved into cash and short-term bonds. It was a good call. The fund ended the year up with a 70 percent return, keeping pace with the NASDAQ and making his clients as well as himself happy and wealthier.

Grecko Makes His Millennium Mark

Grecko turned even more cautious in 2000. He stayed out of the markets even though the NASDAQ kept climbing to even greater heights. Instead he began to gradually build up his bond positions, figuring by summer the Fed would be through raising interest rates. Once again his instincts had proven to be correct. Stock prices were falling; the economy was slowing down, and a presidential election cycle was starting to heat up. Markets hate uncertainty, which is why Grecko remained out of the markets. He continued to build the fund's cash and bond positions. Grecko stayed focused on treasuries throughout all of 2000 and 2001 – a position he held until the end of 2001. After the attacks on 9/11, the Fed injected massive amounts of money into the credit markets. Greenspan was slashing interest rates with a furry never seen before. The money supply was growing at double digits. Never before had the Fed created so much money and credit out of thin air.

Money and credit began to flow everywhere. Interest rates fell to half century lows. For Grecko, that meant it was time to change strategies. It was an easy time to obtain credit. For his hedge fund that meant it was time to leverage up and look for bigger arbitrage opportunities. J. Gordon Grecko returned to what he had learned at the Solomon bond desk. The fund began to leverage up its portfolio. Grecko’s name, reputation and his father’s position in the Senate had the investment banks lined up at his door handing out cash. His reputation for accurate market calls had the investment banks believing Grecko printed his own money through higher returns. By the end of 2002 his fund was leveraged 20-1. By the end of 2003, leverage had increased to 30:1. The fund continued to move into higher risk positions. With interest rates falling and hedge funds multiplying like rabbits, arbitrage opportunities were getting harder to find. This made it necessary to take the fund's leverage position even higher and move even further towards the tail end of the curve. By the end of 2004, leverage in the fund was approaching 40:1. That year profits in the fund were $6.4 billion. To put that in perspective, that return was more than what Caterpillar made selling earth moving tractors and trucks. It was more than Sears made selling washers, dryers and tools. It was enough money to put Grecko’s fund on par with another cash flow machine: the energy sector. The funds profits put Grecko in the same league as big oil.

The fund made that money as a result of two decisions; a correct call that credit spreads would continue to narrow rather than widen and long-term interest rates would head down rather than up. Those two correct decisions, combined with leveraging up the balance sheet, made the fund a fortune that year. The brief hiccup in interest rates in April and May made the firm's creditors a bit nervous. Grecko reassured them. As interest rates came back down again, investment banks opened up their checkbooks and virtually gave the fund a blank check. By the end of 2004 the fund's balance sheet carried over $150 billion in debt – debt that was tied to every major investment and money center bank on the Street.

While a few of the fund's traders were beginning to get nervous with the leverage that the fund was taking on, they had absolute confidence in their boss. The amount of leverage was sizable, but it paled by comparison to the leverage and the derivative books of the major money center banks. The growth in credit derivatives was explosive. In the last fifteen years, the derivative book at major money center banks had grown from a paltry $10 trillion to $90 trillion by the close of 2004. Interest rate contracts made up the bulk of those contracts (87%). Five commercial banks held 95% of the notional amount of derivatives in the commercial banking system. Most of these contracts were illiquid. Over 92 percent were OTC (over-the-counter) related. Only 8% were plain vanilla type contracts that traded on the major exchanges. Piedmont Bank was the largest player on the street. They insured and backed almost everybody. BankUSA was second and CitiStreet came in third. These three players’ accounted for 90 percent of all derivatives in the banking system. They lent to and insured everybody.

Grecko knew all the major players at each of the banks. He played golf and tennis with most of them. Each one of the banks had a major stake in Grecko’s fund either directly through credit or as counterparty to the fund's derivative plays. It was a close and chummy group. In many ways, it was incestuous. Everybody had a stake in each other's business either through credit lines or hedges. The close relationship between all of the players is what created the risk.

Grecko ended 2004 with a complete assessment of his risk aggregation, breaking down his fund's exposure according to counterparty. Theoretically, things were supposed to be hedged with everyone protected. That was theory – not reality. Derivatives allowed you to hedge a risk, but not eliminate it completely. In essence risk was never eliminated. It was simply transferred to someone else. The hope was that that transfer of risk ended up in stronger hands. Counterparties to a derivative transaction were protected by their collateral. The collateral held up only as long as no one big failed. In the case of a failure of a major player, each one of its counterparties would attempt to sell out their positions. The problem arises when everyone sells at the same time. When everyone sells, the value of collateral backing each transaction evaporates. In the case of failure of one counterparty, the effect would be to leave the other counterparty naked; holding only one side of a contract when the other side no longer existed. When this takes place, each counterparty rushes for the exit gate at the same time. This is equivalent to a bank run. Markets can lock up and in extreme cases cease to trade at all.

The possibility of a lock up was the least of Grecko’s worries as he planned his strategy for 2005. He continued to believe that long-term rates would continue to fall and bet that that the 10-year note would fall to 3.86% by spring. By February his confidence was growing that his call was correct. The 10-year note had fallen to below 4% by the second week of February. He was also betting that risk spreads would continue to narrow. He intended to use even greater leverage to counter lower spreads. It was what he had learned from Meriwether. It was the leverage that turned the nickels and dimes into quarters. However, spreads were thinning and borrowing costs were going up with each Fed rate hike. The fund started to move further out on the risk scale shorting swap spreads. Swap rates were a fixed rate that banks, insurers, and major investors demand in exchange for paying the LIBOR rate, a short-term bank rate. The problem with LIBOR rates is that they are variable and it's difficult to determine where they will go in the future. By using derivatives Grecko had taken the fund's leverage to the extreme. With arb opportunities thinning out, the solution was more debt. The combination of debt and derivatives is what enabled the fund to turn its dimes and quarters into dollar bills. By early spring the firm’s derivative book had grown fourfold. Leverage had grown to the highest level in the firm’s history. Grecko’s firm, WedgeBook Partners, had $20 billion in equity, $150 billion in debt and controlled assets of $1.5 trillion.

Grecko's WedgeBook Partners Turned Fractions Into A Whole Lot of Money

While WedgeBook had become one of the major players on the street, their risk exposure was small in comparison to its creditors. With the average investor out of the markets buying real estate, the financial markets had become the exclusive domain of the big boys – the money center banks, hedge funds and investment banks. John Q had abandoned his mutual funds in favor of real estate investing. The retail end of business had become so slow that investment banks were laying off their staff of technical and research analysts. Nobody was interested in long-term investing anymore. The money was made by trading. Using leverage allowed you to get more bang out of each trade. It was what multiplied fractions and turned them into whole numbers. The markets had become the exclusive playground of the rich and powerful and Grecko was one of its big players.

By the end of March the fund was going further a field. WedgeBook had become a major player in the Russian debt markets. However, even there spreads had narrowed considerably. By late spring Russian sovereign debt yielded no more than 200 basis points over Treasuries.

In addition to narrowing credit spreads, short-term borrowing costs were continuing to rise. The Fed had raised the federal funds rate at its March FOMC meeting. The notes accompanying the meeting indicated that further rate hikes were on their way. This presented a problem for the fund. The yield curve was beginning to flatten. Borrowing costs were going up, while the returns offered on fixed income securities continued to fall. This impaired profits. The firm's computers were failing to find opportunities. Grecko needed an edge and a call from Piedmont provided the answer. With short-term borrowing costs rising and long-term fixed returns falling, the fund needed a cheap source of capital. Piedmont suggested selling gold bullion. Gold lease rates had fallen dramatically with one year rates no more than 20 basis points. Gold had continued to trade within a narrow $20 trading range for the last three months. The dollar was rallying, which would keep gold in check. As the stock market struggled with each new Fed rate hike, money was pouring into the Treasury market. This lowered interest rates and raised the value of the dollar. The Piedmont suggestion of selling bullion made sense. WedgeBook sold 100 tons of gold short at $420, thereby netting the fund an additional $1.3 billion.

Gold continued to trade in a very short range throughout most of the spring and the fund continued with its gold short sales. By summer WedgeBook had sold short by 500 tons and net more than $7 billion, which was redeployed into higher returning investments. By summer the firm’s portfolio was looking more exotic. It showed just how difficult the markets had become with nickels and dimes harder to come by. Almost half of the portfolio was made up of junk bonds and emerging debt. Nearly one-third consisted of interest rate swaps with the balance of the fund in everything from energy shorts, equity pairs, and foreign currencies, to long and shorts on various indexes. The most profitable trades had been the precious metal shorts. In addition to the gold short sales, the fund had also begun to accumulate a sizable short in silver. WedgeBook had sold over 20,000 contracts short silver when silver had been above $8. The precious metal shorts were accounting for most of the firm’s profits this year. By late spring and early summer the fund was printing money again. Its clients were pleased with their mid-year report, which was already showing double-digit returns.

The Perfect Financial Storm Brews and Breaks

Returns on the fund reached their peak in early July. From that point forward it was all down hill. By the end of August, the financial and political world began to take on a life of their own. A series of events were about to unfold that would shake the markets to their very core. The collapse of WedgeBook and the near bankruptcy of its creditors would be one of those events. The other storm was in the Middle East and an unexpected event here at home. But for now those events were far away. As summer set in, Grecko was in the mood to relax. He decided to spend a few weeks in Europe in July. August would be spent at his beachfront mansion in the Hamptons before his return to a robust schedule in the fall. Before embarking on his trip to Europe, Grecko reviewed all of the firm’s positions and felt comfortable with most of them. Credit spreads had started to widen again, but the firm's profits were large enough to provide a comfortable cushion. Gold and silver lease rates were flat and as along as they stayed that way, with the metals trading in a narrow range, Grecko had no worries. Besides, the markets were usually dull during the summer, so he anticipated no major surprises. The trouble spots that would surface by the end of the summer were barely visible on the radar. Isn’t it always this way? A bomb is dropped, a president or archduke is assassinated or jet planes fly into a building, and suddenly a tinderbox is lit, a crisis erupts and the world suddenly appears different. At the moment, volatility continued to fall and as long as it kept falling ,the financial world remained stable.

The problem no one paid attention to is that debt levels had risen to unimaginable levels. The culprit was low interest rates. Double-digit bond yields were a thing of the past. With hedge funds multiplying like viruses, the only way to earn a respectable return was through the use of leverage. Hedge funds were resorting to borrowing to inflate their returns. It wasn’t just the hedge funds. The money center banks had leveraged their balance sheets in ways that were beyond description. The money center and investment banks were the real problem. They were the ones extending the credit. They were the insurers of last resort. In the world of derivatives where risk was passed around like a hot potato, they were the ones holding the bulk of the potatoes.

The investment markets had learned from the crises of the 90’s and this new decade that if things got bad enough, the markets could always rely on the Fed. In essence it was the Fed who stood behind the banks. If troubles emerged, they could always rely on the Mr. Greenspan. The Fed chief could be counted on when it mattered most – when liquidity evaporated and markets locked up. Greenspan would keep cutting interest rates until liquidity to the system was eventually restored. In following this familiar pattern, a moral hazard had been created that permeated most of Wall Street. Its major players knew that they could continue to move further and further out on the risk curve knowing they always had the Fed as a safety net to catch them if they fell. Greenspan had opposed any form of regulation. Instead, he praised the innovation and productivity of the financial markets. His opposition led to a lack of disclosure when it came to measuring risk. While most investors might be able to distinguish basic balance sheet risk, they were ill prepared and uninformed when it came to off balance sheet debt and completely befuddled when it came to derivative risk. If debt isn’t clearly shown or has been removed from most financial statements, most investors don’t know where to find it. In the case of derivative exposure, there was a gaping hole left from deregulation that had yet to be plugged. This hole widened each year with the derivative book of money center banks expanding exponentially.

The other unrecognized problem was measuring risk itself. On Wall Street risk had been defined as volatility. It permeated most trading rooms on the Street eventually becoming the Holy Grail of finance. It was as if closing prices each day meant something other than what they were. A closing price told you nothing about company's on and off balance sheet risk. Prices couldn’t forecast a firm’s derivative risk nor disclose the risk of its counterparties. All most traders knew or cared about was what the models told them. That fact that some future trade or price would deviate from the norm was considered a statistical freak. Rogue waves were viewed as infrequent events and something that their models had statistically eliminated. The problem with most of these models was that they were based on pure mathematics that imbued an air of certainty when in reality none exists. That was where the hubris lies. Just because you haven’t seen one recently doesn’t mean one won’t appear. There would come that one day where they would appear out of nowhere, without warning, undetected, taking the markets by surprise.

That is when dangers of leverage come home to roost. If you have no debt, you can hold on to your positions. You can’t be forced to sell and you won't go broke. Leverage gives way to the same brutal dynamic. It cuts both ways. It magnifies gains on the way up as well as multiplies losses on the way down. Yet for many on the Street including Grecko, they had become immune to risk as a result of the moral hazard. What Grecko had learned in his time spent on the Solomon bond desk was that you ride your losses until they turn into gains. If you had access to capital to stay the course, you would be rewarded in the long run. Grecko had that access, which is why the amount of leverage in his fund gave him little cause for worry. That confidence would be shaken before the summer’s end. Events were about to unfold in many unexpected ways in unexpected corners of the markets and in the economy. It wasn’t just Grecko’s world that would be shaken to its core, it was also the world of John and Terry Wheeler.

To be continued...

Jim Puplava

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