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But as long a you have the capital to issue a lot of independent 5 % non-payment risk loans, you can get away with simply discounting it 5 %.

The salient point here is that you only get to do that with idiosyncratic risk, because systemic risk is, by its nature, not independent. This is why properly run industrial societies use government back-stops to ensure that not everyone is unemployed and broke at the same time. Because the government, as the only entity which is definitionally solvent, is the only entity which can serve as a backstop against systemic risk.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Mar 13th, 2012 at 10:17:36 AM EST
[ Parent ]
I think the key thing we should have learned from LTCM is that it's difficult to determine which risks are independent, which are not, and what sort of feedback the dependent ones will create for one another.
by rifek on Tue Mar 13th, 2012 at 03:00:20 PM EST
[ Parent ]
No, the key take-home points from the Long Term Capital Management fiasco are:

  • The market can remain irrational longer than you can remain solvent.
  • Don't bet your entire business that you're the smartest guy on the block.
  • Don't bet your entire business on any single transaction, particularly when that transaction does not keep the two first bullets firmly in mind.

Of course, none of this should have been in any way novel or surprising, and the fact that humanity regularly has to re-learn such simple matters of common prudence does not auger well for our collective cognitive prowess.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Mar 13th, 2012 at 03:18:59 PM EST
[ Parent ]
We knew those before.  LTCM thought that, if some risk spreading is good, more is better, but they never took into account that if you spread risk far enough, it becomes recursive.
by rifek on Wed Mar 14th, 2012 at 02:41:54 PM EST
[ Parent ]
They drank their own cool-aid.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Mar 14th, 2012 at 04:34:04 PM EST
[ Parent ]

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