Japan - A decade of lost glory!

Japan pioneered technology - be it cars, music or televisions and earned heavy royalty through exports. Also a strong tariff policy protected home market from imports which pumped up the yen and led to a massive buildup of new found wealth among consumers & government. Liquidity was high, which spawned an era of easy money, and that fueled a frenzy of stock-and-real estate speculation unrivaled since the U.S. Great Depression. Clearly the market manias were ignited by ridiculously loose credit policies.
Almost overnight, the newly wealthy Japanese were viewed with fear. Japanese cars filled American roadways and Japanese-owned companies started buying out US companies overnight – remember Universal, Columbia pictures…
At the peak of the frenzy, a piece of land at Imperial Palace in Tokyo was more than the value of the entire state of California - which defied all wisdom & senses, but which was mathematically correct as prime office space was going for $139,000 a square foot in Tokyo’s Ginza district, way back in 1989!

But “Irrational Exuberance” is “Irrational” after all. Japanese financial system, especially banks tumbled & Japan couldn’t even overcome 10 years of stagflation. 10 years of lost glory!
In Dec 1989, Nikkei 225 Index topped out at around 39,000. By September 1990, it had nearly been halved. Nikkei ultimately bottomed at 7,830 in April 2003. It hangs around 12,700, still down 67% from its trading high 19 years ago).
The fallout from that meltdown was incredible. By early 2004, houses were selling at 1/10th their peak value, and commercial real estate was selling for less than 1/100th of its peak-market value. All told, an estimated $20 trillion in stock market and real-estate wealth had been vanished!

Oil's Risk Premium

Oil is a difficult commodity. The position that oil commands, no other commodity can ever have.

The dual status of oil as an important commodity and proxy for global macroeconomic risk dates back to 1973-74 oil crisis, when OPEC waged an economic war against the West with crude as its weapon in support of the Arab attack on Israel. This elevated the commodity's profile to unprecedented heights on global stage. Since then, oil's price has reflected the forces of both supply and demand, and GLOBAL RISK PERCEPTIONS.

Nobody can determine how much risk premium does Oil command on any given day, but yes it does command increasingly more. Nearest to Oil as a significant global commodity was Gold. Yes, gold too is influenced by global risk, but gold has no strategic economic use. Jewelry and industrial demand are pricing factors for gold, but those applications are hardly critical in the global economy. Even if world sees Gold supply shortage, people simply can stop wearing & storing more gold. The only question is price, which is largely driven by sentiment and the vague memories that the metal was once used as legal tender.

At the moment, there's no shortage of risk fears. The challenge for the world is separating the Oil's risk-premium from the pure economic factors. This is inherently a speculative task and so no one can be confident that they understand how much of oil's price is affected by risk considerations vs. supply and demand analytics. Nonetheless, the biggest risk is underestimating, or ignoring the potential for an oil risk premium-which can and does fluctuate widely over time.

No lesson learnt from LTCM

Everyone remembers the high profile blowup of LTCM 10 years ago, but nobody learnt the lesson. The basic reasons of LTCM blowup was:

1. Very high levels of leveraged used to generate huge profits from minuscule arbitrage opportunities,
2. Expectation that liquidity will always remain high in the markets,
3. Financial models are the pennecia of all risk management needed.

Current scenario looks no different, other than the scale of this crisis. Its no more "one hedge-fund" problem now, it spans globe. Its the most biggest banks & financial institutions that are core to global financial system, are facing the heat. LTCM nearly single handedly brought the financial system to near collapse, but then a bailout package was available. Just no bailout is possible this time, the crisis is huge. Nearly $800 billions have been written down till now & few wall street veterans believe that another $400 billion is still to come. Can you imagine that the wealth worth a whole Hedge Fund industry size (of nearly $1.5 trillion) will be eroded by the time this subprime crisis ends.

Probably its the imperfections of global financial markets, assets were so much overvalued which were never worth that much. So they came down! But this reminds us of LTCM, and we have hardly learnt anything. Still Banks & Hedge Funds are highly levered (Carlyle disclosed 32x leverage, LTCM was 30x when it got bust). Risk mamagement measures is far from efficient. yes, trading/ financial models can churn numbers & predict well, but only when economic conditions & markets are stable. In case of "irrational exuberance", nothing works but greed and fear!