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I just finished Richard Bookstaber's new book, A Demon of Our Own Design: Markets, Hedge Funds, and the Perils of Financial Innovation, and he makes some fair points.

He asks a very important question in the book, in my opinion, “Why have economic cycles become less extreme while financial cycles have become more extreme?”. 

After all, our knowledge of financial instruments has increased over time, we use computer applications to help us hedge risk in better ways today, and we have better and more reliable streams of information for traders to navigate today's financial waters.

His answer, which I find intriguing, is that liquidity is the most important determinant of short term price swings (which is very different from the conventional answer - fear and greed).  He points out that financial instruments with different risk profiles quickly became correlated with each other because they were packaged together.  (Perhaps traders now have better means of smelling blood in the waters as well?)

I suppose this may be the reason we see Bank of America purchasing Countrywide today.  Bank of America had a lot of information about Countrywide because of their $2 Bn in the company over the summer, and they probably realized that providing liquidity to Countrywide's positions would not only enhance the value of today's $4Bn takeover, but also the existing $2 Bn investment made earlier.

Interested in your thoughts,



Posted on Friday, January 11, 2008 6:27 PM Critique , Finance | Back to top

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