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Extra info for The Economist (21 May 2016)
Sample text
It finally became obvious that Jett’s trading performance was an accounting illusion with no economic substance. Kidder fired Jett, and General Electric, Kidder’s parent company, took a charge of $350 million. qxd 7/13/07 2:42 PM Page 42 A DEMON OF OUR OWN DESIGN company to PaineWebber for $600 million in late 1994. One more illustrious Wall Street name passed into history. These and any number of other screwups made risk management a hot topic on Wall Street. Merrill Lynch was early on the case because of a spectacular trading loss on its mortgage desk in 1987, followed shortly thereafter by Bankers Trust.
Meanwhile, in Orange County, California, treasurer Robert Citron had been structuring trades with the help of friends at Merrill Lynch to borrow on the short end of the yield curve to finance positions in the usually higher-yielding intermediate-term rates. Citron’s strategy depended on short-term interest rates remaining relatively low when compared with medium-term interest rates. This they did in the early 1990s, so Citron’s yield curve bet made money and everyone was happy, with no questions asked.
Because all of the firms running these programs had the same type of hedging strategies in place—albeit with different clients—in the face of a market drop we would all have to sell to increase our hedges. Palmedo’s conclusion: “You have $3 billion of positions you need to hedge. Between you and LOR and everyone else who is doing this—not counting some places that have started doing this sort of hedging in-house—there must be 20 times that amount. ” Palmedo had figured it out. In his view, actions would drive the market down even further, and this in turn would require us to increase our hedges further, which would lead to a downward spiral in prices.