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IN THE autumn of 1998, Buttonwood was at a conference organised by Credit Suisse First Boston in—appropriately enough—Monte Carlo, when Allen Wheat, the then head of the investment bank, stood up after dinner and delivered a breathtaking mea culpa. Some sort of apology certainly seemed in order given the huge sums the bank had just lost from extravagant punts on Russia in particular and financial markets in general. The bets went spectacularly wrong after Russia defaulted, financial markets went berserk, and Long-Term Capital Management (LTCM), a very large hedge fund, had to be rescued by its bankers at the behest of the Federal Reserve. CSFB eventually admitted to losses of $1.3 billion, though the bank’s official figures and the numbers bandied about by insiders were somewhat at variance. To cut to the chase: had they Mr Wheat’s balls, Buttonwood thinks that the bosses of many a big bank will be making a similar speech before the year is out.
The reason is simple: the size of banks’ bets is rising rapidly the world over. This is because potential returns have fallen as fast as markets have risen, so banks have had to bet more in order to continue generating huge profits. The present situation “is not dissimilar” to the one that preceded the collapse of LTCM, says Michael Thompson, a strategist at RiskMetrics, a consultancy that specialises in the very risk-management models that banks use. Like LTCM, banks are building up huge positions in the expectation that markets will remain stable. They are, says Mr Thompson, “walking themselves to the edge of the cliff”. This is because—as all past financial crises have shown—the risk-management models they use woefully underestimate the savage effects of big shocks, when everybody is trying to wriggle out of their positions at the same time.
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