…and there is no one there to hear it, does it still make a sound? Chaos theory posits that even the wind from the wings of a butterfly has the power to set off a tornado in Texas because of the unpredictable interrelatedness of the natural world. So I think chaoticians would say that a tree falling the in woods not only makes a sound but has the potential to cause any number of significant calamities. Those people who think the tree doesn’t make a sound must still believe in the Tooth Fairy and the Easter Bunny, too.
In that context let’s ask another question, “does a single hedge fund blowup really have any consequence to the larger financial landscape even if the media is not there to report on it?” Of course it does. And chaoticians would say that it has calamitous potential within the complex system we call the markets.
With the losses many hedge funds are facing so far this year there have been many rumors swirling around lately of hedge funds blowing up. Up until a few weeks ago these rumors had created some degree of fear in the markets that I believe was justified.
Many hedge funds use leverage, to a scale unavailable to individual investors, to gamble on already-levered financial instruments called derivatives. Derivatives are complicated products that allow investors to place bets with numerous counterparties on less complicated products like bonds, stocks, interest rates, etc. The combined leverage, lack of liquidity and interrelatedness of derivatives have led Warren Buffett to dub them, “financial weapons of mass destruction.”
So with the potential for financial calamity so palpable why is the VIX, the so-called “fear guage” for the stock market, showing near-historic complacency by participants in the derivate world? Maybe they still believe in the Tooth Fairy.