Investors Beware: Market Risks Are Higher than Ever

The following commentary comes from an independent investor or market observer as part of TheStreet's guest contributor program, which is separate from the company's news coverage.

NEW YORK ( -- After the shot across the bow in 2008, you might have expected regulators and market participants would use the experience to change for the better, to become more prudent and to reduce the sorts of risky behaviors that almost crashed the entire system.

Unfortunately, you'd be wrong.

LTCM and Moral Hazard

In 1998, there was a firm called Long-Term Capital Management (LTCM, as it is commonly referred to today), staffed by the best of the best, including one of the very top bond traders that Wall Street ever produced as well as two future Nobel laureates.

LTCM boasted of its use of complex models that were supposed to generate outsized returns while operating with a risk-minimizing profile that, mathematically, was only supposed to experience severe losses so infrequently that the periods between them would be measured in the thousands of years.

Unfortunately for LTCM, their models badly underestimated real risks, and their leverage was such that their original $1 billion in capital turned into total losses of $4.6 billion in a little over four years, nearly dragging down the entire financial system in the process.

While this experience has much to teach us in the way of market risk, hubris, and the dangers of leverage, it really needs to be understood in terms of the rise of moral hazard on Wall Street. The main lesson that Wall Street seems to have learned from the LTCM disaster is that if the wipe-out was big enough, the Federal Reserve would swoop in and rescue things.

Message received: Go big or go home. Take on as much risk as possible, secure in the knowledge that if things got bad enough, the Fed would simply print up what was necessary to make all the players whole again, with perhaps one core player or institution thrown under the bus for the sake of appearances.

Fast forward to 2008, and that exact experience was replicated perfectly, thereby reinforcing Wall Street's perception that it is best rewarded by chasing big risks and big returns. And if things didn't go as hoped, the good ol' Fed would always be there to push the reset button.

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