Friday, October 17, 2008

Unraveling The Economy

October 2008 saw Sigma Finance — the last of the SIVs (structured investment vehicles) — unravel, dragging 27 billion dollars down with it. The complex debt instruments called SIVs were central to the financial crisis. Sigma was undone when JP Morgan cut the short term funding line. The Sigma fund was managed by the ironically named Gordian Knot Limited of London.

Shakespeare couldn’t have written it better…In fact, Shakespeare makes reference to the knot in the first act of Henry V when he has the Archbishop of Canterbury say:

Turn him to any cause of policy | The Gordian Knot of it he will unloose | Familiar as his garter

Legend has the Gordian Knot securing an ox cart to a temple in the ancient Phrygian city of Gordium — tied to a prophesy that whoever could solve the puzzle would rule Asia Minor. Of course no one could until Alexander studied the problem and came up with a very different solution. Centuries later, Gordian Knot Limited’s activity in SIVs was part of a shadow banking industry so complex that, had it proved sustainable, all its participants may have become the new masters of the universe…a big finale in the dramatic financial play we have been watching at the dawn of the new century.

In one version of the legend, Alexander, seeking to legitimize his effort to conquer the world, goes to Gordium, which is under Persian rule at the time. Alexander is determined to fulfill the prophecy of the Gordian Knot. While wrestling with the problem, he eventually asks his seer if it matters how it is solved. Without a clear answer, he draws his sword and slices the knot in half. Hence the metaphor “cutting the Gordian Knot” which describes a bold and unconventional solution to a complicated problem. Similarly, for all it’s complexity, Gordian Knot Limited’s fund was summarily undone with a swift cut by JP Morgan.

It’s fascinating that that Gordian Knot Limited failed to see the irony in their name. When they structured their risk management approach, they apparently thought they were Alexander. It turns out they were the knot. It’s more ironic — almost prophetic — if you read the last lines on their website:

"Our aim is simply to make money for investors with minimal risk. And if the banking system becomes more efficient as a consequence, that’s good for everyone, and we’re pleased to have played our small part."

The banking system may not have become more efficient in the way they envisioned, but it has been been simplified by the elimination of quite a few players. The notion that a shadow banking system was the innovative solve we were all looking for seems naive in the immediate aftermath of the collapse. Hopefully, we will remember that things done in the shadows are usually done for shadowy reasons…Hopefully we will remember — and put to use — the reminder from Justice Louis Brandeis that Sunshine is the best antiseptic.

Original posted at InsideWork.

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