Anatomy of a Crisis: The "Credit Woes" of the Summer of '07 – (6)

The essence of arbitrage is constant. Its form varies from one occasion to the next, depending on the circumstances. So while it is possible to demonstrate the concept of arbitrage with a simple example, the particular form in each case must be elaborated. It is this variation of the form that appears as a new product, a new market or a new strategy and for which financial engineers in the City and Wall Street are eternally given credit.

The critical point to note is that the particular form of arbitrage disrupts the status quo with varying degree of severity. In the heydays of globalization in 1998, the New York Times Magazine devoted a section to globalization under the heading “The Nuke of the 90’s.” An awestruck former Treasury official was quoted as comparing the “global markets” to nuclear weapons and adding: “The global markets are the most powerful force the world has ever seen, capable of obliterating governments almost overnight.”

Hegel said that myth is the expression of impotence of mind that cannot express itself independently. Hyperbole of this kind, too, is the expression of the impotence of a mind that notices the potency of a force but can neither comprehend it theoretically nor, consequently, describe it logically. The nuclear-force like irresistibility and destructiveness that overwhelms the uncomprehending observer is the resolve and drive of speculative capital to exploit arbitrage opportunities no matter the obstacles or consequences. This "ruthlessness" is a natural appendage to speculative capital’s modus operandi.

How does speculative capital react to the circumstance of low interest rates, a relatively flat yield curve and decreasing default rates (that lowers credit spreads)? How did it react in actuality when these conditions prevailed beginning 2002?

We are now ready to focus on the current crisis.

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