176 THE BiG DROP
September of 2008. There I was in September 2007, a year
earlier in Tokyo, and the Tokyo stock market was going down.
I remember my Japanese friend said: “Wait a second, Jim, we
don’t understand what’s happening. You Americans have a
mortgage problem, but we don’t understand why that should
affect the Tokyo stock market.”
The reason the Tokyo stock market was going down was
because the two were linked. That is, when you’re’ in financial
distress, when you’re in trouble, you don’t sell what you want;
you sell what you can. In other words, you sell whatever you
can to raise cash to quell the trouble.
What was happening was that U.S. hedge funds and U.S.
investment banks were getting margin calls on their mortgage
back securities position. They didn’t want to sell those because
there was no market or they would suffer enormous losses.
Instead, they were selling Japanese stocks, which were pretty
liquid. They were selling Japanese stocks to raise cash to meet
the margin calls on the mortgages. That’s how contagion works.
That’s how all these markets are linked. It happened in 2007–
2008, it happened in 1997–1998. By August, everybody was sell-
ing everything. Everybody wanted his or her money back. Credit
spreads were widening. That’s where Long-Term Capital lost its
money because we were basically “the bank of volatility.”
We would sell a security that looked a little rich, we would
buy one that looked cheap, and there would be some spread
between the two. You could be pretty confident that over time,
the spread would come in. As those securities got closer to
maturity the pricing would converge.
They were essentially two different flavors of the same
security; you’re two different maturities of the same security.
There was a security swap that was denominated in the same
currency.
Whatever it was, it was enough in common that your expec-
tation was that any spread between the two instruments — the