Two Lessons From the Last Five Years

I propose two lessons learned from the last five years:

  • There is no such thing as a risk-free return
  • There is no such thing as a perfect hedge
We are very, very close to seeing much of the financial system blow up because banks, particularly in Europe, have bought sovereign debt and leveraged it 30x to 40x.  The theory was that sovereign debt denominated in Euros, yen, or dollars was essentially risk-free.  Once that theory was proved to be bankrupt, financial institutions are now claiming all their sovereign debt is perfectly hedged.  I think we will find that untrue as well.  Hedging mechanisms don't work when the whole of the market is tanking -- its a similar problem to why earthquake insurance does not work.  No insurance company or counter-party can pay off when every single policy has a claim.

9 Comments

  1. Russ R.:

    "why earthquake insurance does not work..."

    Earthquake insurance works just fine... it just has to be diversified. That's why the reinsurance market exists.

    And for events that are too big for the reinsurance market (e.g. a quake in San Franciso of the magnitude that was recently experienced in Japan), reinsurers sell catastrophe bonds to investors, in effect buying additional coverage from capital markets.

  2. Jim Ashmore:

    One thing that the 2000 market meltdown and 2008 to present meltdown taught me was that there are no risk-free anythings. Even moving your money to money market accounts is still risky. If the money market fund holds European bonds, they could lose money and the fund can lose money. The buck was almost broken in 2008 and would have been if the Fed had not stepped in.

    Oh, and cash in your bank account is not risk-free either. If there is inflation or an outright default, you could lose 30% to 100% of your purchasing power, overnight. Oh, and the banks don't have to let you have your money. The government could put limits on how much cash you can pull out or convert to other assets. Just ask the Argentineans about currency controls.

    Oh, what if the FDIC goes broke and your bank implodes? You thought you had $100,000 of insurance. Nope! You could get a big haircut on your safe savings account!

    Lastly, you think those gold and silver coins are safe. The government could change the rules and mandate a price you have to sell to them. Or, any capital gains you make on the price of gold are taxable, even if inflation is 30% a year. So, there is risk everywhere and anything could happen to your assets.

    Have a nice day!!

  3. Mark:

    That is why I invest in cigarrete's and lady's stockings to barter.

  4. Andrew:

    Read Ferfal's site about Argentina, it's disturbing how they are mirroring us, just a few years more advanced.

    The FDIC, if effective, is still an insurance policy. Since 2 big banks transferred 150 Trillion in derivative exposure to their FDIC accounts, assume if there's a bank problem you'll be on the short end of payout, if at all. Figure, years, if at all. Since the FDIC has merely billions to cover.

    But the FDIC sticker on the bank says 250 large, so you're all good, right? Kinda like my 101K is now, though it may be about 33K level at this point.

    If I'd done the math when I was 16 and Dad said, Son, get an IRA and a 401K and you'll be a millionaire when you retire... I think I'd have been a bit smarter at this point in my life at 33, but who knows. Maybe I'd have just blown my spare cash on strip clubs. Hindsight.

  5. Fred Z:

    I would disagree a little bit with your "There is no such thing as a risk-free return".

    I would say that risk-free return is both impossible and immoral.

    The latter point is more important.

  6. el coronado:

    Actually, these last 5 years have taught me the very best investment strategy I've ever seen - taught it to me good & HARD, sadly. Here it is: a)The single best investment right now is the asset class that everybody's dumping on. The one **everybody** knows only a fool, idiot, or conspiracy loon would be in. Like, say, gold or silver in 2006. b)Conversely, the single WORST investment is the one that everyone's talking about; getting excited about; making magazine covers; the one they're running late-night infomercials about. Like, say, real estate in 2006.

    That's the good news. Hopefully, some day I can put it to use and make wonderful and grossly obscene profits with this knowledge. The bad news is, right now, there doesn't seem to be ANY asset class that meets the 'yay!' or 'boo!' criteria. Real estate stinks to high heaven, so I'd like to grab some, but...they never got around to clearing out the rot from the boom, so it's still toxic as hell. Who wants to buy a termite/mold-ridden asset class? The BRIC's are about to crash-land, so they're out. Europe is in actual meltdown before our very eyes, so they're extremely out. Bonds are like playing Russian Roulette with an automatic, so *that's* out....Gold & Silver seem to be about the least worst option - and with hyperinflation supposedly just around the corner, I think we can all agree that's the way to go. Absolutely. No question.

    Unless of course the roughly 50% of economists out there calling for imminent deflation are right.

    It would appear we live in interesting times. Hmmmm....maybe *Oil*.....the only possible way oil won't go to the moon is if we find ourselves in a worldwide depression! Oh. Wait.....

  7. morganovich:

    well, there was a "perfect" hedge. it was called a CDS.

    but the EU carved out a sneaky deal to force "voluntary" write downs.

    this was the literal equivalent of your insurance company changing the definition of "fire" while your house was ablaze.

    with the whole concept of insurance on sovereign debt now destroyed, you are going to see rates spike.

    it's a classic example of unforeseen consequences.

    germany protects it's landerbanks, who wrote a ton of Greek cds's, but does so at the price spiking rates in the whole EU.

    small wonder that that brokers are upping margin reqs on Italian debt. (to 11% from 6)

    that cuts leverage nearly in half.

  8. Gaunilo:

    Re: CDS swaps

    These swaps are useful if individual parts of the market tank, but in a general melt-down they cannot cover the risks they claim to cover.

    It is a classic case of companies being allowed to place bets they can't cover, and make the profits if they win. If they lose in a big way, too bad.

    I had an acquaintance years ago who was a poker pro back before it was cool to be one. I asked him if all of the games required full cash cover for chips. He said they didn't, and they kept it honest by killing anyone who couldn't cover a bet. Probably worked pretty well. Maybe we should apply it to CDS's

  9. JamesB:

    Worst part is the regulators allowed that sovereign debt - issued by the regulators? - constituted good assets for capitalization requirements of the banks, regardless of the issuer. This is the stuff of the Basel II, etc. accords. Banks looked at the sovereigns and of course selected the highest yield. Yield is of course is based on credit quality. Built-in destruction. Not sure yet about the intent of the draftsmen.