I would agree that pure-play stock leverage is probably not at “insane” levels, but there is a massive amount of money that is being run in multi-discipline strategy with the assumption that correlations will not be high between strategies. I am by no means an expert in the area, but from what I have gathered from some who are, there is immense leverage based on this assumption. In fact, the new portfolio margin levels which reduced “regular” requirements are based on this assumption. I would venture that we won’t know until we get an across the board decline like we did on Thursday, where most risk assets declined AND treasuries as well. Of course it would likely have to stick for a while as you mention…..

As for derivatives, I remain extremely skeptical that the large banks have it under control. One need only to read the last 10 years of Berkshire letters from Buffet and his dismay with unwinding General Re’s book. There is no way in **** that JPM or C or UBS have a better handle on counterparty risk or correlations of their “assets”….in my opinion anyway!

The $64 billion dollar question is who holds the risk in a crisis? How well capitalized are the ones who who be asked to deliver liquidity when it is demanded. Derivatives are tricky because they net to zero in aggregate, but the counterparties may have decidedly different abilities to make payment in a crisis.

Some exposures can’t be hedged. There is no natural counterparty for them. A financial entity can only do the following for risk control in that case:

1. Cross-hedge (might provide some relief)
2. Keep spare capital around (how quaint!)
3. Have enough seemingly uncorrelated exposures that diversification keeps any problem to a reasonable size.

Trouble is, the world is more correlated during a crisis. If I were at one of the major investment banks and in charge of risk control, I would push as hard as I could to analyze the strength of the counterparties, and see which contingencies have the weakest counterparties behind them. Some managing directors would start to scream because it would hurt a very profitable business, but an exercise like that could save the investment bank in a crisis.

I wonder if you are under characterizing the leverage currently present in the system – particularly stocks. Yes margin requirements exist when they did not in 1929, but futures trading is massive at present and leverage there can be 20+ to 1. Also, as you indicate, hedge funds and fund of funds are so dominate now. We have fund of funds that are leveraged several times investing in hedge funds that are leveraged several times investing in a lot of OTC options and derivatives contracts which have not been stress tested at 3+ standard deviations to see if they’ll perform as all of the pricing models forecast (paint me VERY skeptical they will). Also, with commercial banks up to their eyeballs in commercial real estate and derivatives, the financial system is massively leveraged with a fairly risky asset profile.