I read with amusement this week the “Agreement Among PWG And U.S. Agency Principals On Principles And Guidelines Regarding Private Pools Of Capital.” Now, I think this is a serious issue; I’m not convinced that we are in a better position to deal with systemic risk than we were back in 1998. I think that many institutions are in better shape, but for the system as a whole, the degree of leverage, both implicit and explicit, is higher now.

Now, I can take two paths here. Path one: I like systemic risk, since I am a conservative investor. I like getting bargains that are screaming, as in the Fall of 1987, the Fall of 1998, and the Fall of 2002. What I wouldn’t like is the Fall of 1929 and its aftermath. My risk control methods would allow me to do relatively well even in that scenario, but great relative performance when you are down over 20% is not my idea of a fun time. I prefer scenarios where my neighbors aren’t getting harmed badly. That said, my best relative performance as an investor came during and immediately after panic periods like we have had in the past 20 years. (No guarantees about the future though.)

The second path is more interesting though. What if the government gathered all of data from every major investor? Say, for every firm managing more than $100 million, measured by assets, rather than equity, they asked for inventories of both the assets and the funding sources. For nonpublic assets, they would also need the counterparty data. The purpose of this would be to ascertain who owes cash to whom, and under what circumstances payment would need to be made. Ideally, with this data, one could identify where market players with weak balance sheets are overexposed to risks.
Now, this will never be done, but just imagine for a moment. What would the government do if it had data like this? At present, nothing, like the report that they put out. They wouldn’t know what to do with it. They don’t have the analytical meanpower to deal with the complexity of one derivative swap book, much less all of them, the hedge funds, the securitizations, the CDOs, etcAt best, they could contract it out, asking the investment banks as a consortium to set up a separate company to do the analysis for the New York Fed, and the Department of the Treasury. It takes a thief to catch a thief, but would the government be willing to shell out enough to get effective data and analysis? I would suspect not.

The same problem exists in the auditing of swap books at investment banks. Anytime an investment bank runs into an auditor smart enough to audit their books, they hire him and pay him ten times the salary. So, even if the government makes noises that they want to control systemic risk, I view it as kind of a joke. They don’t have the data or intellectual resources to even begin the project.

Let me put it another way: if the government wants to reduce systemic risk, let them create risk-based capital regulations for investment banks, and let them increase the capital requirements on loans to hedge funds and investment banks. Or, let the Fed change the margin requirements on stocks. These are simple things that are within their power to do now. In my opinion, they won’t do them; they are friends with too many people who benefit from the current setup. If they won’t use their existing powers, why would they ask for new ones?

We will have to wait for the next blowup for the Federal Government to get serious about systemic risk. They might not do it even then. Upshot: be aware of the companies that you own, and their exposure to systemic risk. You are your own best defender against systemic risk.

Many market commentators, myself included, have been talking about the amazing amount of liquidity in the markets. Caroline Baum wrote a piece recently asking what liquidity really was, and she did not draw any real conclusion, in my opinion. For someone as smart as Caroline Baum to not come to a conclusion, means the concept must be pretty tough.

Last week’s copy of The Economist took another stab at it, and here is the critical quotation:

Helpfully, Martin Barnes, of BCA Research, an economic research firm, has laid out three ways of looking at liquidity. The first has to do with overall monetary conditions: money supply, official interest rates and the price of credit. The second is the state of balance sheets—the share of money, or things that can be exchanged for it in a hurry, in the assets of firms, households and financial institutions. The third, financial-market liquidity, is close to the textbook definition: the ability to buy and sell securities without triggering big changes in prices.

Pretty good, but it could be better. These are correlated phenomena. Times of high liquidity exist when parties are willing to take on fixed commitments for seemingly low rewards. Credit spreads are tight. Credit is growing more rapidly than the monetary base. Banks are willing to lend at relatively low spreads over Treasuries. Same for corporate bond investors. And, if you are trying to generate income by selling options, it almost doesn’t matter what market you are trading. Implied volatilities are low, so you realize less premium, while giving up flexibility (or, liquidity).

The demographics of the developed world favor saving over spending, given the given the graying of the Baby Boomers. Given that the excess credit is heading for the financial markets, and not to the goods markets, we are getting asset price inflation, but not goods price inflation. Spreads tighten, implied volatilities drop, and companies get bought out of the public markets, and get levered up in the private markets. The excess of credit also lowers the costs of carrying assets, which in turn leads to more trading, and bid/ask spreads tighten.

In short, what we are faced with is a situation where there is increasing leverage among market intermediaries in order to earn high returns off of assets with low unlevered returns. This cannot persist indefinitely, and when it reverses, the markets will be ugly. This is why you should insist on high quality stocks and bonds in this market environment. When the willingness to take risk diminishes, the low quality stuff will get killed.