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The Conundrum of Risk

One of the positive things about international travel is that it gives me a large amount of time to read and think. This week we are going to look at some of that reading on the current issues surrounding the apparent willingness of investors to court ever increasing amounts of risk in the face of not only US central bank tightening but tightening by central banks everywhere, which has historically not been a bullish environment. I trust it will stimulate your own thinking.

But first, I want to announce that I along with my partners Altegris Investments will be hosting our third annual Strategic Investment Conference in La Jolla, California next May 18-20. As usual, we have a powerhouse lineup of speakers. Martin Barnes of Bank Credit Analyst, Dennis Gartman, Richard Russell, Louis-Vincent Gave, Mark Finn and my personal (as well as someone called Oprah's) doctor Dr. Michael Roizen (who wrote the RealAge series of books and the recent blockbuster bestseller You - The Owner's Manual). With this lineup you can expect not only solid information and some fun, but some very serious debates. One of my rules in designing a conference is to get speakers who are going to help make me a better investor and analyst. I think we have done that and more this year.

My Investment Conference in May

Due to regulations, we must limit attendance to "qualified" individuals and all attendees must be approved in advance. "Qualified" in this sense is a legal term which designates certain levels of net worth and not meant to say that all of my readers are not excellently qualified and astute analysts of investments and the markets. In general this means to attend you must have $2 million or more in investments, or be institutional investors. While I wish I could open up the conference to all of you, I do not make the rules. I just follow them religiously. If you are interested, click this link below to access our "Save the Date" form to allow us to contact you to help us determine if you are eligible for an invitation as soon as they are ready. If you have any questions as to whether you qualify for the event, please send me an email. Attendance is limited. I think it is likely this conference will sell out, so I suggest you act now and click on the link and give us your email address to notify you when the conference information is ready in a few weeks.

The Conundrum of Risk

Last week in London I was reading a rather longish essay from my friends at GaveKal. In their analysis was the following column from Hedge-World by Hunt Taylor, who has long been a font on interesting analysis for our industry. I wrote Louis-Vincent Gave and asked if he could get me permission to reproduce this piece to you, as I think it dovetails with some of the ideas I have been pondering. Sadly, Louis wrote me back that Hunt had just died in a motorcycle accident in Arizona, but that he thought it would be a nice tribute to use the column. My sincere condolences to his family and friends. Those of us on the periphery who benefited from Taylor's deep insights will miss him.

Let's set the stage. GaveKal was writing about the proliferation of new investments and financial vehicles available to corporations and individuals. They, of course, see this explosion as a very good thing, as opposed to others who see the increase of total debt in the system as bad. But then they add this paragraph of concern:

"But for all of our enthusiasm about Our Brave New World , and for how our world keeps changing for the better, we nevertheless fear that there is one trend we should not discard too lightly: the tendency of investors to project their recent experiences into the future. This tendency might be the third explanation behind the large increase in the velocity of money, and one of the explanations behind the markets' ability to make multi year highs in the face of tightening primary liquidity, high oil, weak Yen etc..."

This is something about which I have written at length. It is part of the human psyche, and one of the main reasons that analysts and investors are so wrong in their predictions. It is why we have runaway bull markets and every now and then bubble markets. We move the price of an asset class until it is priced for perfection. Then along comes a disappointment and the bull stumbles or the bubble is pricked.

One of the main themes of The Millennium Wave is that we are going to see unprecedented waves of change in the next 20 years. But one of the things that will not change is human psychology. Human beings are not just irrational. We are as a group predictably irrational. We tend to make the same mistakes over and over again.

As Nobel Laureate Hyman Minsky points out, stability leads to instability. The more comfortable we get with a given condition or trend, the longer it will persist and then when the trend fails, the more dramatic the correction. The problem with long term macroeconomic stability is that it tends to produce unstable financial arrangements. If we believe that tomorrow and next year will be the same as last week and last year, we are more willing to add debt or postpone savings for current consumption. Thus, says Minsky, the longer the period of stability, the higher the potential risk for even greater instability when market participants must change their behavior.

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Now, with that in mind, let's go to Hunt Taylor's column. Put on your thinking caps, gentle readers. This one is chock full of insights.

"Let us start with what we know. First, these markets look nothing like anything I've ever encountered before. Their stunning complexity, the staggering number of tradable instruments and their interconnectedness, the light-speed at which information moves, the degree to which the movement of one instrument triggers nonlinear reactions along chains of related derivatives, and the requisite level of mathematics necessary to price them speak to the reality that we are now sailing in uncharted waters.

"Next, we know things have been getting less, not more, turbulent, and that the tendency towards market serenity (complacency?) has been increasing. This is counterintuitive. It's not as though the 21st century has been lacking in liquidity shocking events. Since the bursting of the tech bubble, we've had a disputed Presidential election, 9/11, the collapse of Enron and Worldcom, the invasion of Afghanistan, the war in Iraq, US$70 oil, the largest debt downgrade in history and the failure of Refco, to name just a few. There seems to be an inverse correlation between market complexity and market stability, for now anyway.

"Counterintuitive though it may be, it's not like we don't see this pattern everywhere we look. Take aviation, as one example of many. There were three fatal flights per million in 1979 as compared to 0.5 in 2004. Flying today is statistically 6 times safer than it was 25 years ago, even though technology now does most of the actual 'flying' with autopilots, GPS navigation and the like. In medicine, engineering, even warfare, risk is being reduced at the junction of technology and human endeavor....

...the present level of financial technology has allowed the western world to take leverage to new levels - ratios never before contemplated in our financial history. It is without a doubt smarter leverage, and it is, in no small part, responsible for the wealth we enjoy today as a society....

"...But something isn't different, too, and it's what keeps me up at night. It's the other side of the hyper-efficient frontier: the investors. Over the years, when trying to make sense of the impossibly complex global economy, I think a lot about the elegant advice of Albert Einstein, who said everything should be made as simple as possible, but not more so. Two simple things I understand are risk and return, both of which seem to have been coming down.

"Lets' start with return. There are several truths about return that have held up well over the centuries, making for a good statistical sample. Eventually, returns diminish relative to assets invested. The point where the diminishing returns occur vary across investments, but were it not true some very smart investor would have wound up with all the money in the world by now. We also know there has been an explosion in asset growth in efficiency capital, the term I use to describe the societal function hedge funds and prop desks perform, and that returns in that space have come down. I'm still trying to find someone who thinks that's a coincidence.

"The next thing we know about return is that asset classes have a risk premium. They will pay you a return relative to the amount of risk the 'market' deems you to be taking by owning a particular asset. The risk of a T-Bill is less than the risk of a small cap stock, and so is the return over time. Now let's talk about what we don't know. Or, to be fair, what I don't know. If these hypotheses about the hyper-efficient frontier are true; if the restructuring of the world's capital and derivative markets and the explosion of efficiency capital have structurally lowered risk in financial markets, then wouldn't risk premiums also be lower? Let me say that again. If markets really are less risky, why would they continue to pay us the same return? Wouldn't that be the proverbial free lunch that isn't supposed to exist?

"The implications here are large and it's too early to prove them. There will not be enough data actually to prove anything for years. The premise is that the growth of efficiency capital has not just lowered the returns in hedge funds, but by lowering the risk across capital and derivative markets, it has lowered the future returns in those markets as well. Great for the business economy, but a new, and unappealing paradigm for investors.

"There was a saying in the seventies among commodity traders: 'Watch out for the risk, and the returns will take care of themselves.' Today, returns do not seem to be taking care of themselves, and going forward, it may be that investors have to actively seek riskier assets or structures to earn a respectable risk premium. So let's talk about risk.

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"We can start by acknowledging that the nature of risk in the markets has changed. It could be higher or lower, but it's different. The cumulative impact of technology, telecommunication and financial product innovation has, at the least, altered the way information is shared, orders are transmitted, and both risk and return factors are dispersed. The proliferation of derivatives has created leverage never imagined a generation ago, and trillion dollar exposures now exist in instruments that make the '90s seem like a different century. Ok, they were a different century. But empirical data supports the conclusion that market risk is changing, at least in the short term.

"This leaves us with two options, and their respective implications: Markets are structurally less risky, leaving us to answer the question about future risk premiums, or Markets are still as risky as they ever were, but the nature of the risk has somewhere been altered...

"... and this brings us back to the question I raised in my last column about 'risk compensation,' the proven tendency in humans to react to safer conditions by taking more risk. You make me wear seat belts, I drive the car faster.

"Having given it some thought, I believe we are adjusting our risk levels in the financial markets back up to where they were before we employed all this efficiency capital. In fact, we may have no choice. Sitting on the short arm of chromosome 11 is a gene with the Stars Wars-like name of D4DR. Its function is to regulate the flow of dopamine in the brain. Dopamine is a neurotransmitter which, among other things, regulates the flow of blood in the brain. To greatly oversimplify, the level of dopamine in the brain affects behavior. Too little and individuals tend toward lethargy, too much and they become easily bored and tend to seek adventure. Put simply, we may one day discover that, for all our efforts at building safer roads and more efficient markets, our collective appetite for risk is set at the genetic level. Genetically or not, the generalized response to the more-or-less recently created hyper-efficient frontier seems to be that we keep adding leverage.

"The warning signs are there. The Bank of England's 'Financial Stability Review' in December of 2005 said the following: 'The U.K. financial system remains healthy. However, the persistence of the 'search for yield' across financial markets continues to fuel an increase in highly leveraged and potentially illiquid financial products. It has placed pressure on financial intermediaries to ease lending terms, challenged operational controls within the financial sector, and may have heightened the vulnerability of the U.K. financial system to adverse developments.'

"The BoE goes on to talk about crowded trades, the potential for financial contagion, the possibility of smaller banks with rising loan losses cutting back on lending with dangerous consequences in a macro downturn, and concentrated lending to emerging markets, culminating in potential risk to the payment system, otherwise known as a liquidity shock. I've seen this movie before. So after all this, I'm left thinking about the old wedding rhyme: 'something old, something new, something borrowed, something blue.'

"I've had 30-plus years of learning experiences in markets, all of which tell me that technology and telecommunications will not do away with human greed and ignorance. I think we will drive the car faster and faster until something bad happens. And I think it will come, like a comet, from that part of the night sky where we least expect it. This is something old.

"But I have learned to trust my eyes and ears and overrule my heart, when I have to. Everywhere I look, technology is making things faster, more efficient, safer. I cannot find the law of physics or economics that says it cannot happen in financial markets as well. I think, because risk will be lower, return will be as well. And savvy investors may have to seek additional risk, and manage it well, in order to earn an excess return. This is something new.

"I think shocks will come, but they will be shallower, shorter. They will be harder to predict, because we are not really managing risk anymore. We are managing uncertainty - too many new variables, plus leverage on a scale we have never encountered (something borrowed). And, when the inevitable occurs, the buying opportunities that result will be won by the technologically enabled swift.

"At least, that's what I think tonight. My goal every morning is to wake up humble, with an open mind. It's harder than it looks, and I fail far more often than I succeed. These ideas represent secular change on a fundamental level. They go against all our learned experiences. They could be wrong, and we won't know for a long time what the correct answer was. And, for all of that, there is still money to be made. The tactics may have changed, but then tactics usually do, every ten years or so. The shape of alpha may change and reappear in new forms and arenas, but it won't go away. And it can be captured by those who can adapt. Those who don't? Well, the song they sing will be something blue."

Lost in Translation: 45,000 Derivatives

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Let's pull out one important paragraph. "I think shocks will come, but they will be shallower, shorter. They will be harder to predict, because we are not really managing risk anymore. We are managing uncertainty - too many new variables, plus leverage on a scale we have never encountered (something borrowed). And, when the inevitable occurs, the buying opportunities that result will be won by the technologically enabled swift."

Why are we no longer managing risk? Primarily because of derivatives and other forms of insurance. It was the advent of insurance at a pub in London which later became Lloyd's lo London that enabled the quicker proliferation of trade and commerce. Insurance of all types spreads the risk of any one negative event from one person to many persons.

And thus credit default swaps, one form of derivatives, have enabled more and more firms to mange their risk and feel comfortable increasing their leverage, adding to the pool of capital looking to go to work. But in an effort to mange risk we create a new form of uncertainty.

Bill King brought this to my attention this morning: The WSJ in GM Debt Poses Challenge To Derivatives Market: "The car maker has about $30 billion in debt. Traders estimate more than $200 billion in credit derivatives are linked to GM. But because such derivatives don't trade on an exchange, nobody knows for certain how much credit-default swap protection has actually been written on GM. And nobody can say with confidence that they even know who is on the other side of the trades that they have entered into. Such uncertainty is one reason that, since last year, regulators have asked participants in the fast-growing market to get their operational act together. That encompasses everything from dealing with a backlog of unconfirmed trades to figuring out who their counterparties are when one side transfers contracts to another party. The Fed has asked market participants to report by today on their progress in dealing with these and other issues...Four years ago, the derivatives market was a fraction of the size of the underlying corporate-bond market. Today, it is estimated at $12.5 trillion, more than twice the underlying market's size, and it continues to expand rapidly."

As King wryly notes, "So GM CDS have created a 6.67 fold increase in the $30B risk that they are supposed to mitigate. What possibly could go wrong ?"

What if I told you there are 45,000 derivative trades the confirmations for which are at a minimum of over 30 days late? Doesn't sound good. But that's not the whole story. Regulators, led by the New York Fed, have been pressing the industry hard to get solve what could be a real problem in the derivatives markets. Even though Greenspan did not want those markets regulated, he did note that inadequate infrastructure was "a significant problem."

To make a long story short, a report was released last July from an industry committee detailing the problems and making 47 suggestions as to new policies and procedures. Last September, the Fed, along with other regulators, called the main players (named "The 14 Families") to a meeting and more or less said, "clean up this mess or we will step in." At the time there were 97,000 trades that were unconfirmed for 30 days or longer. Also, traders would buy a "credit swap" and then sell it the next day, but not tell the original party, who now did not know who his counter-party was.

This week, the number of late unconfirmed trades was cut to 45,000, 2 1/2 months ahead of the target. Re-assignments are reported in one day, much to the moaning of hedge funds and traders who do not want to reveal their strategies. Most of the trades are now matched electronically. But as the WSJ notes:

"The problems aren't solved. There is a backlog of thousand of unconfirmed trades. About 40% of new trades still aren't matched electronically. There's no centralized utility to process credit derivative trades. But the industry and its regulators are on the way to replacing the pipes before they burst - without cumbersome rule making or humiliating any one firm to make a point, or waiting for a crisis to force action."

Let's be very clear. While derivatives sound like potential weapons of capital destruction to the average investor, they are a very necessary part of our capital markets. The world would come to a screeching halt without them.

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They in fact allow for market participants to "buy insurance" from a one time event by placing the risk with parties who have an appetite for such risk.

Are derivatives risky? Of course. That is the point. As Taylor noted, it is the potential risk (and the risk premium it yields) that drives the potential reward. If there were no risk in them then there would be no profit, and on one would buy them.

It is the massive buying and selling of all sorts of derivatives that has distributed the risks of the various markets to a much larger universe, who presumably have calculated the costs of that risk and built in a profit. Of course, there will be problems. Hurricane Katrina was a problem for insurance companies. But because they sold risk (hurricane) insurance over a wide variety or regions and types of insurance, they were able to withstand the storm, even though their profit margins were surely hit.

(This brings up an interesting side point. There are many hedge funds that are simply banks or insurance companies in drag. Instead of listing on a stock exchange, they run a private fund. Instead of a stock which can go up or down, you get a fund which can go up or down. Instead of a board which sets salaries, the management charges 20% of the profits as their fee for management (along with a typical) monthly management fee of 1-2%.

This trend is not just in banks and insurance companies. I am seeing more and more hedge funds which are really just some type of business which lets management charge a percentage of the profit rather than the typical salary and stock options. I like that model. Management and investors are on the same side of the table. Of course, just like any business, that fund can fail.)

Just the same, hedge funds buy lots of derivatives, any one of which could go bad at any time. In fact, most hedge funds and investments banks will assume that some will in fact go bad. They just try to diversify across enough types of derivatives from many companies and "charge" enough in the form of buying risk at a decent price to offset those losses.

The massive amount of derivatives and their rapid growth is on the surface a troubling trend. But Harry Browne taught me a lesson that I will never forget. In analyzing a whole economy, you have to trust the individual players in the market to tend to their own businesses. Self-interested parties will work to make sure they are ok.

Each of those funds and investment banks knows their own books. They have very risk managers whose job it is to make sure the risks and rewards are balanced. To assume that the world is going to end because of derivatives assumes that the world of finance in populated mostly by fools. My brief sojourn says this is not the case. There are some very bright people.

Of course, very bright people brought us Long Term Capital. But those people and the banks which loaned them money lost a lot of their capital. And deservedly so. They took risks because of greed they should not have done. The world rocked along fine even as those firms and individuals lost billions.

Now, the New York Fed had to tell them to play nice. It was a very scary moment. But the system worked. Those who took the risks lost their money.

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And in some crisis in the future, some uncertainty event, there will be a number of funds and individuals which will lose their money. That is the way of the world. In the next uncertainty event, the headlines will be screaming, but the world will move right along. That will be small consolation to those who are hit by the train, but it should bring a sense of optimism to the rest of us.

The whole result is that risk is distributed to more and more players. And that is a good thing, except. Except for Black Swans. Just because you have not seen a Black Swan does not mean one does note exist.

Black Swans (as Nicholas Taleb in Fooled by Randomness called system shocks) still exist: "Reality is far more vicious than Russian roulette. First, it delivers the fatal bullet rather infrequently, like a revolver that would have hundreds, even thousands of chambers instead of six. After a few dozen tries, one forgets about the existence of a bullet, under a numbing false sense of security. . . . Second, unlike a well-defined precise game like Russian roulette, where the risks are visible to anyone capable of multiplying and dividing by six, one does not observe the barrel of reality".

I hope Taylor is right. The shocks will come, but they will be shallower and shorter, because the risks are more distributed. The trick for clever managers and investors is to make sure they are distributed to someone else.

Home Again, Home Again

I am going to quit a little early tonight. My twins are home from college for the weekend. It will be nice to see them. It looks like we night actually get some winter weather in Texas and I want to beat the ice, not to mention get to bed and deal with some jet lag.

London was fun. I enjoyed being on CNBC. Being a guest host was a hoot. On Wednesday, I had a really interesting dinner party. Bill Bonner and Simon Hunt, both of whom I quote often, some very smart local money mangers, another from South Africa and Tom Kass (who works with EFG), one of the brightest biotech analysts I have ever met. We had dinner with my London partner, Niels Jensen, who is also Danish.

We did discuss the irrational and out-of-proportion response to the publication of cartoons in some third rate Danish paper. The irony of the vilifying of a nation which almost makes a fetish of being non-offensive should be lost on no one. To show our solidarity, we decided to let Niels pick up the check.

In future letters, I am going to be writing about some of the amazing things that are happening in the biotech world. Tom really opened some eyes.

One of the books I read this last week was called Getting Things Done. It has inspired me to once again see if I can increase my own personal productivity. We will see. Have a great week.

Your deciding to get organized analyst,

John Mauldin Thoughts from the Frontline
John Mauldin

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