Risk-avoiders are actually increasing the risk

As even Morgan Stanley’s share price drops 50% this year, Franco-Belgian lender Dexia enters emergency talks on possible break-up (and Greece’s failure to meet 2011 budget targets will be turned into new 2012 targets), pressure mounts for UBS to be broken up while RBS, Bank of America and Merrill Lynch also struggle, investors look around for the new ‘safe’.

But the routes they are following to achieve this are just more of the same, and therefore are not reducing their risk but increasing it.

“Investors are funnelling more assets into hedge funds that protect them against extreme events” this article reports.

In a very uncertain world, the idea is effectively to take out ‘insurance’ against unlikely but severe events.

The problem is two-fold.

First, hedge funds are highly leveraged, highly ‘uncertain’ instruments, and so what appears like safety is actually introducing more volatility into the system.

And second, if one of these uncertain events happens, the hedge contract will kick in. The entity who bought the hedge will ask for compensation to pay for the “extremely unlikely but severe event”, and the entity that sold the hedge will now come under even greater stress as it tries to settle the deal.

With banks in the precarious state they are in, it might only take one “extremely unlikely but severe event” to place the system — the straw that broke the camel’s back.

Considering the system as a whole, this step increases the net volatility, and therefore increases the risk of the system. And therefore it increases the risk to the individual taking out the hedge.

A Mexican stand-off does not become any safer if one party points a larger gun at the other party’s head.

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