"Don't Look Now But The Water Is Still Rising!"

On CNBC today, Secretary of the Treasury, Henry "Hank" Paulson stated, ”As the Fed addresses liquidity this makes it possible, this makes it easier, for the market to focus on risk and pricing risk. This will play out over time and liquidity will return to normal when the market has a better understanding, investors have a better understanding, of the risk-return trade off.”

As I live and breath, Risk AND Return in the same sentence coming from the lips of King Hank (I almost named this piece "The Return of Risk" .) What a change of heart! Less than one month ago, he stated, again on CNBC, "There has been a very significant housing correction. I think we're at or near the bottom there. I don't deny there's a problem with subprime mortgages, but I really do believe that's containable."

In fairness to Mr. Paulson, he went on in that interview to say, "When I came to Washington, one thing I knew we needed to focus on is how do we get ready for a financial shock? We weren't predicting a financial shock. I'm not predicting one, but they're not predictable. And it's been since 1998 since we've had a financial shock. So we need to be ready. And there have been a lot of changes in the markets since 1998. We're much more integrated into the global economy. Private pools of capital are playing a more important role. There is expanded use of financial derivatives. All of which, I think, have made the markets more efficient and more liquid. But again, the next time we have a financial shock, we'll be seeing how some of these things perform under stress for the first time. But again, I believe we fortunately have a very strong global economy and a very strong US economy."

Well, he was right, at least partially - "private pools of capital are playing a more important role" and "there is expanded use of financial derivatives" and "the next time we have a financial shock, we'll be seeing how some of these things perform under stress for the first time." The problem is he, like so many others, assumed that the growth in the global economy was the be all and all that would keep our boats afloat. Sadly, as he feels the water lapping at his feet, King Hank now is getting a painful lesson in the reality of models and markets.

I know some of my colleagues believe that I have gone off the deep end about models. Truly, I have not; I’ve made these same remarks for years. I have always believed that we need to strike a balance between the advanced analytical and diversification techniques that we have at our disposal and the common sense we have gained through experience. From tulips to “dot coms” to sub-prime and private equity junk, this need for balance has not altered. We forget, at our peril, that risk and reward are two sides of the same coin.

I think that among the greatest dangers we face in the markets is hubris, which my old adversary the Greeks saw as the one fatal flaw in the human condition – it was the sin of overbearing presumption and arrogance which they believed most deeply offended the gods. It is the classic flaw of the risk taker, who, revelling in the euphoria of a “win”, fails to judge where that “win” is leading. It perhaps would help us if we remembered that for those same Greeks euphoria was a feeling of great happiness or well-being commonly exaggerated and not necessarily well founded!

Cassandra