Catastrophic, Systemic Risk Is Not An Actionable Investment Focus

by: Mark E. Bachmann, CFA

The term "systemic risk" has been around for a long time, but became fashionable during the 1990s to characterize the bouts of financial market instability that punctuated that decade. Probably the most memorable periods of turbulence from the era occurred in 1994 and 1998, in response partly to economic crises in Latin America and Asia, respectively. In both cases, improbable chains of causation were set in motion around the world that ultimately resulted in financial calamities having no obvious tie to the original triggers.

For example, the 1994 bankruptcy of Orange County, California, or the 1998 collapse of Long-Term Capital Management were discrete events, but they occurred within storms of strange and unpredictable market happenings that created the pre-conditions for them. Normal correlations gave way to surprising new ones and turned traditional forecasting and some types of hedging into futile exercises. Leveraged institutions fail under such circumstances.

During periods of systemic stress, everyone becomes exposed to problems they cannot foresee, because the chains of causation are complex and hidden.

Risk managers of the early 2000s came to embrace the term "systemic risk." They liked it because it suggested that this seemingly chaotic kind of threat that had so recently unnerved them was perhaps not so scary after all. Like anything, they decided, it could be analyzed. They believed they could control it through exhaustive statistical study of past events and high-tech modeling of the future.

This ambition never had legs. The events of 2008 changed the game for risk managers, as for institutional investors who once prided themselves on having mastered scientific methods for coping with risk. Most individual investors never had such illusions in the first place, but they too were whipsawed by surprises and left demoralized by the blitzkrieg ravaging their portfolios.

What was happening was that systemic risk was mutating and taking a whole new form. It was becoming catastrophic systemic risk.

Such risk essentially by definition implies future developments that are unforeseeable, unmodelable, and uncontrollable. The failures of major institutions like Merrill Lynch, Countrywide, Bear Stearns, Lehman Brothers, AIG (NYSE:AIG), Fannie Mae (OTCQB:FNMA) and several others, unthinkable only a year earlier, proved that something new and terrible was afoot. It had defied the abilities of many of the smartest and highest-paid financial people in the world to anticipate. Europeans, initially tempted to blame the crisis on Anglo-Saxon banking perversions, were soon shocked to find that their own institutions had mishandled risk in much the same fashion. Catastrophic systemic risk had gone global.

The problems that burst into the open in 2008 have not been resolved as of late 2011. Massive government intervention in the forms of direct bank support, fiscal stimulus, intensified regulation, and an unprecedented degree of monetary accommodation have masked the worst of the problems for the time being, but most certainly not reversed them.

Hence, the specter of catastrophic systemic risk is still with us and is showing signs of another ugly mutation.

At the present time, Greece, derided by some commentators as being too small to deserve all the attention it's getting, is an obvious prime candidate for the role of trigger-point. No one seems to quite know, or be willing to say, what institutions have concentrated exposure to Greece, but there have to be some. Should even a couple of significant banks be weakened by further devolution of the Greek crisis, confidence problems would likely engulf them and force governments to intervene with support. Such a development would sensitize those governments to arguments that the euro had been an unworkable idea from the start and could not now be saved.

Astonishingly, some Americans now seem to be trying to watch all this with a degree of detachment, as though playing a role-reversal game with their European friends who had similarly tried to distance themselves from the early stages of the American sub-prime mortgage crisis in 2008. However, contagion resulting from any prospect of an imminent termination of the euro would cross the Atlantic in a heartbeat. And were that to happen, the poor fundamentals underlying the U.S. Dollar itself would be exposed to the light of day, and the international monetary regime thrown into chaos.

If both of the world's major currencies slide into crisis simultaneously, all bets are off as to what comes next.

But what does all this mean for investors? I've been following financial markets for more than thirty years, and as far back as I can remember, pundits on the sidelines have been warning loudly of out-of-control debt, baseless money, and approaching systemic disaster. Anyone heeding these voices in the 1970s and digging in defensively through the 80s and 90s in expectation of Armageddon would have died far poorer than he needed to. What materialized, instead of Armageddon, was one of the most prosperous quarter-centuries in our history.

But that was then, and this is now. Maybe the time has arrived to start giving these devils at least some of their due. We need to consider the possibility of the current crisis taking another fast downward spin from here. The problem is that such a catastrophe could follow various radically different tracks, as a cacophony of financial, political, and geopolitical variables came into play. And many of these possible scenarios would suggest contradictory strategies for investors and financial survivalists.

Disaster theorists have for the most part long advocated gold as a panacea for catastrophic market conditions. Some have offered more complex strategies involving other commodities and commodity-based securities. However, the underlying assumption they all make is that hyperinflation is the core danger, when in fact it is only one the possible problems. Any full-tilt systemic meltdown would likely involve both inflation and depression, either in alternating periods or possibly at the same time in a new species of supercharged stagflation.

If we want to look back on 2008 as perhaps a small-scale dry run of what a worse collapse might look like, we should remember that the price of gold actually declined by around a third between March and November of 2008. The prices of most commodity-based stocks declined by thirty to sixty percent. These values only recovered once the markets concluded that depression was not really on the horizon.

Hence, I've decided that for all practical purposes, catastrophic systemic risk is not now really an actionable focus for investors. Overwrought guys hawking their scary newsletters and advisory services have a perspective worth listening to, since the world indeed right now seems to be tracking their script with uncomfortable accuracy. However, I have yet to hear one of them suggest a defensive posture that I can regard as prudent. Following their advice could cost a fortune should our economy somehow find its way out of its current impasse, yet still prove entirely useless in a prolonged meltdown.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

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