John Hussman: Financials Can't Quantify Their Own Risks, Let Alone Others'

Excerpt from the Hussman Funds' Weekly Market Comment (2/19/08):

[From an earlier Hussman Market Comment in 2003] "Once again, however, the iron law of equilibrium is that every risk swapped away by someone is held by someone else. According to Bloomberg, over half of the world's trading in the credit swaps market is concentrated among five banks: J.P. Morgan (26%), Citigroup (10%), UBS Warburg (9%), Bank of America (7%) and Deutsche Bank (7%). As Warren Buffett has noted, ‘Large amounts of risk, particularly credit risk, have been concentrated in the hands of relatively few derivatives dealers, who in addition trade extensively with one another. The trouble of one could quickly infect the others."

... Last week, AIG (AIG) was hit hard when it admitted it could not “reliably quantify” its losses on these credit default swaps. One wonders how companies can have much sense about the risks of their counterparties when they cannot reliably quantify their own.

I continue to believe that there is substantial risk of audit delays and “qualified” opinions in the upcoming reports of financial companies. It is difficult to see how analysts and some financial news anchors can seriously be looking for the market to have “discounted the bad news” when companies are still at a loss to quantify their news at all. It is equally difficult to see how financials can “come clean” with their losses when those losses generally have not yet occurred because the major wave of mortgage resets that started in October probably only now beginning to produce delinquencies. It's impossible to know yet which mortgages and how much will end up in foreclosure.

Editor's note: Relevant sector ETFs include the iShares Dow Jones U.S. Financial Services Index Fund (IYG), Financial Select Sector SPDR ETF (XLF), Vanguard Financials ETF (VFH). See also the full list of sector ETFs.