Risk Won't Get Repriced

One of the problems with the credit crunch was that risk wasn't proportionately priced. Relatively risky investments didn't pay all that much more than safer ones, and so investors couldn't get that last visceral hint that they were writing a check for real danger. The problem was that there is just too much money in the world seeking a home, and that hasn't changed. For example, D&O (directors and officers) insurance premiums have actually been dropping in price for years, even though the chances of corporations getting sued by shareholders aren't dropping equally quickly. According to brokers I've spoken to, the reason is that there are always new sources of money trying out this type of investment, creating competitive pressures. I've heard the same from an economist who consults to upper management at large corporations.

And that money hasn't all disappeared in the recent market thrashings. Look at a Wall Street Journal article today about hedge funds bouncing back:

Through the end of the third quarter, hedge funds have seen $164 billion in new asset flows this year, already a record for a full year, according to Hedge Fund Research Inc., based in Chicago. The previous record year was 2006, with $126 billion in new asset flows. As much as $45 billion was invested in hedge funds in the third quarter, when markets were the most turbulent. Some 71% of that went to big hedge-fund firms -- those managing more than $5 billion each.

A lawyer at a major real estate firm told me that his clients in Europe were about ready to start a buying spree in the US because they have cash and because the exchange rate between the Euro and dollar gives them even more leverage.

The money goes pouring in, and it all has to find homes, so the differential between high risk and low risk will continue to remain small, not because the risks are that close in nature, but because the supply of money outstrips the demand. So people will continue to invest, largely ignoring the real risks, because they can't afford to be picky. They're all at a dance where they want to get picked, it's getting late, and being choosy means being alone. It's only in the morning that they see what they've done, but by then it's too late.