I propose two lessons learned from the last five years:
- There is no such thing as a risk-free return
- There is no such thing as a perfect hedge
We are very, very close to seeing much of the financial system blow up because banks, particularly in Europe, have bought sovereign debt and leveraged it 30x to 40x. The theory was that sovereign debt denominated in Euros, yen, or dollars was essentially risk-free. Once that theory was proved to be bankrupt, financial institutions are now claiming all their sovereign debt is perfectly hedged. I think we will find that untrue as well. Hedging mechanisms don't work when the whole of the market is tanking -- its a similar problem to why earthquake insurance does not work. No insurance company or counter-party can pay off when every single policy has a claim.