Where is the next skeleton in the cupboard? This question is often asked by investors these days. There is no doubt that very low interest rates on US T-bills price in a lot of skeletons. I read many research notes in the last few days. In general people do not agree whether we see liquidity problem or solvency problem, or both. Or maybe it is about trust, trust about ratings, about balance sheets properly reflecting off-balance sheet items, such as implicit exposure of banks to their SIVs. There is also no agreement about who will pay the bill, will regulators face losses on accepted collateral and taxpayers will foot the bill, or will those who took the excessive risk assume the responsibility for their actions and pay the bill. Because typically they made a lot of money before, they have deep enough pockets to face the excessive risk taking consequences.

Among many research notes I found a very informative piece by the Institutional Risk Analyst about leverage in reverse, worth reading.

While the focus is on very transparent actions by central banks in developed world, I think that responsibility for securing orderly functioning financial markets is also in the hands of emerging markets’ central banks and SWFs, seating on 7 trillion plus assets, often invested in a very conservative way. At times when private sector appetite for risk fades, they could step in, stabilize the markets and make a lot of money at the same time buying cheap assets that will appreciate in value when liquidity comes back. This would not be perceived as a moral hazard as they will act in their own interest, to make more money for their countries (see my paper on why it matters a lot).

As usual Brad Setser blog offers an excellent overview on the topic, see his post on reverse financial engineering. He is quite right that in many markets price discovery process ceased to exist, and as long as this is the case valuation of many portfolios will be an academic exercise, far away from reality. My suggestion above becomes even more valid.