The problem with all those sophisticated hedging techniques

The Wall Street Journal reports [subscription required] on the little-understood risks associated with hedging, particularly at some major financial institutions:

. . . some worry that today's improved and sophisticated hedging techniques have created a false sense of security among investors, and that a dramatic market collapse is still possible if issues arise in areas where there is little transparency, such as the world of derivatives.

The important thing to remember is that hedging can't really eliminate risk -- risk can only be transferred. It's like the first law of thermodynamics. It can be transferred from one trader or institution to another but it can never be eliminated. With some of the major investment banks having booked big gains on bets on the subprime collapse, many on Wall Street are still wondering who was on the other side of the trade. And there is also concern that the banks are failing to make adequate disclosures about how they are making their money. Some have asked whether the banks' earnings are, as Enron's earnings were once described, a black box.

Whenever you hear about hedging and risk management, remember that one company can control its risk. But there always has to be another party to the trade and there is simply no way for the economy as a whole to eliminate the risk of giving mortgages to people who can't afford them.