Bookstaber: That’s a great example, because rules like that set requirements on things like value-at-risk and minimum capital levels. You think, OK, that’s going to take care of bank risk, but then you have a blowup in some country in Asia, and suddenly all the banks have to liquidate their investments there because they are over their Basel II capital limits, because volatility has gone up and the value of their portfolios is dropping. But it gets worse: A bank will say, "I can’t do any more in Southeast Asia, but I do have some investments in Brazil; I guess I can liquidate them to meet my capital requirements." And then everybody starts selling Brazil, for no reason other than they all happen to have it in their portfolio and need the liquidity. So Brazil goes down. These types of regulations can cause a chain reaction.

THE PROBLEM lies in the word "surprise." A real risk is something that people are not expecting. —Ethan Berman

Roubini: But to say that regulation is always bad doesn’t make sense. The whole hedge fund industry is totally unregulated, and there is no transparency. There is no disclosure. You can say that the market is the best regulator, but investors cannot tell, in many cases, who is a good manager, and what the managers they hire are doing. So how can the market regulate them with no disclosure?

Today, the amount of derivatives—whether credit derivatives or interest rate derivatives or other types—outstanding is a multiple of what it was in 1998. If something systemic happens this time around, it’s going to be much uglier than LTCM. People say derivatives spread risk, but it’s not really obvious that risk is being diffused through the system or whether it’s being concentrated. If there are some key parts of the financial system in which risk has been concentrated, or some of the key players are doing most of the transactions, then if one of them goes belly up, we are in trouble.

Bookstaber: It’s a continuum; you can regulate up to a certain point until it starts to become self-defeating. My point is that, just by the very nature of how the market is designed, you are going to end up having another crisis. Hedge funds are probably going to somehow be involved in it because so much of the risk-taking today is by hedge funds.

Worth: Spreads in the credit default swap and leveraged markets have been historically tight for a long time now, despite the Fed’s 17 quarter-point rate increases. That seems to contradict predictions of a credit downturn in early 2007.

Ethan Berman: Clearly the market is telling you there is no problem whatsoever. You can’t deny that spreads are too tight on many fronts—and the argument that spreads are tight because interest rates are really low was more true several years ago than it is today. But people still believe it.

A very valuable aspect of the growth credit derivative market is that less and less credit is being concentrated in a few hands. That is a good thing. The bigger concern is that people don’t understand the risk they are taking. Many individual investors have credit exposure that they don’t realize is credit exposure because it is in some bundled package, and they don’t have the tools to measure or manage that.

When markets aren’t particularly transparent, there tends to be big winners and losers. I know of hedge funds that have literally bought a credit and sold the same credit at the same time with two different dealers and made money. And, by the way, both of those dealers made money as well. That isn’t representative of the largest part of the credit market by any measure, but it shows how the lack of transparency leads to irrational pricing.