Where'd The Beach Go?

A Rising Tide of Risk Often Triggers a Draining of Liquidity
There's a reflexive relationship between the act of lending and the underlying collateral that supports lending.
This relationship helps explain why liquidity, seeming so abundant during asset price booms, can dry up so fast "without any explanation." Investors suddenly realize that the castle built to the sky rests on a very thin foundation.
But there's a new twist in the markets these days. The massive gorge of credit, a.k.a. hundreds of trillions worth of derivatives, has led to the notion (or "hallucination" if you ask me) that because these derivatives have been spread across a greater number of investors, that your investment risk is reduced.
The modern portfolio theory says that if you spread risk you tend to reduce your relative risk. I guess I'm not supposed to argue with that, but I will anyway. For try as I might, I just can't feel good about the amount of risk that's spreading like wildfire throughout the markets.
Maybe it's because I know modern portfolio theory is itself flawed. What the rational person assumes and what the Gaussian Bell Curve assumes are really fantasies (theoretical constructs to be more precise). But these fantasies do serve a purpose: they allow the Capital Asset Pricing Model and the elegant curve of the efficient frontier to materialize magically before our eyes.
However, after being in the investment trenches for over 20 years, I've realized that in the real world you can only properly quantify risk after the fact. At critical stages

in the cycle, investors are far from rational. The curve isn't always shaped like a bell. Plus, those pesky outliers that the modern portfolio theory claims should rear their ugly heads only once in a million or so years have a way of showing up much more frequently.
Our point is that at some stage the system must reach risk saturation no matter how many little "safe" investments are created. My pool holds about 16,537.5 gallons of water where it's in the ground or 16,538 old gallon milk jugs. So I ask: Is there a qualitative and/or quantitative difference if a whole bunch of smaller investors - which are closer to the ground of the real economy - go belly up instead of one or two big ones?
The fact of the matter is that once again few investors seem concerned about risk. And the few investors who seem concerned are all currency investors. We say that because of the price of "com dollars" (commodity dollars representing high-yielding currencies) going higher and the yen (the world's key funding currency) going lower.
We continue to believe that if any of this risk stuff starts to matter - the lowly buck might actually catch a break. If risk pours into the rest of the world, the safe haven money will flow back into the U.S. from U.S. fund managers rushing to salvage some collateral.