Montag, Mai 10, 2010

Risk, Risk, and Risk...

There is risk and then there is risk, and then you have risk.

There is the fundamental risk, which is what you have when you enter into any kind of transaction, be it private, public, personal or whatever. Things never always work out the way they were planned, and it is the sign of maturity and responsibility to be on top of such risks: betting all of your money on having a horse win a race, for instance, in order to pay off debts, is highly immature and extremely irresponsible. When such a bet fails, it's your own damn fault, and the ruin is richly deserved. If you don't ask that pretty girl or handsome guy out, if you don't take that risk of rejection, you'll never know that they think the world of you and are just as hesitant as you were. Rejection is not fun and the fear of rejection is a huge restraint for most. Helping colleagues at work meet a common goal is risky when there's someone there who is more than happy to take the credit for what you have done and assigns to you the blame when something goes wrong. Hiding failure and poor performance is a greater danger than admitting it, as you take the risk of being found out as a liar and a cheat (for getting that bonus you know you didn't deserve). Having children is a risk, they may turn out to be the greatest heartbreak you have ever known when they're arrested for prostitution or child pornography or running Ponzi schemes.

This is the basic risk that we all go through every day of our lives, and it is the sign of a healthy personality that you can absorb setbacks and disappointments and yet take the risks needed to lead a happy and fulfilled life (and many psychological problems stem from an inability or unwillingness to take risks and/or recover from setbacks and disappointments).

Then there is the risk that can be hedged and canceled out. This is what drives the markets for credit default swaps and the similar derivatives: here the market sets a price on a risk that is based, basically, on the wisdom of the demand-clearing function of the markets. This is quantifiable and can be considered a simple cost of business, part of due diligence, a way of avoiding events that upset business plans and ruin bottom lines. The cancellation of this risk, of course, comes at a price, with the price set by what the market thinks the risk may be (set your risk premium too high and no one insures themselves against the risk if they think the risk is lower; set your risk premium too low and everyone's your friend, but at the cost of you taking on the risk without the necessary rewards. This is also what drives insurance policies of all kinds, including, at the end of the day, your basic social security programs. If you're worried about dying and leaving your wife and children destitute, then buy risk life insurance; if you're worried about someone hitting your car, buy car insurance; if you're worried about being able to pay doctor's bills, buy health insurance.

This is the risk that can be canceled out, removed from the calculations. Easy-peasy, if your know that it will cost you. In a perfect world, this kind of risk-canceling doesn't actually work, since if everyone knew the exact risk, the price would be set such that the risk premium would equal the profit premium, removing any incentive to actually take out such insurance: hence, there is imperfect information, with those offering risk coverage usually employing significant numbers of people whose only job is to quantify these risks and use that information to offer coverage for the risks at a higher price than the risk entails (after all, they're supposed to generate a profit from the business) and generating, as a result, a market with asymmetric information which is then hence biased to those offering risk protection.There is one fundamental aspect to these risks: they are the perceived risks, the ones that people think they can handle objectively, the ones that drive business markets for risks.

Then there the real risks out there, not just the Black Swan risks, but the reality of the risks involved that have been hidden from purveyance, of risks turning out to be different than expected.

These are the risks that the markets now face. Entire hedging systems have failed - the rating agencies failed to correctly identify the risks out there, Greece lied about its true levels of indebtedness, the Obama Administration is lying about the affordability of US debt - leaving people who thought they had bought insurance, instead realizing that they are completely exposed to these risks.

What do they do? First and foremost, panic and try to find the coverage that they want at any price in order to avoid carrying any sort of business risk.

Why do this? Why not embrace the risk and go with it?

Because careers have been built avoiding exactly this. Lawyers and accountants exist not only to provide risk coverage, but also to demand it, in an ultimately foolish and destructive pursuit of risk-free business.

Got news for everyone: while you can offer derivatives and CDS instruments for any and all kinds of risks, you still can't stop those risks from continuing to exist.

Now, consider this.

Credit default swap rates are used as a leading indicator of actual risks: the higher the likelihood - real or perceived, the difference is left to the perceptual psychologists (disclaimer: part of my undergraduate degree) - of a risk being realized, the greater these are. But right now we are seeing the market dry up for CDS instruments.


Because those in the business see too much risk and have the option of not offering the instruments at all. The risk involved for them has become too great: it is better in such a case not to do business. However, it drives up the prices for CDS when there are fewer and fewer offering them. It is a vicious circle that leads to fewer and fewer transactions as the fears mount.

Does that mean that the market isn't working? What does this all mean?

What it really means is that the bond market - and CDS instruments are (in)famously insurance against bond defaults - is facing a transition, one that is, in my opinion, a healthy and needed transition that corrects a market distortion.

What is this distortion? Simple: the belief that you can enter a risk-free transaction.

There is no objective basis for such a belief: there is only the increasingly desperate attempt to continue to believe this.

This is the sentence that led me to write this:

Investors seeking to protect themselves from losses on bonds or speculate on creditworthiness by buying credit-default swaps drove up benchmark indexes in Europe and the U.S. last week by the most since December 2008....

The problem isn't the fundamentals driving prices for bonds or creditworthiness, but rather the perceived need by investors to protect themselves from losses or to speculate on creditworthiness.

If investors would understand that there is no such thing as a free lunch (TAANSTAFL, thank you Robert Ansom Heinlein!) then markets can return to functioning normally. There is, after all, indeed no such thing as a risk-free investment, there is no such thing as a risk-free life, there is no such thing as a risk-free relationship. You cannot hedge all risks, you cannot buy broken-heart insurance, you cannot buy failed-career swaps.

Right now the market players are acting like dysfunctional and neurotic people, desperately trying to avoid living a life of risk when that is, in reality, the only game in town.

Until that changes, until adults return to the scene and both maturity and responsibility drive decisions, rather than the chimera of some sort of synthetic, risk-free world, the problems will continue.

Where's the derivative for that?

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