Investment Initiatives » The Dangerous Quest for Security

09.18.08

The Dangerous Quest for Security

Posted in Blog at 3:26 pm

Self-preservation instincts are usually a good thing to have. The survival of any species usually depends upon the survival of individuals, which is why we have such instincts in the first place. But occasionally, the instinct actually gets in the way of survival. Panic responses—e.g., thrashing wildly when in fear of drowning—are an obvious case in point. But there are subtler ones. Consider the instinct many have to overeat. Biologically, one is storing up fat as a hedge against periods of famine in the future. But in our almost famine-less world it only leads to sluggishness, a decline in the ability to exercise, a decline in physical attractiveness and ability to mate, and ultimately to heart disease and premature death. Businessmen’s perpetual search for insurance to repeal the law of Risk and Return may be a comparable instance of an ultimately destructive instinct.

Almost every human wants to be able to foresee the future. But a future clearly foreseeable to all carries no positive benefits: everyone knows exactly what all courses of action are worth. This is why anyone engaged in a speculative transaction will pay so much for an informational asymmetry, and why regulators of business activity move so firmly to try to close all such asymmetries down. Investors—especially savvy, professional institutional investors—know that they need to ratchet up the risk component of their portfolios in order to get satisfactory returns. But the survival instinct keeps whispering in their ears that they need an escape in case of trouble, a safer, more bomb-proof shelter in which they can wait out any storm. The obvious solution is to lower one’s risks to the level one can afford. Yet many will continue to search for the Philosopher’s Stone which will render every risk harmless, without much impacting return. In the process, they buy a lot of snake oil. The latest such product is credit-default swaps. When an individual relies upon a defective product such as a parachute which fails, the individual dies. When a whole industry relies upon a defective product in the same kind of situation, an industry can be annihilated. This week, the securities industry is looking at something uncomfortably close to annihilation.

Credit-default swaps were supposed to be a kind of insurance for fixed-income investors. Since bonds are already supposed to be low-risk, why was there a demand for this kind of insurance? Because the investments the investors were buying were actually high-risk. Why were they high-risk? Because the sophisticated statistical wizardry of the mathematicians who constructed the collateralized debt obligations could not diversify away the systematic risk of the mortgage market which was ultimately being financed, nor (unlike traditional bonds) was there a regulated market in these instruments to price that risk into them: if the the housing market were to suffer a broad-based decline, then further protection was needed. So far, so good. As long as the buyers of insurance are not deceiving themselves about what risks they are running and how much they are paying for a particular amount of protection, fine.

The problem was that everyone wanted to believe, not that they had some downside protection, but that there was no risk left at all. Thus, by insuring a BB instrument with a AAA counterparty, the investors then wanted to believe that they actually held AAA instruments, and that they could pile up more leverage on them, and lend still more money to the ever-expanding mortgage market, booking still higher returns, without providing for the actual risks they were running. (The credit rating agencies’ assessment of the risks on this paper were all too high as well, but that is another story.) All of the market participants, busily trading each others’ derivatives, were trusting each others’ high corporate credit ratings, without regard for the fact that at the bottom of this inverted pyramid there were some extremely risky loans, and a great deal of inherent leverage to the economy. To make it worse, they had all levered themselves up to the hilt, to maximize profits in what is otherwise a form of investment with thin margins, hence the emphasis upon ratings in the first place. The credit rating agencies were not paying any attention to this pyramiding of risk either, which kept the ratings of those on the other side of these transactions at unrealistic levels. The housing market had to continue to rise forever, or the process would suddenly go into reverse. Now, many individuals can insure themselves against uncorrelated events of moderate or even high probability (a fire, an auto accident, their own death), and a few individuals might, if they so choose, find someone willing to insure them against an event of low probability which would also correlate with other disastrous events (an earthquake, a war), but a large number of individuals cannot insure themselves against strongly correlated events of even low probability—especially when the potential losses cannot be quantified. The event bondholders were insuring themselves against was—whether they realized it or not—any significant break in the housing market. But the correlated event was the collapse of the market upon which that insurance depended.

Any investor can tell you that trees don’t grow to the sky, but the holders of CDSs believed they had found a way to ignore that dismal fact and stay in the game to the end—they were insured. No one asked himself what might happen if the market ceased to be continuous, counterparties disappeared, and they had to mark their paper down to a fraction of its face value. Without an orderly, regulated market in fact, this was almost certain to occur. But no one wanted to miss out on the huge profits others were making, and hey, the paper was insured. Well, if one can get huge returns without risk, why, let the good times roll, and don’t worry if an activity you don’t quite understand has suddenly become four or five times the size of all your other businesses combined.

The problem was further exacerbated when regulators believed that banks had effectively insured their risks through derivatives. Instead of allowing a certain amount of capital to run quantifiable (if inherently unknown) risk, now the banks were allowed to have an unknown amount of capital to be running unquantifiable (and still unknown) risks. The huge increase in leverage which has brought down Bear Stearns, Lehman Brothers, AIG, and more than 30 banks was a direct result of the hidden leverage in piles of overlapping derivatives. In hindsight, we all know that the banks, their shareholders, all their employees (except perhaps any derivatives traders who immediately transferred their huge bonuses into gold in Swiss bank vaults), insurers, regulators, capital markets, and the general public, would all have been better off if the banks and other holders of debt securities had not sought to insure them.

The moral: you cannot insure what you do not fully understand. This, at least, should temper the process of financial innovation going forward.

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