Risk moonshine: credit derivatives, Part 1

June 20, 2007 | Capital markets, Primer Posts

Leyster_jolly_toper

“Risk? I love risk!”

Wine is good for us, but a big slug of pure alcohol can kill you.

 

Brain_alcohol

This is your brain after booze

It’s all a question of which, and how much, and when.

Like alcohol for people, risk is good for financial markets. Like alcohol, it stimulates, and lowers inhibitions. It encourages euphoria during its presence, but can leave a financially depressed feeling afterwards.

 

Risk is a byproduct in every capital transaction — indeed, every financial transaction increases the ecosystem’s total risk. Both capital provider and capital consumer increase their risk profiles:

 

· If I take money from you, promising to pay it back somehow, I’m making a bet that I can perform; if I fail, I lose badly.

· If you give me capital, expecting to get a return, if I fail, you lose too.

 

Win_win

We can both win if you think and aren’t a horse’s ass

Thus the more financial velocity we have, the more the system’s total risk exposure — yet, without risk, money and people are both idle, and there is no economic progress.

 

Markets work in part because they enable commodities and money to migrate to those best able to deploy them. The same principle applies to risk, which is commoditized and traded via derivatives, as illustrated in a very useful primer from the Economist:

 

Naughty or nice? The question that Father Christmas poses to every child who clamours for a present also haunts the credit-derivatives market.

 

Naughty_but_nice

Why not both?

Are these devices a clever way to disperse risk, making the financial system safer, as their enthusiasts claim?

 

Dispersal

We’re safer because we’re dispersed

Or are they “financial weapons of mass destruction”, in Warren Buffett’s phrase, that are poorly understood and perilous boosters of credit?

Why can’t they be both, by turns and by circumstances?

 

Mr. Buffett has long had an interest in being an insurer, buying GEICO, and insurers are paid money to take risks.

 

Warren_buffett

You see, you’re betting you’ll die, and I’m betting you won’t

So one may understand Mr. Buffett’s general orientation that risks are high, and therefore that his insurance company should be paid a lot of money to assume them.

So far the optimists have had the better of it. People have worried about financial derivatives for 20 years, but economies have proved remarkably resilient. These exotic instruments have not yet produced the cataclysm that Jeremiahs have long forecast. Indeed, the equity bear market of 2000-03 did not result in a banking crisis, as it might have done 30 years ago, when derivatives were still rare.

 

Here is a clue: if in fact risk has migrated to those better able to manage it, then the system should be able to tolerate more risk without overloading, because the risk is distributed.

 

Distributed_2

It filters through the whole system

We have seen something like this in the weakening residential home market and its followup consequence, the subprime shakeout. The housing market’s crumple zone has dispersed risk both among participants and over time, so that although it’s clearly caused localized harm, there has been no systemic or structural failure.

So far credit derivatives have proved a triumph of the financial sector’s ingenuity. By dividing the bond market into digestible chunks, they have increased investors’ appetite for corporate debt. That may well have lowered the cost of capital—good for the economy, since it should allow companies to invest more over the long run.

 

I’ll give the Economist its caution, but it seems inescapable to conclude that better risk allocation expands capitalization and contributes to a lowering of interest rates.

But credit derivatives have yet to face a really bracing test. They have grown in a time of low interest rates and narrow credit-spreads (an extra yield over government bonds to offset risk).

 

Everyone looks like a world-class bicyclist when pedaling downhill.

 

Peloton_descends

No dopes here, just athletes

What then are these unicorns, the derivatives?

Credit derivatives are financial instruments that “derive” their value from the bond market. They can cover any bonds that are not issued by governments — that is, where investors face the risk that the borrower may not repay.

 

Governments too can default on their debt, but since that risk is as pervasive as Michelson’s ether, everybody elects to ignore it.

 

Michelson_morley_interferometer

Bounce it around all you want, there’s some risk in a Treasury note

Their rapid growth stems from three market quirks.

1. A traditional corporate bond bundles together a whole group of risks. A bond price might fall because investors are generally demanding higher yields for all fixed-income assets (interest-rate risk), because investors prefer bonds of one maturity date to another (duration risk), or because they think the company that issued the bond will have trouble repaying it. Derivatives separate this last factor—credit risk—from the other two.

 

Just like distilling grain into alcohol, derivative creation and other financial engineering (like securitization) concentrates risk in a smaller or secondary object (the “B piece”), and in so doing removes risk from the primary object (the “A piece”).

 

This allows investors to insure themselves against the risk of default or, alternatively, to speculate that a default will occur. The instrument that does this is a credit-default swap or CDS. Hence A agrees to pay a series of premiums to B; who agrees to compensate A if the bond defaults.

 

By_default

Click here for credit default swaps

These particular derivatives are a kind of mortgage insurance, an external credit enhancement.

This allows investors to speculate on default without owning the bond itself. Those who buy protection could make substantial profits if the company gets into trouble, since the value of the swap will rise sharply. Plenty of speculation occurs and CDS positions are sometimes much larger than the bonds outstanding.

A secondary benefit of distilling risk is that it becomes visible — and when made manifest, it can be evaluated by the collective intelligence of the distributed network.

 

Invisible_man

I think we know where the risk is

To date, the insurers have tended to do better than the speculators. This partly reflects today’s benign economic conditions (few companies have gone bust), but also relates to the second quirk in the market.

 

2. The highest-rated bonds (known as investment grade) tend to have delivered better returns than were necessary to compensate investors for the risk of default. In other words, someone who insured such bonds against default would have, on average, made money (conventional insurance companies, which insure against fire or theft, have not always done so well).

 

Throughout history, markets have generally tended to overestimate risks that are new or complex. People who took those risks — and have the enormous balance sheets to make risk-taking prudent and risk-insuring credible — have done well. Over time, as the risks become better known and establish a history, then the spread premium for taking the risk compresses — the risk curve flattens. That too adds ecosystemic value, for it makes capital cheaper.

 

Slicing_meat

Our tranche of subordinate debt, coming up!

3. Credit derivatives allow corporate bonds to be sliced and diced on the basis of risk. Some investors (such as banks and insurance companies) may prefer to own the highest-rated (AAA) debt for regulatory or solvency reasons. Others, such as hedge funds, may want to take more risk and earn higher returns.

Here’s the market at work — migrating risk to those most comfortable with it. Migrating and trading risk is possible only if the risk is extracted, like a distilled essence, from the larger medium in which it resides.

 

Extraction

A complex financial machine to extract the risk

What does all this have to do with housing, and housing affordability? Quite a lot, because the biggest source of debt is — you guessed it — residential lending, including subprime lending:

[Continued tomorrow in Part 2.]

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Date: January 28, 2009, 1:00 pm

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