Financial derivatives are a good thing. Discuss.
Much has been written about credit derivatives in the mainstream financial press, most often with a take on whether they are “…a clever way to disperse risk, making the financial system safer…? Or are they “financial weapons of mass destruction”…poorly understood and perilous boosters of credit?” (taken from a recent article in the Economist but I could have selected any of dozens and found the same line of questioning.)
As someone who used to run a credit trading business at a large investment bank, I obviously have a view on the micro and macro issues surrounding credit derivatives, and perhaps the fact that I am no longer in such a position (and so no longer have a direct vested interest) will actually will give sceptics pause before dismissing my unreserved belief that they are – like any financial derivatives allowing better and more granular risk management (see my earlier thoughts on particle finance and risk quarks) – a welcome and useful addition to the financial ecosystem. And given the importance of credit risk in the risk firmament (in terms of explicit and implicit exposures embedded in the economy) it is no surprise that the market is growing exponentially in size and sophistication.
Rather than go into a long essay developing my views on the subject, which I suspect regular readers to be able to guess at in any event, I will refer you to an article I wrote three years ago (published in Euroweek in June 2004), entitled a “Brand New Line of Credit” if you are so inclined. Alternatively, the Economist briefing I allude to above does a pretty good job of articulating the issues to a non-specialist audience without dumbing it down to the irrelevant. (As an aside I wonder if the Economist would be willing to pay me for all the clicks and recommendations I send their way…the least they could do is refund me my subscription price! 
)
However, in reading this briefing, there is one line of reasoning (again often repeated) that is a classic example of how context often colours thinking on (the suitability/riskiness/acceptance of) financial products, leading to different conclusions for what are fundamentally equivalent or entirely analogous things. (See this post on the sameness of betting/options/insurance as background on this line of thinking.) In particular, I am puzzled as to why insurance of default or repayment risks is questioned any more than any other insurance market.
…However credit derivatives create a moral hazard…
…So the system may seem to have become safer, but new dangers could be in the making. Perhaps credit derivatives will alter the behavior of investors and companies, encouraging them to take more risk. That seems to have happened in the American sub-prime mortgage market, where underwriting standards fell sharply in recent years, leading to a rapid rise in delinquent loans. Perhaps corporate borrowers will default more than derivative investors imagine, or perhaps investors will recover less value when they do default.
In other words, if individuals feel safer they may act less responsibly. This is the “seatbelt problem”: motorists wearing belts may drive faster knowing they are less likely to go through the windscreen if they have an accident. The overall level of risk ends up the same.
Oh boy…there are so many holes and fallacies in this line of thinking, I don’t know where to start. Firstly, the whole point of risk management tools is to allow and even encourage economic actors to “alter their behavior” – to optimize their risk based on their appetite/mandate/purpose/skills/capital/etc.; “take more risk” in this generic negative connotation is absolutely devoid of any meaning. But it sounds scary (think Count Floyd)! As for the sub-prime mortgage market, my quick and dirty thoughts are here, but suffice to say that it has been an unmitigated success in extending the access to capital and lowering its costs for a significant and previously under-served part of the economy. Were there poor practices? Uninformed customers? Certainly I’m sure. But people have car accidents to – sometime due to faulty products, sometimes due to ignorance, sometimes due to their own stupidity, and sometimes to miscalculating a deliberately taken risk. Society has developed pretty effective means for seeking to minimize, mitigate and learn from all these possible negative outcomes without calling into question the usefulness and enormous benefits provided by the automobile.
As for the “seatbelt problem” or moral hazard, I’m not sure I can add much to the thousands of papers, articles and books that have tackled this subject , but I will take issue with the implication that “the overall level of risk ends up the same” is a poor outcome. Again the “overall level of risk” is firstly largely devoid of meaning – context is important – and even assuming that the author is implying some relevant closed system to give this notion context, the distribution of risk within that system is more important (in determining the probability of good or bad outcomes for the system) than it’s absolute level. Half the problem probably arises out of the semantics of the word ‘risk’ which is understood by most people as monolithically something to be avoided rather than something to be managed (avoid/hedge the risks that are irrelevant or dangerous to you and embrace those where your talents, experience and expertise allow you to benefit from them.)
Coming back to my question – why is insurance of default or repayment risks questioned any more than any other insurance market? For me it is obvious: if you think that insurance is a useful financial tool in an economy, I don’t know why you would discriminate against one type versus another; indeed the issues thrown up by moral hazard would seem to be much more serious in many other (unquestioned) insurance markets, probably because they have been intelligently addressed. My suspicion however is that much of the fear of credit derivatives comes from a combination of nomenclature, lack of understanding and faulty reasoning. I touched on the latter above, and the first two are probably inter-related – the semantic distinction between derivatives and insurance (which is just a product subset of the former) is unfortunately embedded in the public’s mind however irrational it may be. Of course Wall Street and City investment banks and bankers do nothing to dispell this myth (except perhaps in extremis when the regulatory and political pitchforks are well and truly bearing down on them) because, well…what would you rather be: a Derivatives-Trader-Master-of-the-Universe? or some insurance guy? Hey Tom Wolfe never wrote anything about any risk manager at an insurance company… Besides it’s easier to charge a lot for something that sounds complicated.
So…as long as I can insure against the risks of my factory being destroyed by a tornado, I don’t see why anyone would question my desire or ability to insure against the insurance provider being able to pay out when the tornado hits…
(…but I wouldn’t be surprised to see a symposium on credit derivatives shown on Monster Chiller Horror Theater, it would be right up Count Floyd’s alley:)
