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:)
May 9th, 2007 at 2:48 pm
Sean,
You stated above that credit derivatives allow economic actors to “optimize their risk based on their appetite/mandate/purpose/skills/capital/etc.”
I am never short of amazed at how truly hard it is to have conversations with senior leaders of Fortune 500 firms about risk appetite. There is truly a risk cognition problem in many, many people. In the context of a meeting on risk tolerance and hedging strategy, I had a senior VP tell me that he was willing to lose $100 MM on fluctuation in physical commodity prices but only $5 MM on “paper.” For him, the risk quark meant nothing. He’s exactly the type of person who sees all derivatives as “financial weapons of mass destruction.”
I think the risk cognition problem frequently gets too little attention. Not to sound too much like a Nassim Taleb fanboy, but I see lots of evidence that humans are hard wired to live in Medianistan and not TailEventistan. It takes real work to learn to think outside of our hardwired mindset of responding to highly probable events and mis-valuing the tail events.
If we break all risk atoms, define the risk quark, model it appropriately, and trade it efficiently will anyone in Medianistan come to the table? Will the Medianistans sell out of the money options, get their clocks cleaned and scream “Risk Quarks of Mass Destruction!!!”
With the risk quark must come risk cognition education. And not just for traders.
-JD
May 11th, 2007 at 6:41 am
[…] With reference to Sean’s post about financial derivatives how much of that “no - never!” is down to not actually understanding the product sufficiently to utilise derivatives as part of an investment (or indeed ‘insurance’) strategy to actually achieve what they genuinely need? […]
May 17th, 2007 at 11:47 am
JD, I know. I know. The risk cognition problem is huge. I has perhaps the single most frustrating thread connecting more than a decade spent engaging with both investors and corporates.
I’m not a philosopher or linguist but I wonder to what extent the fact that we use risk (with all its negative connotations - see wikipedia definition for example) to articulate all concepts of uncertain outcomes, leads to an unnecessarily fearful attitude towards any discussion of managing these outcomes. Perhaps we should be talking not of risk management but of opportunity management?
Taleb’s books are on my Amazon wishlist, but even though I have yet to read either, given the extensive and interesting analysis and discussion of both in the blogosphere, I almost wonder if I need to! In any event it certainly sounds like we would agree on many things.
Your last question get exactly to the heart of the matter and indeed is perhaps the most significant known unknown that I have been facing in considering a number of different possible future investments and/or business opportunities. I don’t have the answer. Clearly education (in every sense) will be a key to unlocking the financial atom for the benefit of all.
May 25th, 2007 at 7:43 pm
“Perhaps credit derivatives will alter the behavior of investors and companies, encouraging them to take more risk” - pah! is what I say
I do feel the word “derivatives” needs to be re-invented thanks to the high levels of miss-understanding of their usage within the media. Take a leaf out of the “kiwi” fruit and get re-invented (or more correctly re-represented)
There are two key issues:
1. The word “derivatives” has so many meanings (or more correctly, derivatives are extremely flexible instruments) - for example, derivatives can be used for (not exclusively):
- insurance and risk protection
- speculation
- highly leveraged speculation
- risk re-packaging
- capital efficiency for trades
2. The “precieved” complexity of “derivatives”.
Point 2 first - Well the fundamental products are in fact pretty simple to understand (in terms of mechanics), the complexity comes in pricing / structuring. Get the price wrong (as a market maker) and you are potentially in for a big hit (e.g. Baqnue Populiaire Netextis).
Perhaps the media could spend some time educating on the “risks” involved in miss-pricing and right-pricing…
Point 1 - the media (and even good old-boy Buffet - whom I do massively respect, even more so since his recent philantrophy), tend to focus on the speculation / leverage side of derivatives, as these are most “likely to blow up” and hence lead to a good “story”. They don’t focus on the fact that their “capital protected nest egg retail financial product” is in fact creased from a bunch of option structures (and is basically risk re-packaging and risk protection / insurance).
With regards to using derivatives for capital efficiency - I do firmly believe that many “traditional” equity funds could have performed significantly better if they had executed their trades using derivatives and used the excess capital to purchase insurance (again via derivatives) - locking in returns and protecting downside. However, this would have needed “trading” knowledge/skills (other than “going long”) within fund managers, regulators, consultants and trustees (who write the madates) - a tall order
and hence why the talent and returns are in the decent hedge funds.
Continuing on…
The point which should scare you (it does me), and seems to get lightly touched on in the financial press (except in comments from people like the FSA and various central bankers) is the level of risk re-packaging both in the capital markets (via derivatives) and insurance markets (via re-insurance) and the convergence of risk-repackaging across capital markets and insurance - who owns the risk? what happens when the risk un-winds? where IS the risk? who is regulating it? BIG questions…
There are arguments that this spreading of risk does in fact “dampen” the effect or a major financial “bump” (as oil does in a shock absorber), but I am not convinced…
May 28th, 2007 at 7:54 pm
Thanks for the comment Nigel. I’m not sure I share your anxiety as to ‘where might the risk be’ - to be sure, much risk has migrated from regulated to unregulated pools of capital (and with corresponding lower levels of transparency) but generally (notwithstanding some degree of pure regulatory arbitrage) these new owners are better homes for the risks that end up there. That is not to say there won’t be disasters - cf. Amaranth - but that they (a) won’t matter and (b) (because) they won’t be systemic (cf. Amaranth.)
Indeed, I am highly sceptical (perhaps I could even be accused of being cynical) of the ability of ‘enlightened’ regulators or politicians protecting citizens or the economy via proscriptive legislation. By that I mean regulation who’s ultimate result is to mandate (or strongly favour) a particular asset allocation over another (think UK equities until 2001 for example.) This approach is particularly dangerous for in the name of prudence, great (and stupid) risks are taken by those least able to bear them.
May 29th, 2007 at 9:23 pm
Nigel, you might find this article interesting:
http://www.blog-re.com/2007/05/read_this_before_you_get_into.html
I’ve bounced around between the derivatives and reinsurance worlds and I found the above link interesting. It points to a major difference between capital markets and reinsurance: relationship management. It’s tangential to your comments above but interesting and related.
-JD
July 13th, 2007 at 5:30 pm
[…] Interesting article by Sean from The Park Paradigm on financial derivatives and the usual doom-mongering surrounding them. […]