Risk Reversion

Felix is preparing to give a speech to some bond dealers, and he's been kind enough to post his notes to his blog. Here's a bit I like:

I believed along with Alan Greenspan that when it comes to debt instruments in general, and credit derivatives in particular, "These instruments enhance the ability to differentiate risk and allocate it to those investor most able and willing to take it."

But if you look at what happened in practice, the art of securitization always seemed designed to create ever-increasing quantities of risk-free debt. Banks thought they were selling loans and mortgages to people who wanted the risk, but they weren't: they were carefully packaging those loans and mortgages into bonds carrying a triple-A credit rating. And people buying triple-A risk don't want any risk at all.

I think this is a pretty important insight. And Felix goes on to tell stories with which you're probably familiar -- how bond insurers, and Fannie and Freddie, and ratings agencies all participated in the theater of turning the risky into the riskless. As it turned out, that couldn't be done. What's interesting to me, though, is the way in which one small round of de-risking feeds subsequent rounds. Because a CDO is deemed safe, it can be squished into CDOs-squared which are also safe. As the rounds continue, the system becomes ever more fragile, containing the seeds of its ultimate collapse. It's almost enough to think that maybe it's a bad thing to try and reduce risk -- that people handling potentially dangerous snakes ought to be shown the poisonous fangs right off.

It's interesting to me that Felix introduces this argument in his speech, citing Warren Buffett's statement that insuring municipal bonds can essentially make the municipal bond market fall apart. In a tight spot, stakeholders with insured bonds will be less likely to work toward a negotiated solution, making default more likely. And if defaults begin occurring, then suddenly every municipality has an incentive to default. It's interesting because this looks very similar to the problem of firm creditors with CDS hedged risk refusing to negotiate to keep firms out of bankruptcy. Why should they? They'll get paid more in the wake of a default event.

A lot of recent financial innovation has been defended on grounds that it improved the flow of credit or made credit easier to obtain. But increasingly it seems that it did this by allowing everyone to stop doing their homework. Magical de-risking processes made the need to do homework before investing unnecessary. Magical hedging formulas did the same thing, and saved lenders the trouble of caring when a borrower got in trouble. The financial system became like a fancy new car -- full of top-of-the-line safety features, traction control, ABS, and so on. And like drivers who seem so effortlessly in control and completely safe that they forget how deadly two tons of steel traveling at 80 miles per hour can be, market participants were lulled into forgetting how dangerous finance can be.

Maybe financial products should be more like the snake -- less inviting, with poisonous fangs out in the open for all to see.

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