Sunday, February 28, 2010

How Do You Describe Risk Today?

In an article for the Financial Times in June of 2009, George Soros described his Three Steps To Financial Reform. No matter what your opinion of Mr Soros may be, he has some well educated opinions of what should be included in reforms. The first two are directed at regulators having responsibility for bubbles on their watch and second, credit has to be less freely available. These reflect his friendliness to both regulators and investment banks, and he does say change is necessary. The third point is more important to investing today. I think he has done a good job of describing today's markets and why investors have to understand what systemic risk looks like if they are to be able to design a suitable risk profile. Inquiring minds might also want to read my earlier article on risk with insight from mutual fund manager, John Hussman, titled Risk Receptive or Risk Averse? What is Risk?.

Third, we must reconceptualise the meaning of market risk. The efficient market hypothesis postulates that markets tend towards equilibrium and deviations occur in a random fashion; moreover, markets are supposed to function without any discontinuity in the sequence of prices. Under these conditions market risks can be equated with the risks affecting individual market participants. As long as they manage their risks properly, regulators ought to be happy.

But the efficient market hypothesis is unrealistic. Markets are subject to imbalances that individual participants may ignore if they think they can liquidate their positions. Regulators cannot ignore these imbalances. If too many participants are on the same side, positions cannot be liquidated without causing a discontinuity or, worse, a collapse. In that case the authorities may have to come to the rescue. That means that there is systemic risk in the market in addition to the risks most market participants perceived prior to the crisis.

The securitisation of mortgages added a new dimension of systemic risk. Financial engineers claimed they were reducing risks through geographic diversification: in fact they were increasing them by creating an agency problem. The agents were more interested in maximising fee income than in protecting the interests of bondholders. That is the verity that was ignored by regulators and market participants alike.

Soros also has an interesting position on the use of credit default swaps (CDS). The financial derivatives that contributed enormously to the velocity of the collapse in the financial markets.
Finally, I have strong views on the regulation of derivatives. The prevailing opinion is that they ought to be traded on regulated exchanges. That is not enough. The issuance and trading of derivatives ought to be as strictly regulated as stocks. Regulators ought to insist that derivatives be homogenous, standardised and transparent.

Custom made derivatives only serve to improve the profit margin of the financial engineers designing them. In fact, some derivatives ought not to be traded at all. I have in mind credit default swaps. Consider the recent bankruptcy of AbitibiBowater and that of General Motors. In both cases, some bondholders owned CDS and stood to gain more by bankruptcy than by reorganisation. It is like buying life insurance on someone else's life and owning a licence to kill him. CDS are instruments of destruction that ought to be outlawed.