Tag: finance

Risk Aversion

In general, the higher the risk of an investment, the higher the expected return demanded by an investor. Readers familiar with the capital asset pricing model will know that there are two types of risk in the economy: systematic and nonsystematic. Nonsystematic risk should not be important to an investor. It can be almost completely eliminated by holding a well-diversified portfolio. An investor should not therefore require an higher expected return for bearing nonsystematic risk. Systematic risk, by contrast, cannot be diversified away. It arises from a correlation between returns from the investment and returns from the stock market as a whole. An investor generally requires a higher expected return than the risk-free interest rate for bearing positive amounts of systematic risk.

John C. Hull, Options, Futures and Other Derivatives, fifth edition, p.61

One quibble I have with a lot of the discussion of mortgage investments (such as this one, which I think is otherwise very good), is that it seems to offer a choice between two possibilities:

1) The current market prices of the securities correctly reflect their expected return

2) The securities are currently undervalued due to panic or other irrationality

I am fairly confident that neither of these positions is correct. Risk aversion is not irrational. If an investor loses more than he can afford to lose on one investment, that loss will itself cause secondary losses — if the investor is an institution, it might lose its credit rating, or go insolvent, causing some of its human and institutional capital to be impaired. Therefore, the expected utility of an risky investment is lower than its expected return.

As alluded to by Hull, in many cases much or all of the risk of an investment can be diversified away, leaving the extra risk premium small or zero. This is clearly not the case for mortgages. There is a possibility of a loss of somewhere on the order of a trillion dollars. No investor can absorb or hedge that. Many large investors — sovereign wealth funds, private equity, etc. -— have taken on stakes. Some are probably still looking for better prices than they’ve so far been offered. All will be looking for very substantial discounts against the expected return, because they know there are more sellers than buyers.

That is why I believe claims that this is a profit opportunity for the government.

That’s not the same as saying the government should be buying up mortgages at above current market value — there are other good arguments against it. But it holds up one piece of the argument, provided we assume that government is in fact better able to absorb the potential losses than private investors, which seems reasonable to me, though I can’t quite put my finger on a non-handwavy reason why.

Mortgages and scale

Arnold Kling, who knows what he’s talking about, says that the idea that mortgages will turn out to have a better return than their current market prices indicate is rubbish. In his view, the market prices are likely to accurately reflect the true value.

As far as I can see, that is unlikely. In a simplistic model, underpriced mortgages will be bought by investors who can make profits by holding them. But surely any such model assumes capital is plentiful relative to the assets under discussion. The crucial fact here is that, because of the past hideous underestimate of risk, the size of the mortgages held by institutions who shouldn’t be holding them is, apparently, in the high hundreds of billions of dollars. Many other investors have felt they are a good long-term bet. But most of those investors have already bought as much as they can afford, or else are holding on for better bargains, knowing that there is no competition to bid the prices back up in the short term.

On that argument, a buy-up by the US government is indeed a profitable opportunity for it. I think it could be defended on those terms. If I were drawing it up, however, I would want it explicitly to aim at making a profit. I would set a fund of fixed size to buy assets, planned to ensure that some of them are left over, and then spend it over a shortish period buying whatever seemed to be most competitively priced. The aim would be to make profits, and hopefully do some general good in the process; not to save overexposed financial institutions at any cost.

Is this counter to my principles? Yes. I do not consider myself a “naive libertarian”, in that I recognise that state intervention can be beneficial in some cases. However, I think that forgoing such benefits, by separation of economy and state, would be a better general policy than allowing fallible politicians to identify allegedly beneficial interventions. This intervention, even if beneficial, sets a horrific precedent, and will terribly undermine all free-market arguments for years to come. It could usher in an era of big government. That’s why it should be opposed.

Indeed look at the converse. If it doesn’t happen now, and the system survives with less damage than the proponents are claiming, what a valuable example it will be of how markets are able to adjust to the most severe problems.

Washington Mutual

September 26, 2008


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Since Washington Mutual, like Northern Rock, has now gone bust without owning securitized mortgage derivatives, can we please lose the idea that securitization was the problem. Mortgages were the problem.

Without securitization, the financial system would have been much more exposed, but it would have just been the retail banks, not brokerages like Bear and Lehman.

Also, if securitization has been done properly, and the brokerages had actually sold the securities they created, there would have been much less of a problem. All the loss would be carried by investors who were not leveraged and were risking funds they could afford to lose. I know I said that before, but now Tyler Cowen is saying it too (or at least approvingly quoting others who are).

Now it can be argued that, had the risk not been spread out by securitization, the problems of bad loans would have come to a head much sooner, and the total impact would therefore have been smaller. That might be true. It is totally equivalent to saying that if there was no regulation of financial institutions, the problems might have got obvious sooner and therefore have been smaller. True or not, it’s a strange way of looking at things. Since nobody is using the John Adams seat-belt argument that regulation is the problem, then blaming securitization should be out of court as well.

What was the problem?

Since I have claimed that the derivatives involved in the financial system problems were not too complicated, what was the real problem?

There are many candidates, too many to cover right now. The use of irrelevant statistics to justify risky holdings, as I mentioned before, was a large part of the problem. The government pressure to make more and cheaper loans to less creditworthy borrowers has been widely commented on, and may have contributed significantly, but can’t excuse the banks’ errors.

The actual error made by the banks was very simple – embarrassingly simple, really. They bought mortgages to securitize them. They split the securities into high-risk, medium-risk, and low-risk bits. They valued the bits and found that they were more valuable than the original mortgages, which meant the process was profitable to them. They sold the high-risk bits to speculators and the medium-risk bits to long-term investors. But they kept the low-risk bits. Thats it! That’s the error!

Presumably, after they valued the low-risk bits, they found that nobody actually wanted to buy them at that valuation. What they should have done was price them down until people did want them, then re-evaluate the whole business on the basis of the actual market prices that they got for them. I have no idea whether that would have meant that securitization would have carried on or not. But either way, it would not have left the financial system dangerously exposed to the housing crash. At worst, it would have ended up as the “normal” sort of Wall St scandal – clever investment bankers sell a whole load of toxic crap to investors (see auction-rate, internet IPOs, etc. etc. etc.)

Why did the banks hang onto these investments, rather than sell them? I guess that they believed they were “really worth” pretty close to par value, and that buyers didn’t want to buy them at that price just because they were uninformed. Also, because they were rated as so safe, the regulators were happy to consider them non-risky for the purposes of capital requirements. That was the regulators’ biggest error. Because of course these two justifications contradict each other. If the securities can’t be sold at their alleged “real value”, then they are tying up the banks’ capital, and should be counted as such.

(I’m surprised we haven’t heard more about the mezzanine tranches that were sold to fund managers, pensions, insurance, etc. They were never seen as safe, so the bodies holding them could afford to take losses on them.)

It almost seems a shame that this whole crisis is caused by one such straightforward error. It ought to be something like “derivatives are too complex” or “regulators were subverted” or “government forced banks to make bad loans”. It’s a let-down that it was just “banks held one particular type of investment that it was never their business to hold, just as a by-product of one business line”.

Financial Complexity

September 22, 2008


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I want just to grab one factoid out of the swirl of information and misinformation relevant to the current financial situation – the idea that the problems were caused by fiendishly complicated derivatives (see, e.g., here)

Horribly complex derivatives do exist: a “snowball”, for example, “is a structured swap with a funding leg and a coupon stream whereby the coupon paid on a given date is given by the sum of a fraction of the coupon paid in the previous period plus an amount determined by the realization of the rate process in the coupon period itself”

However, while estimating the value of a snowball requires so much computer power that researchers are designing custom hardware and offloading computation onto graphics chips, the difficulty of valuing a derivative does not depend on the derivative itself being complex. The mortgage backed securities which are the most obvious cause of the current problem are actually quite straightforward. That doesn’t make them easy to value.

The point of the complexity is in fact to make them easier to value. After all, no amount of differential calculus will tell you whether Mr Bloggs at number 11 will default on his mortgage, if you don’t know whether he has a job, and what his credit card balance is, and whether house prices on his street are going up or down. If you have good statistics, however, you might have a decent stab at how much a thousand mortgages are worth, or how much the best 400 out of a thousand are worth.

That was the theory. It failed, not because of the complexity of the derivatives, or because of errors in the mathematics, but because the statistics were crap. Statistics collected over ten years during which house prices only ever went up were not of much use when prices started to fall. Statistics collected on mortgages originated by lenders with their own money cannot be used to accurately model mortgages originated by lenders working only for commission. Et cetera.

The other bugbear instruments in some commentary are the “weapons of financial mass destruction”, credit default swaps. These are simpler still; just a guarantee by one party of a debt owed by another. The main problem with them is their very simplicity – rather than selling them on like securities, someone holding one would just create a new one to cancel it out. That’s what makes it so difficult to sort things out when a participant like Lehman defaults – its net position is manageable, but that net consists of astronomical credits and debits that almost, but not quite, cancel each other out. If the CDSs were more sophisticated (with central clearing), the problems would be smaller.

I think that this New York Times piece is very good, except for the one point, that the difficulty of valuing a mortgage derivative is not due to its inherent complexity, but mostly just because it’s made out of mortgages.

Buying large-scale insurance

May 26, 2008


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I made a shocking admission in a comment at Samizdata – that there was something important that I thought might be difficult for the market to provide.

The issue was agriculture. Globally, agriculture is heavily state-dominated, and in the short term (at least until recently), the most profitable way to run agriculture was not to have any, but to buy in food from abroad, subsidised by foreign taxpayers.

If Britain had followed that policy for the last couple of decades, we would now be in even more trouble responding to the sudden increases in global food prices. (Assuming that land which has not been farmed recently can’t quickly be brought into production – which is a question I am not able to answer).

Now in theory there would be a market opportunity, insuring against food shortages by maintaining – even at a loss – the capability to ramp up food production quickly, so as to be able to profit from shortages.

What I said was that this kind of large-scale investment, which is likely to show negative return but has a compensating possibility of a large profit, would have to be handled through the financial markets. As they have been functioning relatively poorly recently, the investments might not have happened.

(This is still in my fantasy Britain where the EU was not already subsidising farming to survive).

Thinking about it some more, there are various ways in which this kind of investment could be made.

The most obvious is to fund the losses by selling out-of-the-money commodity call options. If food prices do not rise, the options expire unexercised; if the prices do rise, you’re in.

If that can’t be made profitable, it means that the options are too cheap.
I would have thought there were plenty of buyers of such options – people who wanted insurance against expensive food. Supermarkets would be a prime potential buyer.

But here we see the real problem. Farmers are politically popular (how else would they get all that help?). Supermarkets are politically unpopular – there is always political activity seeking to restrict them. They are simultaneously accused of driving down wholesale prices, driving up retail prices, and squeezing out competition.

Insuring against food shortages costs money in normal years. If these costs are transferred from politically popular farmers to politically unpopular supermarkets, the chance of getting government help correspondingly declines. Therefore the mere tendency of government to involve itself in the industry acts to rule out the most effective market solutions before they even start.

Financial Regulation

April 18, 2008


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I think its fair to say that the financial industry has not been admirable over the last few years. One of the best accounts of what went wrong is this:

Prince was saying he was constrained to follow the conventional wisdom, even when it was palpably insane.

It is therefore understandable that people are saying the manifest errors of the industry should have been restrained by regulators. Given that governments end up bailing out the casualties, it cannot be denied that government has the authority to attempt to prevent such bailouts becoming necessary.

The question is not whether the government is entitled to prevent excesses, it’s whether it would actually succeed in doing so. Is it really the case that politicians or civil servants will be less influenced by the crowd effect of conventional wisdom than are financial executives with, in some cases, millions of their own on their line?

One year ago, there was no motivation for regulators to get banks to cut down on lending, to stop buying mortgages, and so on, even if the powers existed for them to do that (which, to a degree, they do). If you are asking regulators to prevent bubbles, you are asking them to outguess the market, which, while not impossible, is not something I would generally expect them to achieve.

ICI: the investment fund

September 8, 2007


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John Kay mourns the decline of ICI, now taken over by Akzo Nobel.

The products, the jobs, and the profits that old ICI used to make are all still going. What has gone — and what Kay is specifically mourning for, is the old ICI management organisation.

The heart of his argument is this:

The board of ICI accepted losses in pharmaceuticals for 20 years, in the conviction that drugs would eventually provide future sales and profits growth. Only after two decades was this belief vindicated through the commercialisation of Black’s discovery. Through his subsequent work for SmithKline, and the influence of his work on Glaxo, Black was the architect of Britain’s broader success in the industry.

Old ICI financed research out of its manufacturing profits. To my young mind, this seems an odd arrangement. Financing new business is the job of financiers, not manufacturers.

Kay picked one example of where the old arrangement worked well, but to me it sounds dreadfully fragile. If development of pharmaceuticals is the responsibility of the paint industry, then a bad couple of years in the paint market would mean no development. If managers of the paint industry feel themselves mainly responsible for development of other industries, they are likely to be less effective managing the paint.

Kay does not seem to be making the argument that investment in future industries is not happening – and indeed it is happening, in Britain, and elsewhere, but the investments are being made by specialist venture capitalists drawing on the broader capital markets, not by managers of other industries having a flutter with their firm’s profits.

There are several reasons why such investment funds (random example from Google) would be expected to do it better — they are specialists, they have wider access to capital. Today we see a great deal of investment into early-stage development of potential future chemistry-related industries.

The only reason why the old ICI model might be better would be if the successful managers in one industry, were, by virtue of their position and proven technical expertise, the best placed to make decisions about investment in future industries. If this were ever the case, it is by now much less so – it has been widely observed that the advance of science and technology has meant that specialisations become ever more narrow.

The story Kay tells of ICI sounds to me not so much a model to be emulated, but the rare exception to the story he has told many times, and more convincingly, of megalomaniac bosses trying to turn their companies into something else. See on Swissair, on HP, on BT — “policy making in business requires more than slogans and visions”. “Dreams are no basis for a sound corporate strategy”. That one dreamer got lucky at ICI in the 1960s does not shake the wisdom in those other columns.

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