The Law of Perverse Outcomes

“…Bondholders of the world beware. Those that have guaranteed your debt (the US government, British government, Washington-back mortgage lenders Fannie Mae and Freddie Mac, derivatives insurers) are running tremendous risks. I say “those” but what I really mean are individual traders now responsible for managing complicated positions AND making a profit. There’s a long history of traders in risk making faulty calculations…”
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Wouldn’t you know it? I make it all the way through Asia with nary a stomach problem and felled, at last, by garlic shrimp in Darling Harbor.

The Law of Perverse Outcomes…people get not what they expect, but what they deserve.

My stay in Sydney was short anyway. Just a few days to pack up my bags one more time. I did, at least, get a chance to talk with a man we’ll call Kevin. Kevin is a trader. He used to work the swaps desk for a major international investment bank. We discussed a financial meltdown over tea.

A short history of a derivatives trader…

Kevin came to Australia twenty years ago from England. He’s seen the halcyon days of the bull market. He started off his professional career as an actuary, in the business of scientifically assessing risk for insurance purposes. Trading derivatives (swaps are one subset of the derivatives universe) was probably a natural move.

After all, according to Greenspan and others, the derivatives market allows for more sophisticated risk intermediation. It turns liabilities (debts) into assets by packaging them up and parcelling them out, often with a snazzy credit rating, to investors looking for a higher yield than say, the money market or a U.S. Treasury bond.

“It’s not the GSEs you have to worry about, although there is certainly a problem there in its own right. It’s the CDO and CBO market,” Kevin said. He was talking about the securitisation of debts and bonds.

The jargon of trading debt decoded…

A CDO is a collateralised debt obligation…a CBO…collateralised bond obligation. The CDO/CBO market, according to the British Bankers’ Association, has a notional value of just under $5 trillion. The business of trading debt is big.

In the great hunt for a few points on a trade…and investment instruments to sell investors…CBOs and CDOs represent a strange new devilry. Packaging up debts in and of itself is not so wicked.

But it IS an occasion for financial sin…and there are three cardinal ones.

First, you can be a hedge fund and make a wrong directional bet in the derivatives market. This is what happened to Long Term Capital Management. They expected global interest rates to converge. They had a position in Russian bonds. Russia defaulted. LTCM was leveraged to the hilt. Once their Russian position fell apart, they were forced to liquidate everything else, which brings me to the second sin, default.

Default is always a risk when you buy debt

Greenspan has said that the derivatives market allows for the dispersion of risk in the market from a few players to many players, sort of like saying if you cut a big piece of evil up into many little pieces and give those pieces to individuals, you’ve made the world less evil by making evil less big.

It doesn’t work that way, of course. Especially when all the purchasers of the evil count on it for income.

I’m oversimplifying and moralising. But I should stop, because the problem IS serious, not least because of the last and greatest sin: insuring risk.

There aren’t a lot of firms that guarantee CDOs and CBOs. And that’s exactly the problem. Some insurance firms found a good business in guaranteeing the quality of otherwise non-triple-A rated CDOs and CBOs. That is, some institutions are barred from buying emerging market sovereign, corporate, or municipal debt on the open market because ratings agencies like Fitch, S&P, and Moody’s have rated the debt less than triple-A. If it ain’t triple-A, some institutions are forbidden from buying.

Turning the risk around…and making it worse

But if an insurance company comes in and slaps a guarantee on the packaged up debt, it’s effectively given the junk a triple-A rating, making it safe for the big money to come in and play.

All of this is fine, although difficult to do. The real risk comes from having so few derivatives insurance firms. Insurance firms like MBIA carry enormous risk should any of the derivatives they’ve guaranteed default.

The obvious risk, and the reason Warren Buffett has called derivatives “financial weapons of mass destruction” is that a major derivatives insurer goes under…wiping out all the guarantees that the firm has extended to CDO and CBO bond buyers. It’s the vaunted “daisy chain of risk default.”

This is the modern financial era we live in

There is a gut-busting irony to this predicament the West has gotten itself into. The West has a longer history of creating “sophisticated” financial instruments. And yet Far East Asia is gobbling them up at a ferocious pace.

Kevin tells me the Japanese are famous rain makers for the investment banking industry, buying up exotic new debt products almost as fast as they buy Luis Vuitton bags and Burberry Scarves. Instead of a handsome handbag, however, they’re getting something far more dangerous: a liability that looks like an asset right up until the moment it doesn’t.

Bondholders of the world beware. Those that have guaranteed your debt (the U.S. government, British government, Washington-backed mortgage lenders Fannie Mae and Freddie Mac, derivatives insurers) are running tremendous risks. I say “those” but what I really mean are individual traders now responsible for managing complicated positions AND making a profit. There’s a long history of traders in risk making faulty calculations, and I’m not just talking Orange County and LTCM. It’s a common occurrence in financial markets.

Teatime in Sydney…bath time for the credit bubble

By this time Kevin and I were on our second cup of Earl Grey and moved on to the failure of the Western Welfare State and the urgent question of what will replace the dollar standard. We agree that we’re not witnessing the end of the world, just the end of the world as we know it.

We also agreed that the silver lining to this dark storm cloud is your ability as an individual investor to do something about it. You don’t have to sit idly by as the major institutions to which you’ve entrusted you financial future run enormous risks. With the right attitude, approach and advice, you can develop an exit strategy that keeps you out of harm’s way, and liquid in times of crisis.

More to follow…soon. I’m jetlagged and headed for bed.

Dan Denning