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True credit risk cannot be collateralised.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman
by Migeru (migeru at eurotrib dot com) on Mon Mar 12th, 2012 at 12:58:41 PM EST
[ Parent ]
Because of the fact that most defaults happen at the same place in the business cycle?

Peak oil is not an energy crisis. It is a liquid fuel crisis.
by Starvid on Mon Mar 12th, 2012 at 02:49:05 PM EST
[ Parent ]
... and the fact that you can't outsource your due diligence.

The opinion of some dude who hasn't done his own due diligence on the credit risk of a security is just his opinion. The opinion of a million dudes who haven't done their own due diligence on the credit risk of a security is also just their opinion. Putting their opinions together and calling it a "market" does not make it any more than the opinion of some dudes who haven't done their own due diligence.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Mon Mar 12th, 2012 at 04:29:41 PM EST
[ Parent ]
But you can actually outsource the credit risk to someone else. Thah's just what the big Wall Street banks did when they sliced and diced all those toxic mortages, repackaged and sold them on to Düsseldorf and all the others.

Peak oil is not an energy crisis. It is a liquid fuel crisis.
by Starvid on Mon Mar 12th, 2012 at 04:41:04 PM EST
[ Parent ]
You can transfer credit risk, but you cannot hedge it.

Because, unlike market (price) risk, which is anonymous, credit risk is associated to a particular counterparty.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman

by Migeru (migeru at eurotrib dot com) on Mon Mar 12th, 2012 at 04:49:07 PM EST
[ Parent ]
You can pool it, and you can subdivide the pool. But you cannot make the risk go away.

In some jurisdictions you can take it off balance sheet, but that doesn't make it go away.

Or you can sell it, but then the buyer is exposed to the full credit risk as if they had originated the loan.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman

by Migeru (migeru at eurotrib dot com) on Mon Mar 12th, 2012 at 04:54:47 PM EST
[ Parent ]
But you can actually outsource the credit risk to someone else. Thah's just what the big Wall Street banks did when they sliced and diced all those toxic mortages, repackaged and sold them on to Düsseldorf and all the others.

Yes and no. You can sell it, obviously, but you can't outsource it in any meaningful sense. At most, you can buy CDS on your credit risk, but this does not hedge your credit risk - it merely substitutes one credit risk for another.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Mar 13th, 2012 at 09:39:14 AM EST
[ Parent ]
Due diligence cannot protect you from shit happens.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman
by Migeru (migeru at eurotrib dot com) on Mon Mar 12th, 2012 at 04:56:07 PM EST
[ Parent ]
shit happens

The preferred term, used by all the Serious People©, is "Black Swan Event."

She believed in nothing; only her skepticism kept her from being an atheist. -- Jean-Paul Sartre

by ATinNM on Mon Mar 12th, 2012 at 05:12:58 PM EST
[ Parent ]
That's not what I'm talking about. Suppose you know that the True Probability™ of someone being unable to repay you is 5%. Then what? Did due diligence protect you form credit risk?

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman
by Migeru (migeru at eurotrib dot com) on Mon Mar 12th, 2012 at 05:20:34 PM EST
[ Parent ]
If you know that the True ProbabilityTM of non-payment is 5 %, you can discount those five per cent when making the loan.

If that renders the effective interest incompatible with the customer's business plan, then you can not make the loan. If the loan represents a large fraction of your equity, then you can not make the loan.

This is why you need to do it before making the loan.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Mar 13th, 2012 at 09:54:18 AM EST
[ Parent ]
Non-payment will be a lot more damaging to your balance sheet than a nominal loss of 5% interest, surely? In accounting terms you have to list the bad debt in full.

But this is tangential to CDOs, where you can sell the same worthless non-coverage to multiple buyers over and over, with the certainty that if any of them try to claim on their 'coverage' you can shrug and say it's not your problem.

Oh - and the government will probably bail them out anyway.

by ThatBritGuy (thatbritguy (at) googlemail.com) on Tue Mar 13th, 2012 at 10:12:42 AM EST
[ Parent ]
But as long a you have the capital to issue a lot of independent 5 % non-payment risk loans, you can get away with simply discounting it 5 %.

The salient point here is that you only get to do that with idiosyncratic risk, because systemic risk is, by its nature, not independent. This is why properly run industrial societies use government back-stops to ensure that not everyone is unemployed and broke at the same time. Because the government, as the only entity which is definitionally solvent, is the only entity which can serve as a backstop against systemic risk.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Mar 13th, 2012 at 10:17:36 AM EST
[ Parent ]
I think the key thing we should have learned from LTCM is that it's difficult to determine which risks are independent, which are not, and what sort of feedback the dependent ones will create for one another.
by rifek on Tue Mar 13th, 2012 at 03:00:20 PM EST
[ Parent ]
No, the key take-home points from the Long Term Capital Management fiasco are:

  • The market can remain irrational longer than you can remain solvent.
  • Don't bet your entire business that you're the smartest guy on the block.
  • Don't bet your entire business on any single transaction, particularly when that transaction does not keep the two first bullets firmly in mind.

Of course, none of this should have been in any way novel or surprising, and the fact that humanity regularly has to re-learn such simple matters of common prudence does not auger well for our collective cognitive prowess.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Mar 13th, 2012 at 03:18:59 PM EST
[ Parent ]
We knew those before.  LTCM thought that, if some risk spreading is good, more is better, but they never took into account that if you spread risk far enough, it becomes recursive.
by rifek on Wed Mar 14th, 2012 at 02:41:54 PM EST
[ Parent ]
They drank their own cool-aid.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Mar 14th, 2012 at 04:34:04 PM EST
[ Parent ]
Non-payment will be a lot more damaging to your balance sheet than a nominal loss of 5% interest, surely? In accounting terms you have to list the bad debt in full.

Precisely! The problem with credit is that the risks are all "in the wrong direction". You get a small income stream at a rpofit in exchange for the risk of a large loss. And risk-aversion magnifies the perception of losses.

Also, diversification doesn't quite work. If you have 20 bonds with a default probability of 5% you're virtually guaranteed a loss of 5% no matter what so it's all pain, no gain. You're maybe better off gambling on just one bond where at least you have a sizeable probability of making a profit.

Naked CDS are much "better" - you pay a small fee in exchange for the chance of a big payout.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman

by Migeru (migeru at eurotrib dot com) on Tue Mar 13th, 2012 at 10:20:34 AM EST
[ Parent ]
No, you can diversify it away as long as it is idiosyncratic risk. The fact that you are virtually guaranteed to suffer on the order of 100 defaults out of 2 thousand loans just means you have to charge 5 % extra on all the loans.

Where this breaks down is when everybody goes broke at the same time, because some right-wing idiot (but I repeat myself) was allowed to play with levers of government that he has neither the understanding nor the inclination to handle safely.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Mar 13th, 2012 at 10:29:05 AM EST
[ Parent ]
The fact that you are virtually guaranteed to suffer on the order of 100 defaults out of 2 thousand loans just means you have to charge 5 % extra on all the loans.

It means you're virtually guaranteed no upside and all downside. Logarithmic utility can be really nasty on the downside.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman

by Migeru (migeru at eurotrib dot com) on Tue Mar 13th, 2012 at 10:30:42 AM EST
[ Parent ]
No, it means I'm virtually guaranteed a payment stream of 95 % of the nominal payment stream, assuming the defaults are uncorrelated.

You need to look at the discounted value of the expected cash flow rather than the nominal principal, for the same reason you need to look at MWh produced rather than nameplate capacity when evaluating the required price of volatile energy sources.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Mar 13th, 2012 at 10:36:35 AM EST
[ Parent ]
I agree fully with Jake's side of the argument here.

Peak oil is not an energy crisis. It is a liquid fuel crisis.
by Starvid on Tue Mar 13th, 2012 at 10:46:09 AM EST
[ Parent ]
"assuming the defaults are uncorrelated."

Um.

by Colman (colman at eurotrib.com) on Tue Mar 13th, 2012 at 10:54:33 AM EST
[ Parent ]
In a properly run economy, they are. Because the sovereign employer and investor of last resort makes sure that the macroeconomy does not go boom.

If you hand the keys to the sovereign over to right-wingers, then of course they break it. But that is not dependent on the particulars of finance theory - right-wingers break your economy because breaking countries for fun and profit is what right-wingers do.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Mar 13th, 2012 at 11:05:36 AM EST
[ Parent ]
Analytical simplicity. The general argument still holds even with correlated defaults.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman
by Migeru (migeru at eurotrib dot com) on Tue Mar 13th, 2012 at 12:33:23 PM EST
[ Parent ]
because due diligence forces you to have prepared a plan B for lots of different things, and to demonstrate your general ability to deal with the unexpected.

Wind power
by Jerome a Paris (etg@eurotrib.com) on Mon Mar 12th, 2012 at 05:57:26 PM EST
[ Parent ]
In other words, due diligence is at least as much about "Know thyself" as "Know thy counterparty".
by rifek on Mon Mar 12th, 2012 at 06:53:32 PM EST
[ Parent ]
Sun Tzu and the Art of Finance.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman
by Migeru (migeru at eurotrib dot com) on Mon Mar 12th, 2012 at 07:18:11 PM EST
[ Parent ]
And Lao Tzu and Musashi.
by rifek on Tue Mar 13th, 2012 at 01:49:01 AM EST
[ Parent ]
Due diligence cannot protect you from shit happens.

Define "protect."

Part of doing your due diligence is to make sure that the contract you are entering into will not cause your firm to cease to exist if shit happens. Unless said shit is so bad that your firm has a meaningful risk of ceasing to exist anyway. Part of doing your due diligence is to ask "what could possibly go wrong?" come up with a reasonably comprehensive answer, and then make contingency plans for all of those situations. Even if the contingency plan is just "in case of nuclear war, roll over and die."

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Mar 13th, 2012 at 09:52:59 AM EST
[ Parent ]
:)

'The history of public debt is full of irony. It rarely follows our ideas of order and justice.' Thomas Piketty
by melo (melometa4(at)gmail.com) on Tue Mar 13th, 2012 at 05:07:38 AM EST
[ Parent ]
Because if I loan you money but ask you to collateralise it...

...it's not a loan. It's a liquidity operation.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman

by Migeru (migeru at eurotrib dot com) on Mon Mar 12th, 2012 at 04:47:44 PM EST
[ Parent ]
That is the pawn broker business model, right?

Sweden's finest (and perhaps only) collaborative, leftist e-newspaper Synapze.se
by A swedish kind of death on Mon Mar 12th, 2012 at 05:16:17 PM EST
[ Parent ]
project finance loans are weakly correlated to the business cycle.
This is a sector that's been studied left and right - it has lower default rates, higher recovery rates in case of default, and limited correlation to other banking assets.

Banks know that and they keep on doing it, even as it goes out of fashion.

Wind power

by Jerome a Paris (etg@eurotrib.com) on Mon Mar 12th, 2012 at 05:49:51 PM EST
[ Parent ]
Because if it's collateralized, it isn't at risk?
by rifek on Mon Mar 12th, 2012 at 06:50:14 PM EST
[ Parent ]
What's the credit risk of a secured credit card?

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman
by Migeru (migeru at eurotrib dot com) on Tue Mar 13th, 2012 at 04:34:13 AM EST
[ Parent ]
None, it's fully liquid.  Non-liquid collateral is a different issue.
by rifek on Tue Mar 13th, 2012 at 02:33:52 PM EST
[ Parent ]
Are you talking about different kinds of risk here?

If I pawn a clock or a house, the lender does not have a credit risk, but a risk that their evaluation of the value of the collateral will not be correct when if a time comes when the collateral needs to be sold.

Sweden's finest (and perhaps only) collaborative, leftist e-newspaper Synapze.se

by A swedish kind of death on Tue Mar 13th, 2012 at 03:54:43 PM EST
[ Parent ]
They have a credit risk, that you won't pay. Only after you don't pay do they get to liquidate your collateral. Then they have liquidity risk.

Then again, some people say "all risk is liquidity risk".

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman

by Migeru (migeru at eurotrib dot com) on Tue Mar 13th, 2012 at 04:39:25 PM EST
[ Parent ]
But that is clearly false. Liquidity risk can be made to go away entirely (at least within the system of banks in good standing) through appropriate central bank policy. This will not, however, do anything about credit risk.

Liquidity risk is a political problem of whether you get to defer payment. Credit risk is a fundamental problem of whether you are able to make payment.

- Jake

Friends come and go. Enemies accumulate.

by JakeS (JangoSierra 'at' gmail 'dot' com) on Tue Mar 13th, 2012 at 06:55:13 PM EST
[ Parent ]
So why are people made to pay interest from the privilege of borrowing from their own collateral?

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman
by Migeru (migeru at eurotrib dot com) on Tue Mar 13th, 2012 at 04:44:12 PM EST
[ Parent ]
I suppose it's just a way to trick retail bank customers. Like "actively managed" mutual funds that behave exactly like index funds, but have three times as high fees.

Peak oil is not an energy crisis. It is a liquid fuel crisis.
by Starvid on Tue Mar 13th, 2012 at 06:04:54 PM EST
[ Parent ]
No, it's actually a way to extract tribute from people with poor credit.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman
by Migeru (migeru at eurotrib dot com) on Tue Mar 13th, 2012 at 06:06:46 PM EST
[ Parent ]
No one is forced to have a credit card. But people can be tricked into it. Just like people can be tricked into putting their savings in "actively managed" funds.

Peak oil is not an energy crisis. It is a liquid fuel crisis.
by Starvid on Tue Mar 13th, 2012 at 06:10:20 PM EST
[ Parent ]
In the US, you're practically an unperson without a credit card:
You need one to make a hotel or plane reservation, or to rent a car, even if you plan to pay cash. Many stores require a credit card to accept your check. Responsible use of a credit card builds a good credit rating, too, marking the owner as mortgage-worthy.

But people who have never had credit or need to repair a poor credit history may not qualify for a regular credit card.

(link)

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman
by Migeru (migeru at eurotrib dot com) on Tue Mar 13th, 2012 at 06:11:05 PM EST
[ Parent ]
I've never used or even had a credit card in my entire life. Why not just use a debit card instead? I do that all the time.

Peak oil is not an energy crisis. It is a liquid fuel crisis.
by Starvid on Tue Mar 13th, 2012 at 06:24:21 PM EST
[ Parent ]
The US system appeared absurd to me too, the first time I heard of it, but there it is. If you can't deliver a credit card company that says you payed your bills on time, you are not creditworthy.

Sweden instead uses implicit credit worthyness unless the central government register says that we failed to pay a bill so many times that it ended up with Kronofogden.

Sweden's finest (and perhaps only) collaborative, leftist e-newspaper Synapze.se

by A swedish kind of death on Wed Mar 14th, 2012 at 04:35:20 AM EST
[ Parent ]
In France, you get to be "interdit bancaire" (blacklisted by a government file, and denied all banking services), basically if you ever write a dud cheque. There is now (this is recent) a government-mandated minimum service that banks are obliged to provide to people who are blacklisted, which amounts to a debit card.

The advantage of this system is that you can (could, until a few years ago) write a cheque for just about anything. The banks are trying hard to stamp out the massive use of cheques (because they cost them money) and force us to use credit (or debit) cards.

Credit card balances are paid off automatically every month from your bank account, so you can't have outstanding balance on your card (what you have instead is an overdraft).

It is rightly acknowledged that people of faith have no monopoly of virtue - Queen Elizabeth II

by eurogreen on Wed Mar 14th, 2012 at 06:59:05 AM EST
[ Parent ]
You still use cheques in France? I think we phased them out in like the mid 80's.

Peak oil is not an energy crisis. It is a liquid fuel crisis.
by Starvid on Wed Mar 14th, 2012 at 10:40:39 AM EST
[ Parent ]
We still use them in the U.S......(I've never seen them in Italy). But the system is broken.
by gk (gk (gk quattro due due sette @gmail.com)) on Wed Mar 14th, 2012 at 11:14:54 AM EST
[ Parent ]
As do I.  The bulk of debit cards here in the US can be used the same as a credit card.  Secured credit cards are frankly a predatory practice no one sees fit to regulate.  They prey on the patently ignorant and on those whose creditors would garnish any bank account they opened.
by rifek on Wed Mar 14th, 2012 at 02:59:15 PM EST
[ Parent ]
You have obviously not been denied a mobile phone contract because you didn't have a credit rating (good or bad: no credit rating is worse than bad credit) which you could only establish with a credit card.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman
by Migeru (migeru at eurotrib dot com) on Wed Mar 14th, 2012 at 03:02:31 PM EST
[ Parent ]
People in that situation should be able to get pre-paid cell phones. If not, that is a real abuse, as there is no risk. As soon as you reach your pre-paid limit you can only use the phone to dial 911 or the provider's line to add more minutes. Now, if you don't have a credit card, it may be necessary to go to a retail outlet to add more minutes to your cell phone. In Arkansas there are plans specifically for low income people designed to provide them with basic communications for health and safety. Such plans provide much better phones than the cheapest available. That is probably a boondoggle for the providers.

"It is not necessary to have hope in order to persevere."
by ARGeezer (ARGeezer a in a circle eurotrib daught com) on Wed Mar 14th, 2012 at 04:42:48 PM EST
[ Parent ]
That's just one example of what you can be denied for having no credit history. You can be denied anything that involves a credit check, which is becoming increasingly standard when dealing with corporations. You may be denied an apartment rental application, for instance. You may be denied a car rental. Your debit card may not be accepted for online payments. And so on and so forth.

There are three stories about the euro crisis: the Republican story, the German story, and the truth. -- Paul Krugman
by Migeru (migeru at eurotrib dot com) on Thu Mar 15th, 2012 at 05:22:04 AM EST
[ Parent ]
From Wikipedia: In Hungary Sweden debit cards are far more common and popular than credit cards. Many Hungarians Swedes even refer to their debit card ("betéti kártya" "kontokort") mistakenly using the word for credit card ("hitelkártya" "kreditkort").

Peak oil is not an energy crisis. It is a liquid fuel crisis.
by Starvid on Tue Mar 13th, 2012 at 06:27:48 PM EST
[ Parent ]

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