Welcome to the new version of European Tribune. It's just a new layout, so everything should work as before - please report bugs here.
Display:
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 ]

Display: