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LQD: Risk risk

by Migeru Sat Apr 5th, 2008 at 05:49:49 PM EST

In a probably futile effort to make myself less unemployable, I'm reading Fabozzi's Bond Markets, Analysis, and Strategies. In it, there's the following list of sources of risk for bond holders:

Bonds may expose an investor to one or more of the following risks: (1) interest-rate risk, (2) reinvestment risk, (3) call risk, (4) credit risk, (5) inflation risk, (6) exchange-rate risk, (7) liquidity risk, (8) volatility risk, and (9) risk risk.
Risk risk? WTF is that? A typo?


Risk risk

There have been new and innovative structures introduced into the bond market. Unfortunately, the risk/return characteristics of these securities are not always understood by money managers. Risk risk is defined as not knowing what the risk of a security is. When financial calamities are reported in the press, it is not uncommon to hear a money manager or a board member of the affected organization say "we didn't know this could happen". Although a money manager or a board member may not be able to predict the future, there is no reason why the potential outcome of an investment or investment strategy is not known in advance.

There are two ways to mitigate or eliminate risk risk. The first approach is to keep up with the literature on the state-of-the-art methodologies for analyzing securities. Your reading this book is a step in that direction. The second approach is to avoid securities that are not clearly understood. Unfortunately, it is investments in more complex securities that offer opportunities for return enhancement. This brings us back to the first approach.

(Italics mine)

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Now we know the cause of the subprime crisis: risk risk.

It'd be nice if the battle were only against the right wingers, not half of the left on top of that — François in Paris
by Migeru (migeru at eurotrib dot com) on Sat Apr 5th, 2008 at 05:50:45 PM EST
When you think that being an adult gives you an advantage at pinning the tail on the donkey while blindfold at a kids' party, you're fucked.

You can't be me, I'm taken
by Sven Triloqvist on Sat Apr 5th, 2008 at 06:07:46 PM EST
[ Parent ]
How the fuck do you properly price something if you don't know the risk premium?

Be nice to America. Or we'll bring democracy to your country.
by Drew J Jones (pedobear@pennstatefootball.com) on Sat Apr 5th, 2008 at 09:20:25 PM EST
[ Parent ]
Well, that's easy. You ask your friendly banker to sell you a complex investment vehicle and take his word for what the thing is worth. Then you give yourself a big fat bonus and when the investment blows up in your face and makes your company insolvent you  say "nobody could have predicted that" and wait for Bernanke to airlift you out to safety. (The picture illustrates Bernake's helicopter helping CEOs escape from their besieged headquarters)

When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. — John M. Keynes
by Migeru (migeru at eurotrib dot com) on Sun Apr 6th, 2008 at 03:49:54 AM EST
[ Parent ]
Migeru's answer is good. But how the fuck do you price something if you do know the risk premium?

The concept of risk starts to look a lot like other quirky parts of the financial furniture we're all supposed to use - it has a moral and class-based angle ('risk is good, up to a point...') which makes me suspect that it's not really about the numbers.

by ThatBritGuy (thatbritguy (at) googlemail.com) on Sun Apr 6th, 2008 at 07:57:01 AM EST
[ Parent ]
Take a guess.

That's what Net Present Value and Future Value calculations are.  Nobody knows what the risk-risk™ free interest rates will be next week, much less in 2021.  Yet the NPV and FV require that knowledge in order to crank out an answer AND that risk-risk™ free interest rates must not change over the life of the security.

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

by ATinNM on Sun Apr 6th, 2008 at 11:17:08 AM EST
[ Parent ]
I bet if people took their binary trees seriously and reported not only the "best" present/future value but a probability distribution, they would realise that pricing anything out to 2021 is nonsense.

When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. — John M. Keynes
by Migeru (migeru at eurotrib dot com) on Sun Apr 6th, 2008 at 11:23:02 AM EST
[ Parent ]
I tend to laugh in the face of anything more than five to seven years in the future. Even before that assessing risk is an entertaining project. 2021 is hilarious insanity.
by Colman (colman at eurotrib.com) on Sun Apr 6th, 2008 at 11:25:12 AM EST
[ Parent ]
How long is your mortgage?

When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. — John M. Keynes
by Migeru (migeru at eurotrib dot com) on Sun Apr 6th, 2008 at 11:29:04 AM EST
[ Parent ]
Hilariously long, so I don't worry about it. I have no guarantee that we'll be able to continue paying it, that the house will be worth anything near as much as we're paying or anything like that. But it puts a roof over our heads and that's the point. It's not an investment.
by Colman (colman at eurotrib.com) on Sun Apr 6th, 2008 at 11:31:35 AM EST
[ Parent ]
All the risks in the subprime mess were all known - people just did not care, because they did not need to:

  • the brokers wanted their commissions on new loans, and had no further liability;
  • the institutions providing the loans did not keep them in their books, and did not care about the underlying risk;
  • the investment banks bundling them into new securities did not hold the risk themselves, and provided extremely detailed risk analysis in their prospectuses, thereby informing potential buyers of all potential risks;
  • investors did not read the prospectuses and bought the securities on the strength of their credit ratings - ratings that historically had a good track record of predicting risk;
  • rating agencies provided the favorable ratings because historical default rates (the main driver of what ratings are about) were very favorable - and chose to ignore, like others, that this was a result of temporary bubble conditions rather than a permanent state of fact.

Et voilà. Ninja (no income, no job or assets) loans turned into AAA assets.

That's not risk risk. That's just plain old fashioned greed masquerading as "financial progress."

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Sun Apr 6th, 2008 at 03:59:11 AM EST
[ Parent ]
I agree on subprime. However, I am actually quite annoyed at how all these finance books celebrate "financial innovation". By and large, the purpose of financial innovation is to create a product whose risk only you can price, and then sell it at a premium to people who don't understand the risks involved. Hence, making money out of "risk risk asymmetry" is actually an important part of the problem with the current financial industry.

When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. — John M. Keynes
by Migeru (migeru at eurotrib dot com) on Sun Apr 6th, 2008 at 04:07:37 AM EST
[ Parent ]
The Financial Innovation you mention seems to me to be like the case where the house gets to invent a shiny new game of roulette without having to remind people that it gets a cut off the top of arbitrary size, and then croupier places undisclosed side bets at the dog track as he sees fit for which the roulette player alone is responsible.

The whole edifice was a con built around a rigged casino  with a side of Ponzi to bring in the suckers.    

by PIGL (stevec@boreal.gmail@com) on Sun Apr 6th, 2008 at 05:48:50 AM EST
[ Parent ]
but buyers should know better.

And in fact, regulation does distinguish between the general public, which is deemed ignorant, and thereby which is protected in terms of what financiers can sell to them, and "professional investors", who are supposed to be able to understand what they are being sold.

If you believe in people or institutions being responsible for their acts, then the greedy buyers of these (literally) overrated securities bear a lot of the blame, and should be punished. When you see the prospectuses put out by Goldman et al. with regards to mortgage-backed securities, you cannot say you were not warned of the risks - they are listed in exquisite detail there. The markets chose, collectively, to ignore them.

It was a choice.

Which points to a suggestion: create a new category of funds where the managers have unlimited personal liability: if the funds they manage lose money beyond a certain threshhold, they have to pay from their money (of course, that won't be enough to make investors whole, but it will certainly make managers a lot more focused on not losing money...)

In the long run, we're all dead. John Maynard Keynes

by Jerome a Paris (etg@eurotrib.com) on Sun Apr 6th, 2008 at 08:07:27 AM EST
[ Parent ]
Amusingly, isn't that exactly the sort of thing the LLP was invented to avoid? Used to be that all the partners in the big accounting/consulting houses were exposed to the risks of negligence of any of the partners, and you could only practice as an accountant if you were so exposed, exactly so that the mind would be concentrated. The LLP does away with that.  
by Colman (colman at eurotrib.com) on Sun Apr 6th, 2008 at 08:11:59 AM EST
[ Parent ]
Well what happened is that partners did (and still do, in the large number of professional partnerships still left unconverted to LLP's)insure themselves against these risks using Professional Indemnity Insurance.

These premiums started to rise rapidly, and led to the demand for limitation of liability. The government refused until they were essentially blackmailed into doing so when PriceWaterhouse and Ernst & Young paid City lawyers Simmons & Simmons around £1m in respect of the legislation that went through in Jersey in 1997 for a Jersey LLP.

Prem Sikka tells the story.

Essentially the UK government is handing out free insurance - as they do to every shareholder in a limited company.

ie the LLP does not quite "do way with that" it socialises what were private risks.

In my view, there should be a "Limited Liability Levy" or tax applied to gross revenues of any entity which has limited liability.

Jersey actually got one thing right in the end. They insisted on a bloody great bond being lodged by LLP's (either £5m or £10m) and this somewhat limites their appeal as a vehicle.....

"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Sun Apr 6th, 2008 at 09:24:02 AM EST
[ Parent ]
"Professional" investors seem to be less concerned with making healthy returns than with making sure none of their peers can out-brag them about their returns at the next cocktail party.

When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. — John M. Keynes
by Migeru (migeru at eurotrib dot com) on Sun Apr 6th, 2008 at 11:19:50 AM EST
[ Parent ]
Very Rumsfeldian...

I also like the way he congratulates you on reading his book, he's got style.

Member of the Anti-Fabulousness League since 1987.

by Ephemera on Sat Apr 5th, 2008 at 06:38:37 PM EST
If he's allowed risk risk, then I think we should be allowed to add some risk ideas to the bond markets, we could sell it as "the risk portfolio", where individuals or groups can by bonds in the following investment opportunities:

Ris K (guaranteed to make money!)

minirisk (investing in renewable energies, esp. multinationals--I hear that Starvid is on the board and pushing for a nuclear portfolio to be added post haste.)

My magic risk (investments in dubious-science; returns are usually of the emotional kind)

Norisk Toomi (a misnomer for bonds tied to major extraction industries; and related rubbish collection and diposal businesses)

The first approach is to keep up with the literature on the state-of-the-art methodologies for analyzing securities

I remember that companies were supposed to make 15-20% profit a year--that equalled a good investment.  Is this rate moving?  The closer it gets to 6%---hmmmm....I was thinking that Chris's ideas (someone was talking to me about islamic banking which is taking off in England, where the interest rate is zero; just families passing property around, no profits taken)

Don't fight forces, use them R. Buckminster Fuller.

by rg (leopold dot lepster at google mail dot com) on Sat Apr 5th, 2008 at 06:55:35 PM EST
[ Parent ]
Yes, I thought about Rumsfeld as well.

When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. — John M. Keynes
by Migeru (migeru at eurotrib dot com) on Sun Apr 6th, 2008 at 02:41:24 AM EST
[ Parent ]
In fact there are two more Risks:

Greed Risk - which consists of ignoring Risks 1 to 9 entirely because you believed what the man in the pub told you about this marvellous bond.

Panic Risk - which consists of ignoring Risks 1 to 9 entirely because you believed what the man in the pub told you about this piece of shit.

Oh, and solveig politely enquires as to... "exactly how reading this balderdash will make you more employable"?


"The future is already here -- it's just not very evenly distributed" William Gibson

by ChrisCook (cojockathotmaildotcom) on Sat Apr 5th, 2008 at 07:06:37 PM EST
Surely Solveig is aware that 90% of employment opportunities in modern Britain are all about balderdash, in one form or another?
by Metatone (metatone [a|t] gmail (dot) com) on Sat Apr 5th, 2008 at 07:53:16 PM EST
[ Parent ]


In the long run, we're all dead. John Maynard Keynes
by Jerome a Paris (etg@eurotrib.com) on Sun Apr 6th, 2008 at 03:46:18 AM EST
[ Parent ]

Must be the risk of setting your pieces wrong.

If you can't estimate the risk, staying away from it sounds like good advice.

by nanne (zwaerdenmaecker@gmail.com) on Sat Apr 5th, 2008 at 10:46:59 PM EST
And always take Australia.

Be nice to America. Or we'll bring democracy to your country.
by Drew J Jones (pedobear@pennstatefootball.com) on Sun Apr 6th, 2008 at 12:06:38 AM EST
[ Parent ]
Must be the risk of being drunk too much:

by das monde on Mon Apr 7th, 2008 at 01:16:17 AM EST
[ Parent ]
We don't have to worry about pissing the Americans off with that commercial anymore as we privatized V&S, producer of Absolut Vodka, last week.

And yes, we sold it to - the French! ;D

(Pernod Ricard)

Peak oil is not an energy crisis. It is a liquid fuel crisis.

by Starvid on Mon Apr 7th, 2008 at 08:09:46 PM EST
[ Parent ]
I bore excessively about this, but something that forms a part of "risk risk" is that there's a number of risks which cannot be adequately quantified.

In the past, people made "judgement calls" about what those risks were. Nowadays, since those risks don't fit into a numerical modelling scheme, they are largely just ignored.

And yes, Jerome and Chris's point about Greed Risk being a major issue is another major part of it.

I guess I need to write that diary about the culture of numbers and measurement and modelling.

by Metatone (metatone [a|t] gmail (dot) com) on Sun Apr 6th, 2008 at 04:55:58 AM EST
Remember this?

European Tribune: Risk, Uncertainty, and the Real Economy by NBBooks on February 20th, 2008

In October 2007, when these crises were just getting started, Marshall Auerback discussed Risk vs Uncertainty: The Cause of the Current Financial Crisis:
Here, uncertainty must be distinguished from the concept of "risk", even though the two are often used interchangeably. The distinction between the two was first drawn by the economist Frank H. Knight in his seminal work, Risk, Uncertainty and Profit (Hart , Schaffner & Marx; Houghton Mifflin Company, 1921). In an essential passage, Knight noted: "Risk is present when future events occur with measurable probability" while "Uncertainty," he elaborated, "is present when the likelihood of future events is indefinite or incalculable".


When the capital development of a country becomes a by-product of the activities of a casino, the job is likely to be ill-done. — John M. Keynes
by Migeru (migeru at eurotrib dot com) on Sun Apr 6th, 2008 at 05:01:53 AM EST
[ Parent ]
I'm trying to think of any financial activity with a consistent and measurable probability.

I suppose actuarial tables should be fairly stable. Is there anything else?

The quants claim to be able to pull trends out of noise, but I think that's more likely to be intelligence arbitrage - better modelling and probably raw data than the market average.

For tradtional investment risk I always assumed someone stuck a finger in the air and said 'Um, well...' before putting down a number.

by ThatBritGuy (thatbritguy (at) googlemail.com) on Sun Apr 6th, 2008 at 07:50:34 AM EST
[ Parent ]
Even actuary tables are unstable as they reflect the affect of past medical techniques, not future ones.  The introduction of antibiotics, for instance, expanded lifespans and their gradual failure should contract lifespans.

Basically, the Future is not predicated by the Past unless you're very, very, lucky or have heavily constrained the potential states of the system under analysis.

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

by ATinNM on Sun Apr 6th, 2008 at 02:15:18 PM EST
[ Parent ]
Heavily constraining "the potential states of the system under analysis" is more, not less, of what Bernanke et al propose for reform of free trade. The language and historical revisions employed to make the case are fascinating.

The great irony though underlying a FRB "regulatory" command (bubble) economy is not so much deregulation --private-sector relief from nominal price and legal constraints-- but the conviction, being that "functional regulation, which maintains separate regulatory agencies across segregated functional lines of financial services, such a s banking, insurance, securities, and futures" is incompatible with converging financial services in a commodity unit,

No single regulator possesses all of the information and authority necessary to monitor systemic risk, or the potential that events associated with finanancial institutions may trigger broad dislocation or a series of defaults the financial system so significantly that the real economy is adversely affected. "Blueprint for a Modernized Regulatory Structure"

Further, the most significant feature of NPV is time-to-market of innovative financial products today, not its future value. Not coincidentally then the US Treasury intends to acquire exclusive market-making authorities and technologies to implement total information awareness (TIA) of the business operations of any firm purchasing financial services. In this respect, US Government presumes compelling state interest in guaranteeing capitalization of depository and non-depository "banks" subject to FRB system surveillance, frankly.

And speaking of Australia, the US "Blueprint" --should I say, business plan?-- for optimal "market stability" is termed ...a "Twin Peaks"[!] model, combining government mandates of Australia and the Netherlands

emphasizing regulation by objective: One financial regulatory agency is responsible for prudential regulation of relevant financial institutions, and a separate and distinct regulatory agency is responsible for business conduct and consumer protection issues".

UK central banking is explicity dismissed. Too, too communist, one might imagine.

Diversity is the key to economic and political evolution.

by Cat on Sun Apr 6th, 2008 at 06:04:27 PM EST
[ Parent ]
I rather miss systematic risk. It is the risk that doomsayers are right - the system is deeply flawed, even if empirical evidence embarrassed them for so long.

I think this is a deep feature of complex evolved systems: they can adopt and resist mounting pressures in a scale-free manner, up to rather abrupt failure at some point.

What Bernanke said last week is rather a vindication of doomsayers (emphasis mine):

Our financial system is extremely complex and interconnected, and Bear Stearns participated extensively in a range of critical markets. With financial conditions fragile, the sudden failure of Bear Stearns likely would have led to a chaotic unwinding of positions in those markets and could have severely shaken confidence. The company's failure could also have cast doubt on the financial positions of some of Bear Stearns' thousands of counterparties and perhaps of companies with similar businesses. Given the current exceptional pressures on the global economy and financial system, the damage caused by a default by Bear Stearns could have been severe and extremely difficult to contain. Moreover, the adverse effects would not have been confined to the financial system but would have been felt broadly in the real economy through its effects on asset values and credit availability. To prevent a disorderly failure of Bear Stearns and the unpredictable but likely severe consequences of such a failure for market functioning and the broader economy, the Federal Reserve, in close consultation with the Treasury Department, agreed to provide funding to Bear Stearns through JPMorgan Chase.

Here you have it: the financial system, the markets and the global economy were on the verge of disorderly collapse, baring a massive bailout. Highly necessary perhaps, but highly hypocritical for sure.

I found this graph in NRO agenda article. I could not trace the graph on The Big Picture blog.

by das monde on Tue Apr 8th, 2008 at 12:00:54 AM EST
[ Parent ]


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