U.S. debt capers may expose “risk-free” fallacy

July 26, 2011

By Martin Hutchinson
The author is a Reuters Breakingviews columnist. The opinions expressed are his own.

Alan Greenspan admitted the financial crisis pulled the rug out from under 40 years of market ideology to expose a “flaw” in his thinking. Uncle Sam’s tottering AAA credit rating may do the same to investors the world over.

U.S. credit faces a downgrade even if Congress can strike a fiscal deal with President Barack Obama. Some European countries could, in time, suffer a similar fate as a result of the Greek bailout. If the pool of liquid assets plausibly considered “risk-free” is on the wane, it would undermine a broad swath of investment thinking.

A “risk-free return” is central to much of modern financial theory. The widely embraced capital asset pricing model, for example, produces its “investment frontier” by assuming risky investments can be combined with those without any risk, at least theoretically, to produce the appropriate blend for a desired return.

Similarly, the Sharpe ratio evaluates securities and portfolios by their excess return over that of a risk-free investment, enabling managers to determine whether they are paid sufficiently for their risk. In options theory, the popular Black-Scholes model assumes an ability to “delta hedge” an option by trading in the underlying security, and then either borrowing the cost of buying or investing the proceeds of selling at the same risk-free rate.

Banks and regulators confront a similar conundrum. Risk management theory assumes the possibility of eliminating risk from portions of a balance sheet. The Basel bank regulatory regime weights Treasury securities of OECD governments at zero.

If the risk-free status quo gets up-ended, the complexities of remodeling would be considerable. At first, investors and other market participants might simply treat AA U.S. Treasuries the same way they do ones currently rated AAA. But that philosophy might not hold, especially if the country’s credit further weakened.

Banks and hedge funds could require greater amounts of capital. Widely used strategies to exploit gaps between short-term and long-term rates would be less profitable. There might be bigger spreads in option markets as investors adjust for the differential between borrowing and lending costs. There would be many more unintended, and potentially painful, consequences. But exposing “risk-free” for the illusion that it is would correct another major flaw in the markets.

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