Opinion

Felix Salmon

The unwilling risk-takers

By Felix Salmon
September 30, 2009

Comment of the day comes from Chris:

The person most willing to take on risk is the one unaware he is doing so. He charges no risk premium…

The resulting market equilibrium is that the guy who is unaware of the risk ends up loaded with it. Then the music stops.

This is possibly a very beautiful and elegant explanation for the extreme profitability of investment banks. They charge their clients a lot of money to take risk off their hands, and then they transformed that risk, using sophisticated financial engineering, into instruments which didn’t, on their face, look risky at all, and which could easily be sold to risk-averse investors. Bingo, massive profits.

Financial complexity and innovation, on this view, are essentially tools of obfuscation. And it’s easy to hide risks when risk-averse investors want debt-like products which retain their face value: such instruments tend to have very low volatility, and so look and feel as though they’re low-risk, even if they’re full to bursting with enormous amounts of tail risk. The answer, as I’ve said many times in the past, is for risk-averse investors to be willing to take a small amount of explicit market risk, and to move towards safe equities (utilities and the like) and away from debt. Because if they go to an investment bank asking for safety, they’re likely to just get hidden risk in return.

Comments
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This sounds a lot like a result on risk sharing from general equilibrium theory stating that in any economy with both risk neutral and risk averse agents, the efficient allocation requires that the risk neutral agents bear all the risk.

Chris’ extension to an economy made up of the ignorant and the mercilessly greedy has me laughing on the outside and crying on the inside. Nice, very nice.

Posted by framed | Report as abusive
 

There are plenty of people that bought derivatives and things like ARP’s that did it purely for increased yield and forgot week one of finance class. The T-bill rate is the risk free rate. If you are earning more than the T-bill rate then you had better know where your risk is.

Posted by jdor | Report as abusive
 

Only the short term T-bills are risk free. For example, if one buys a 10-year T-bill, and inflation rises significantly, the value of that T-bill is reduced.

My investments are not without risk; but those risks are minimal. I have a stable value annuity based as most of my retirement, and S&P average as the rest. The latter is an explicit risk/reward strategy. Still, in the last 2 years, I broke even on my investment….which I think isn\’t that bad of a deal.

Posted by Dan M. | Report as abusive
 

Except that a lot of these people were pension fund managers and other supposed professionals who should have known better if they hadn’t been suckered by the IB’s fiduciary reputations and the rating agencies AAA green flag. Look for the civil suits to follow.

Posted by Tom Hickey | Report as abusive
 

Frankly, all this talk about complexity seems to profoundly miss-diagnose the problem. Even when the structure of the securities was very complex, the problems were very simple. Mortgage Backed Securities were backed by mortgages that didn’t pay as expected.

None of this really has anything to do with the complexity – it doesn’t matter whether the cash flow is supposed to follow a simple path or a complicated one. If there’s not enough cash, someone’s taking a loss. If there’s not even close to enough cash, lots of people are taking huge losses.

A much more basic issue is that the consensus view was that there was a lot less risk than was actually the case. There are feedback effects in that: if all these subprime mortgages are safer because of FICO, the MBS is safer. If the MBS is safer, it’s easier to make subprime mortgages. Etc. But the basic problem has nothing to do with the structure of any particular financial product. It’s primarily that there was a widespread misunderstanding of the risks in the housing market.

Posted by MichaelB | Report as abusive
 

Imagine this next as spoken by Wilfred Brimley at the end of Absence of Malice:

“I’m not sure I can figure out how all this discussion of unwilling risk takers and market equilibrium is any different from how the dumbest rich guy in a small town ends up with a Cadillac that he doesn’t know has been rebuilt, a big house that’s too close to the river, and a lovely wife who spends two hours every weekday afternoon taking tennis lessons. Can you explain that to me?

And then how is it that the used car salesman isn’t a crook, the real estate agent isn’t a fraud, and the tennis pro isn’t eventually going to be looking down a shotgun barrel? Is that what makes high finance so special?

Posted by Dollared | Report as abusive
 

It is the old story of the strong winning out over the weak. This time, strength and weakness is not muscular; it’s informational.

Also,I think there is a basic defect in the structure of securitizing pools of securities.

Put the two together: nobody should ever buy the “equity” tranche of a securitization. Period. I have it on good authority that, if the issuer was to be required to retain that tranche, securitization as we have come to know it would cease.

Posted by Fitz | Report as abusive
 

Best sentence of the financial crisis-

“Financial complexity and innovation, on this view, are essentially tools of obfuscation.

Posted by Bill Shoe | Report as abusive
 

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