Felix Salmon

Why hybrid debt instruments won’t work

By Felix Salmon
January 29, 2010

This time last year, Justin Fox’s idea of a clever blog entry was a video of him skiing in Davos. This year, now that he’s absent from Davos and has a brand-new job at HBR, he’s writing about “the attraction of hybrids like continuous workout mortgages or regulatory hybrid securities”. Staying away from Davos can do wonders for your blog quality! You should read his blog entry, it’s really good — it talks about all the different ways in which debt can be made a bit more like equity, and asks why they haven’t really caught on.

The answer, I think, is that bond investors have no idea how to price tail risk. One of the reasons that bonds are so popular is that they’re easy to price, partly because they do a really good job of hiding risk by pushing it all off into tail events, which then get ignored rather than priced. The slogan is that debt=denial.

The kind of securities that Justin’s talking about, by contrast, are almost impossible to price. If you offer a bond investor optionality on top of the bond coupon, you won’t get paid for it: just look at Argentina, which essentially ended up giving away its hugely-valuable GDP warrants. And that’s a good outcome, for a borrower, compared to securities where the investor can end up losing money even when there isn’t a formal default. Bond investors always want their money back; if there’s a chance that won’t happen, they will charge through the nose. And that’s if they participate at all.

The two main groups of securities are stocks and bonds. Bonds are easy to price, which means they can get away with being illiquid: you don’t need much of a market to know how much they’re worth, and you can hold them on your books at a certain value even when that particular bond hasn’t traded in months. Stocks, by contrast, are pretty much impossible to price, so you need a highly liquid market to tell you how much they’re worth, and you tend to mark your holdings to market every day.

One thing that all of the securities that Justin’s talking about have in common — along with even crazier creatures like CoCo mortgages — is that they’re both hard to price and illiquid. That’s bad for both borrower and lender: the only group who really wins with that kind of security is the investment-banking intermediary. I mean, who would want to buy a mortgage where the interest payments automatically fell if house prices dropped? And who would want to borrow money on the basis of their steady income, if they knew that their mortgage payments could rise substantially just if the value of their house went up? And who would pay for the appraisals which would be necessary to prove that the individual house in question had indeed risen or fallen in value? It’s all horribly complicated and expensive, and those kind of problems are symptomatic of the entire class of these securities. Even the relatively successful Danish model doesn’t really scale to a country the size of the US.

These instruments might reduce systemic risk, but they simply don’t lend themselves to a long and healthy existence being traded in the international capital markets. And therefore, sadly, they ain’t never gonna work, except for on a very small and experimental level. But I’m sure that’s not going to stop Bob Shiller from continuing to come up with more variations on the theme.

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