Opinion

James Saft

The 27-year-olds are taking us down (again): James Saft

March 13, 2013

March 13 (Reuters) – The 27-year-olds making the mistakes
change but the flaws in the incentives and risk models at the
heart of the global financial system remain basically unchanged.

Calling them ‘mistakes’ is charitable, as they are actually
systematic and predictable exploitation of loopholes by
employees without sufficient skin in the very risky game they
are playing.

Here is the game, as it was played in 2008 and as it is
being played now: work for a financial firm, sell insurance
against an event the probability of which, while rare, is
underestimated by your firms’ models. Sit back, collect the
premiums, appear to be “beating the market”, and be paid
accordingly. If the rare event does happen, and it likely will
before your firm has been fully compensated, off you go with
your pay, leaving investors and regulators to clean up the mess.

If you think that model is all in the past, get a load of
what billionaire hedge fund manager Kyle Bass has been buying
from banks which ought to know better.

Bass, speaking at a forum last week at the University of
Chicago’s Booth School of Business, detailed how he has been
making large bets with banks, at very cheap prices, which will
only pay off if Japan’s creditworthiness disintegrates
disastrously within a year of when the wagers were made.

Bass’s thesis about Japan – that its debts are unmanageable
and new policies will backfire – is interesting but not what I
want to consider here.

Let’s concentrate instead on Bass’s account of what he is
buying and why the banks are selling.

“I have 27-year-old kids selling me one-year jump risk on
Japan for less than 1bp – $5bn at a time. You know why? Because
it’s outside of a 95% VaR, it’s less than one year to maturity,
so guess what the regulatory capital hit is for the bank? I’ll
give you a clue – it rhymes with hero,” Bass said.

Unpacking that, Bass is saying he’s buying contracts which
only pay off if Japan jumps to default, or something very near,
within the next year, paying only 1 basis point, or $0.0001, for
every dollar of potential payoff. The bank is making the bet,
Bass says, because its own and its regulators’ risk parameters
consider the possibility to be vanishingly small (where have we
heard that before?) and so allow it to make this kind of bet
without putting aside any extra regulatory capital.

That kind of bet is very profitable from a return on equity
point of view because extra revenues don’t create any extra
capital costs.

“If the bell tolls at the end of the year, the 27-year-old
kid gets a bonus, and if he blows the bank to smithereens he got
a paycheck all year. We are right back there. The brevity of
financial memory is about two years,” Bass said.

THE OLDEST GAME IN TOWN

Is Japan going to jump to default in the next year? Probably
not, but I’d argue that the answer is almost irrelevant. It
doesn’t have to be Japan and it doesn’t have to be this year. As
long as banks allow employees to create a stream of income for
themselves by collecting premiums on low-likelihood events as if
they were impossibilities we will have systemic risk, we will
have added taxpayer burdens and we will have the systematic
picking of shareholders’ pockets.

The same thing is true with hedge funds, many of which are
essentially playing the same game, but to their credit it is
generally only their clients who get stuck with the bill.

Bass, by the way, says he’s bought $500 billion of this kind
of thing from various sellers and that recently a bank
counterparty, having thought better of it, was encouraging him
to sell some risk back.

Federal Reserve Governor Jeremy Stein mentioned essentially
the same dynamic in a speech last month, explaining that a fund
manager can appear to beat a benchmark, like the S&P 500, by
selling insurance against it falling sharply, creating steady
income so long as we don’t have a crash.

“Of course, put-writing also introduces low-probability
risks that may make you, as the end investor, worse off, but if
your measurement system doesn’t capture these risks adequately,
which is often difficult to do unless one knows what to look
for, then the put-writing strategy will create the appearance of
outperformance.”

The brilliant thing about this strategy is that many of the
people employing it don’t actually understand that is what they
are doing; they simply think their risk model is more accurate
and are all too willing to cry “100-year storm” when it all
falls to pieces. That’s why so few of the people who profited
from the good times can see how they helped to create the bad
ones.

To judge by Bass’s account the measurement systems haven’t
improved since the great financial crisis and the incentives
haven’t really changed.

It may not be this year, and it may not be Japan, but sooner
or later we non-27-year-olds will be paying the price.
(At the time of publication James Saft did not own any direct
investments in securities mentioned in this article. He may be
an owner indirectly as an investor in a fund. You can email him
at jamessaft@jamessaft.com and find more columns at blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

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