Pricing Risk: Taking it all Into Account, and No Tears, Please

As a follow-on to my earlier post on OTC derivatives, I have just one thing to say. If you are going to swim in the shark tank, you've got to know where ALL the sharks are. Because if you miss even one, well... And this applies to more than just derivatives. Remember the VNU bond-holders fiasco, where a private equity-proposed leveraged buyout that intended to leave existing debt outstanding caused CDS spreads to blow out by 250 bps practically overnight? Sure sucked for existing bondholders, right? Well, this kind of outcome was possible given the bond covenants and, therefore, it happened. Surprise, surprise. But it shouldn't have been. It wasn't like a debt-funded VNU buyout was some three-sigma possibility. Then why did spreads blow out so much? Because bondholders didn't anticipate that they would get jammed. But it is a gentlemen's market no more, my friends. The risk existed and VNU bondholders simply didn't price it properly. Ok, but that's kind of the game, isn't it? And now we see something similar happening with the subprime mortgage meltdown. As outlined in today's Financial Times:

In the latest twist to the tale, it emerged last week that a group of US hedge funds were up in arms over the banks’ involvement in derivatives based on sub-prime mortgages. The banks both create and sell the derivatives – which offer insurance against mortgage default – and manage the mortgages. The hedge funds say they have been relaxing terms on defaulting mortgages so they will not have to pay out on the derivatives.

Leaving aside the unappealing spectacle of America’s richest – the hedge fund managers – betting on the poorest losing their homes, the question is how the banks can wind up writing insurance against risks that they themselves partly control.

There are two issues raised here. The first is around the issue of hedge funds being pissed off at the banks for being on both sides. Well guys, sorry to say but banks are going to act rationally and look at the entire picture, not each picture in isolation, and if that means taking mark-to-market losses on their mortgage portfolio to protect the value of derivatives contracts, that's exactly what they should be expected to do. It is not as if the hedge funds entering into these derivatives didn't know that banks originate and underwrite mortgages which they often package, structure, and sell, as well as write derivatives against. So given this knowledge, is it reasonable to expect that hedge funds should have priced in the possibility of banks' optimizing their own outcomes to the detriment of derivative holders? I'd say so. Everyone at the table is a shark, and to expect anything less is just silly. So please, no more tears. The best funds make money off of people and firms mispricing risks, and if every once in a while this principle comes around to bite them in the rear, it is just the cost of swimming with the sharks.

The second issue relates to how banks can write insurance against risks they themselves partially control. The answer: because they can and because hedge funds and others buy it. The banks aren't holding a gun to anybody's head. The question is, on its face, just ridiculous. There either is or is not a market for something, and in the case of banks selling mortgage derivatives, there is. So end of story.

The financial markets are tough, my friends. One should assume that homework poorly done will eventually result in one's getting smacked. There are just too many smart people with too much money looking for ways to squeeze blood from a stone. And it never ceases to amaze me just how much blood can be gotten. Again and again and again.

Comments

[Eclectic Contrarian]

I'm sure you read this, but it seems the primary controvery is over Bear's change in language, or as they put it, "clarification". Right. Have you read how explicit they made their equity residual or servicing rights on their underlying MBS portfolio?

[Yaser Anwar]

Trading in exposures to price risk between end-users and dealers in the OTC markets has not led to a concentration of price risk among dealers.

By insuring a large number of independent identically distributed exposures, the bank/dealer is able to reduce the variance of the average insured damages so that results become more stable and predictable.

Every now and then, some dealers' NMV as a % of total market value of their contracts is significantly higher than for the market as a whole. Whether the higher NMV ratio of an individual bank’s position represents significant price risk for that particular firm cannot be determined without taking into account its offsetting cash market and exchange traded positions.

Typically, the net +ve market values of some dealers are balanced by the net -ve market values of others, resulting in the small net market value of the aggregate dealers’ position.

The small NMV of the aggregate dealers' position suggests that demand for products that transfer price risk is sufficiently diverse [read: Pensions, Hedge Funds] to allow a dealer uncomfortable with its price risk exposure to trade that exposure back into the market.

Therefore, a dealer’s exposure to price risk appears to be driven by its appetite for risk rather than by customer, mostly hedgies, demand alone. Because of these exposures, we've seen the multiples of i-banks, especially Goldman Sachs, Co., shrink.

Am I missing something?

[Yohan]

That line about squeezing blood from a stone is a great quote. I saved it for future reference and passed it on to fund colleagues. Great writing.

[Eclectic Contrarian]

Solid post. Caveat emptor.