Thursday, July 9, 2009

The Future Of Risk, circa 1970.

Posted on Rortybomb by Mike:

I’m going to do something more with this later, but for now check out this awesome and eerie quote (source, pdf):

“Thus a long term corporate bond could actually be sold to three separate persons. One would supply the money for the bond; one would bear the interest rate risk, and one would bear the risk of default. The last two would not have to put up any capital for the bond, though they might have to post some sort of collateral.”

- Fischer Black, “Fundamentals of Liquidity” (1970)

In case that doesn’t freak you out, let me explain why it should. That’s 1970 (!!!), and it predicts everything. It’s before the Black-Scholes Equation (same Black) is published and popularized, creating the derivative market, so it is during the first wave of thinking how derivatives would change everything.

He’s saying, in the far future, there will be a market for slicing off the interest rate risk on a bond. There is such an instrument, the interest rate swap, and that market was created in the 1980s. He’s also saying the risk decomposition could be completed by slicing off the credit risk and selling that wholesale. That’s the credit default swap, or the CDS you always hear about, and that was created in the 1990s and popularized in the 2000s. This is the complete market that lead us into the current credit crisis, and here is Fischer Black 28 years beforehand, a consultant at Arthur D. Little at the time, explaining exactly how it would go.

Two extra things of note.

1. This is an example of what I meant as how risk has changed since the 1970s, and our regulatory agencies need to change to handle them. Risk can be sliced and diced up, and having three agencies, all jockeying for money, personal, and access, monitor three instruments on one underlying strikes me as asking for trouble.

2. I like that he notes that “might have to post some sort of collateral” could be a potential issue for this perfect Brave New World of complete markets. Not posting any collateral at all is what AIG did of course (though they couldn’t have posted enough collateral to cover these systematic risk insurance portfolios, but that’s a separate story). It’s fun to contrast how the idea that this highly explosive risk would travel to those who most could handle it, because markets regulate themselves, with Michael Lewis’s AIG Story that AIG didn’t understand their portfolio, got everything wrong and were lead by an insecure madman instead of the rational calculating market.

Markets in the abstract, markets in practice.

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