Monday, February 8, 2010

Citi reinvents end-of-the-world insurance

Original posted on Reuters by Felix Salmon:

In hindsight, one of the silliest and most dangerous excesses of the Great Moderation was the large number of companies — foremost among them AIG, although there were lots of monoline insurers in the same trade — basically selling insurance on the world coming to an end. It’s a great trade: either the world doesn’t come to an end, and you make lots of money, or the world does come to an end, and it doesn’t matter ‘cos you’re bust anyway.

Now, however, after seeing how that trade worked out, we’re wiser, and no large and leveraged financial institution would have the chutzpah to start selling world-coming-to-an-end insurance. Would they?

Credit specialists at Citi are considering launching the first derivatives intended to pay out in the event of a financial crisis…

“The great thing about the index is that it hedges your funding costs while being very simple to trade. I believe it will reduce the systemic risk in the industry, akin to how the advent of swaps means people don’t worry about interest-rate exposures any more – they just pay a fee to hedge it,” [says Citi's Terry Benzschawel].

Like a swap, the contracts envisaged by Citi would be entered into without an up-front premium, with money changing hands according to the index’s movements around a fair strike value.

I’d forgive you if your eyes started rolling after just the first four words: the phrase “credit specialists at Citi” is not exactly the kind of thing which instills enormous confidence in analysts and investors these days. After all, it was credit specialists at Citi who ended up losing the bank billions of dollars on trades which were meant to be too safe to fail. And this trade is in many ways even worse than the one put on by AIG, because Citi doesn’t even get any insurance premiums up front, but still needs to pay out enormously in the event of a crisis.

We learned in the crash of 1987 that when financial markets start selling products which insure a portfolio against catastrophic loss, the very existence of those products can destabilize the market and make it more prone to crashing. And, of course, we learned that such insurance has a tendency not to get paid out on exactly when it’s most needed. But heaven forfend that the market should ever learn from its mistakes.

It’s crucial, in financial markets, that investors walk into risky asset classes with their eyes open, rather than kidding themselves that they can simply hedge those risks away by buying a fancy financial product from Citigroup. But the only people who can stop this from happening are the technocrats at the systemic-risk regulator we desperately need to step in and get sensible about these things. And those people, unfortunately, don’t yet exist.

And as originally posted on Clusterstock by Vincent Fernando:

It's easy to sink into knee-jerk cynicism towards any new financial product these days, but it isn't very productive.

The concept of creating insurance against risk is sound. Huge risks exist without insurance, insurance just attempts to match people with opposite risk exposures, thus hedging away some of the world's risk.

In fact companies already hedge against moderate changes in funding costs every day using interest rate swaps, which are one of the most common and well established derivatives out there. Swaps can frequently be hedged between different companies who have opposite risk exposures, thus eliminating risk for both. Vast amounts of derivatives transactions happen daily allowing companies to hedge themselves from the vagaries of markets and focus on their core operations.

Risk.net: However, there is concern from academic circles that the counterparty risks involved in such a product could create moral hazard. Chris Rogers, chair of statistical science at Cambridge University, said the only participants able to sell CLX-based products would probably be those who are too big to fail.

Thus there are concerns for these new Citi derivatives similar to those for credit default swaps that insure against bond defaults.

Yet we'd point out that credit default swaps are inherently risk-reducing products. They just got a bad wrap due to some stupid exposure accumulated pre-crisis by AIG. Even if credit default swaps didn't exist, bond defaults would still happen during a crisis, causing hideous losses to certain investors. CDSs are badly needed, and this will be shown over time as demand for the insurance protection they provide explodes over the next decade.

To address the concern above, given that we unfortunately now live in the age of too big to fail, perhaps the sale of 'financial crisis swaps' would need to be regulated in order to make sure the government doesn't have to step in and cover their losses one day, just as is happening right now with CDSs.

But let's not fear innovation just for the sake of being cynical, especially when it comes to hedging risk. It's too easy to forget all the financial advances we benefit from.

RIsk.net: "The great thing about the index is that it hedges your funding costs while being very simple to trade. I believe it will reduce the systemic risk in the industry, akin to how the advent of swaps means people don't worry about interest-rate exposures any more – they just pay a fee to hedge it,"

The old 'uh oh, financial innovation, here we ago again line' is pretty tired and backwards looking.

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