Sorry, Not Everything Can Be Hedged

Many people don’t think through questions systematically. That includes very bright people like Dr. Robert Shiller, who said in this article in Fortune, “We should be able to hedge everything from the rising costs of health care and education to national income risk and oil crises.”

Ugh. And this from an esteemed professor at a significant university? And one with which I have sometimes agreed?

I’ve written about this before in some of my market structure articles, where I tried to dig into the difference between natural, hedging, and gambling exposures. I’ll use an ordinary example to illustrate this: the bankruptcy of IBM.

I use IBM as an example because it is so unlikely to go under. But who would be directly affected if IBM went under?

• Stockholders, both preferred and common
• Bondholders
• Banks that have loaned money
• Trade creditors
• Workers

Let’s talk about the bondholders. They could buy protection via credit default swaps (CDS) to hedge their potential losses. In order for that to happen a new class of risk-takers has to emerge that wants to take IBM credit risk, that don’t own the bonds already. It’s not always true, depending on the speculative nature of the market (and synthetic CDO activity), but one would suspect that those that want to take on the risk of a default of IBM would only do it at a concession to current market bond pricing, or else they would buy the bonds and pay fixed, receive floating on a swap.

But often the amount of CDS created exceeds the amount of debt covered. I’m not suggesting that everyone owning bonds has hedged, either, but when the amount of CDS exceeds outstanding bonds, that means there is gambling going on, because it means that there are market players that are not long the bonds that are taking the side of the trade where they receive income in the short-run if the company survives, and pay if the company fails.

I call this a gambling market, because there are parties where the transaction takes place where neither has a relationship to the underlying assets. There is no risk transfer, but only a bet. My view is such gambling should be illegal, but I am in a minority on such points.

Now think about another asset: my house. Aside from being somewhat dumpy, beaten-up by my eight kids, the house has a virtue — I live in it free and clear, with no debts to anyone, so long as I pay my property taxes. So what is there to hedge here? I’m not sure, maybe future property taxes?

Aside from the county, and my insurance company, I’m not sure who has a real interest in my house. If I knew that there were many people betting on the value of my house, I might become concerned. What actions might people take against me in bad or good times?

But maybe no one would have interest in my house. It’s just one house, after all. Who would have a concentrated enough interest in it to wager on it?

Now, some would say, we don’t have an interest in your house specifically, but we do have an interest in houses on average in your area. That’s fine, but there is no one with a natural exposure to all of the houses in my area, aside from the county itself.

This is why I think that most real estate derivatives involve gambling. There is no significant natural exposure hedged. It is only a betting market.

And such it would be for most real assets. Few would want to create markets where the owners know more than they do, or, where there a few options for gaining control if things go bad.

At the end of the day, all of the assets of our world are owned 100%. Everything else is a side-bet. Personally, I would argue that the side bets should be prosecuted and eliminated, which would bring greater stability to the economic system. No tail chasing the dog. Let derivative transactions go on where here is real hedging taking place; away from that, such transactions are gambling, and should be illegal.

To Dr. Shiller, many markets are thin. The concept that everything can be hedged assumes deep markets everywhere, which is not the case. Time for you to step outside the university bubble and taste the real world. It’s not as hedgeable as you might imagine.

Comments

[mdmrjsds:]

I would argue it a bit differently. If everything is hedged, that means any event that has negative economic consequences for someone will result in the transfer of those negative economic consequences to someone else (after all, they are hedged for just that reason). But the second person is also hedged against negative economic consequences, so they transfer the hit to the next person. And so on, until everyone has been hit. Depending on whether it is a hamiltonian cycle or not, it will impact a subset of the economy or all of it. It is a zero sum game, there has been a negative economic consequence making the total pie smaller, so someone has to lose and pay. But everyone is hedged. An infinite regression loop ensues. Ergo, there is no way everything can be hedged.

Sort of like pulling yourself up by your ankles while standing on the ground.

I think only someone who has never worked with systems would come up with this. In system terms, the economy is a closed system, so a loss is a loss for the system and has to be borne by someone in the system. His fallacy is in thinking that there is someone external to the economy (open system) with the resources to take and pay off on the risk, and that they would be willing to do so (after all, they aren't hedged).

Or maybe I don't understand the question. :-)

Jul 09 11:56 AM

[Graham and ...:]

"Hedging" can occur when YOU're hedged, and the other guy isn't. But if "everyone" is hedged, then no one is.

Jul 09 12:37 PM

[Tom Armistead:]

I support the position that gambling in what are by their original intention hedging transactins should be banned. The first reason is that it creates moral hazard: somebody wants a loss to occur and will be better off if it does. Not good.

The second reason is that it destabilizes the financial system. If IBM goes bankrupt, bondholders lose. If IBM goes bankrupt and speculators have bought CDS without owning the bonds, now both bondholders and those who wrote CDS protection have losses. The CDS transaction creates chance of loss where there was none.

Many exposures can be hedged, but there is no reason to trumpet the possiblity as an improvement. Hedging, like any form of insurance, has transaction costs and reduces the overall efficiency of the markets when done beyond the simple needs of prudence. Not to mention most hedges do not work perfectly, and some of the worst of them do not work as planned. Result, the business that thought they were hedging has added to their losses rather than reducing them.

Jul 09 05:38 PM

[ladders11:]

Dr. Shiller is making a legitimate normative statement that the ability to hedge certain exposures would limit risk for many people in certain situations, thereby liberating ordinary individuals from some market risks, and enabling life decisions to be based on non-financial factors. The very concept of a 30-year mortgage exposes an individual or family to significant market risk. If you are 100% certain that you will never need to move, this risk is acceptable. But if your income situation then changes, and moving becomes more likely than not, it may be prudent to limit market risk.

Markets follow people and people follow markets. With sufficient liquidity, the market for a local house price ETF would resemble the market for a local house. Consider the Manhattan real estate market: investors abound, and they aren't doing much more than speculating on the price of buildings. Call it "gambling" if you must. But if you are simply employed in Manhattan, and wishing to live near work, you currently have no means to accomplish this end without delving into this investor's world. With an efficient ETF available to short Manhattan RE, you may lower market risk sufficient to enable you to live near work.

The real estate bubble caused unnecessary friction, e.g. living in New Jersey and commuting to save rent money, or moving to Atlanta where homes are still affordable. This bubble couldn't have occurred without investors who had no interest in occupying the buildings they owned. New York real estate is a "gambling" market - but also a real market. If your family lives there and that's where you want to live, you're required to gamble on prices, and in fact, a functional hedging market would enable you to offset your gamble and minimize the risks.

Meanwhile, options are a good thing where I live. This article throws some unnecessary insults towards Dr. Shiller, who has an extensive track record of significant work in economics and finance, and fails to back them up. But the tragedy of this article is the suggestion that certain markets should be illegal. I don't see evidence that David Merkel has thought through these questions systematically.

Jul 09 07:59 PM

[derryl:]

David Merkel wrote,
"At the end of the day, all of the assets of our world are owned 100%. Everything else is a side-bet. Personally, I would argue that the side bets should be prosecuted and eliminated, which would bring greater stability to the economic system."

I say, Amen! There is no upside to us, the owners of assets and participants in the economy, from gamers who are only there to try to create an imbalance that they can exploit and suck some of the value out of us. It's an old style street con game straight out of Gangs of New York: distract and confuse the mark while you're robbing him.

Jul 10 02:57 AM

[TinyTim:]

"the transaction takes place where neither has a relationship to the underlying assets. There is no risk transfer, but only a bet. My view is such gambling should be illegal,"

very conservative view.
Of course, everyone has heard the liquidity argument, which is especially applicable here since you bring up how thin most markets are.
I am starting to come around to your side though. Just not 100%. Just like reserve banking, there has to be a connection to the underlying assets on both sides.

Jul 10 04:40 PM