Future of Risk: Spot On Prediction from the 1970s

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 about 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 with regard to 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, personnel, and access, monitoring 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.

Comments

[Michael Clark:]

In other words, NO ONE has ANY IDEA what we have out there. All these instruments have been carved up like a Christmas turkey, sent to all parts of the world...and there is no way in hell that we can reassemble that damn turkey.

Aint progress grand? Good thing the SEC was watching, keeping track of everything.

Jul 10 08:18 AM

[paulsjj:]

Where O Where Have All The Toxic Assets Gone?

Jul 10 08:57 AM

[nobby73:]

Maybe the fallacy is that by splitting the product into it's constituent building blocks, this changes the risk to the system as a whole. Also, compartmentalizing the risk can be misleading , e.g. the funder of the product may believe the credit risk has been hedged through CDS, but the funding and the interest rate swap also are credit products, as banks found out to their costs.

Jul 10 09:49 AM

[nobby73:]

They're in Bernanke's woodshed.


On Jul 10 08:57 AM paulsjj wrote:

> Where O Where Have All The Toxic Assets Gone?

Jul 10 09:49 AM

[alajac:]

Selling insurance without reserves sufficient to pay expected claims is fraud. And without any previous claim history (since it was a new product), not requiring 100% reserves was criminally negligent.

Jul 10 12:50 PM

[TinyTim:]

Fascinating.

Funny how one little phrase makes all the difference:
"though they might have to post some sort of collateral."

I'm with Alajac.

My formula for Wall St:
Keep 'em small, simple, transparent and collateralized.

Jul 10 07:20 PM

[Moon Kil Woong:]

Rortybomb got it wrong, in fact AIG sold CDS to Goldman's clients so they could sell their mortgage bond package, then AIG agreed to sell Goldman Sacs another one so they could bet against their own clients and AIG. I guess somehow they either convinced AIG they wanted double the peace of mind or the deal was so good to AIG that they wanted to give them free money.

When Goldman wants to do something 2x with you little alarm bells should be ringing in your head. Anyway, now you understand how hundreds of trillions in derivatives can be made out of a market that is only a few tens of trillions large. Leverage baby leverage. And about that collateral thing, pishaw. Why do you need collateral when you know the taxpayer ends up paying for them all? Especially when the contracts are written to Goldman Sacs.

Jul 10 11:05 PM