Response To Mike Goodson: Risk Is Correlated

by: Andy Greig, CFA
Mike Goodson had a great post that I would like to comment on. I am repeating my response here as I think it may be of interest to all. We are commenting on the similarities between the current credit crisis today brought on by mortgages and the credit crunch of 1997-1998 brought on by foreign debt.

I think the two periods are very similar. One point though, the equity market blew to pieces in 1998 with a 20% decline on the back of the Russian default which of course was directly related to the initial devaluation of the Baht in July 1997 and the failed effort by the IMF to prevent the Asian Contagion. Also, it was 1998 that LTCM died due to a credit crunch and correlation anomalies related to emerging market debt.

The periods are similar because the game was the same. (For the following substitute mortgage loans for foreign debt to equalize the periods.) Funds and banks were reaching for yield in 1995-1998 and the best yields were available in emerging markets. What was not to like? The emerging economies were the poster child of the new globalization. GDP rates were soaring, personal incomes were soaring, and capital flowed freely to these "new economies". Sadly, much of the capital and borrowing was denominated in foreign currencies and largely unhedged. Debt levels ballooned while credit was easy and the foreign banks took on large currency and asset risks.

And like today somebody woke up one day and realized that the asset quality (home values today) was a bit murky. The selling hit, the currencies plummeted, the asset quality collapsed, the perfect storm. Funny how history repeats itself.

The real problem was the correlation of "uncorrelated markets" became correlated as a tremendous number of participants were all in the same game. To raise capital, in fact, to survive risk has to be sold. Risk is everything that has a fluctuating, subjective value. Equities, currencies, bonds, you name it.

Here is the big lesson. RISK IS CORRELATED.

Always and Forever (to quote Shania) risk will be correlated and we will continue to have these so called perfect storms.

I am amazed that nobody seems to get this. Perhaps they do. Perhaps they choose to ignore it because there really is no reasonable way to hedge such an event. Though with the advent of options on volatility I think there is an opportunity to actually hedge out this risk. Obviously, this kind of strategy is not applicable to individual investors but for us Hedgies I see possibilities. I also predict we will see volatility really start emerging as an asset class with various instruments that will allow hedging of converging correlation. Then again if we all do this...