Uncharted Territory

October 27, 2008

Risk Denial

Filed under: Credit crisis, Economics, Housing market, Risk — Tim Joslin @ 9:03 pm

OK, I can remember exactly where I was on 9/11; when I heard about the Challenger and Columbia disasters, the Bradford City fire and the Omagh bombing; and where I saw the Heysel disaster, the Hand of God and that 1998 England-Argentina match on TV, but I’ve rarely before felt I was seeing history in the making, day after day. This year’s Red October reminds me just a little of 1987, though. I spent an inordinate amount of time driving around the M25 that year, often in the night. So I’m listening to the music that reminds me of those journeys: Sade, for me, the sound of the ’80s.

I’m hoping that Sade Adu’s dulcet tones will help me understand the concept of risk, which is giving me a lot of difficulty just now.  Apologies if it seems I’m thinking out loud in this post, but this is my first attempt to put some anarchic thoughts on the screen.

It seems to me that the whole credit crisis has been caused by a pathology that I’d like to term risk denial.

Consider:

  • most people who think they’re “investing” in housing are in fact speculating, by any sensible definition of the term: they’re hoping to profit from capital gain.  In the US, the TV schedules of the early ’00s were apparently packed with programmes about “flipping”.  Here, many buy-to-let (BTL) investors were attracted by the prospect of spectacular rises in the value of residential property, rather than a hard-headed assessment of the realistic profit on rental income, after costs.  Vast numbers of people in the UK and elsewhere are happy to buy or remain in houses much larger than they need – often sacrificing other forms of consumption – because they believe property to be a “good investment”.  An Englishman’s home may be his castle, but, it seems, so is an Irishman’s, a Latvian’s and an American’s.  In short, millions put their money into housing because they saw it as a safe way of preserving or increasing their wealth.  But as we see now, it has proved exactly the opposite.
  • there has also been a supply-side to the huge demand for mortgages.  Take China’s Sovereign Wealth Fund (SWF), for instance.  It’s around $2trn and apparently very conservatively invested, largely in gilts, squeezing out other investors from this ultra-safe asset class by depressing yields.  There was obviously a market for other “safe” investments (or at least ones where the buyer felt the risk was accurately quantified).  Supposedly risk-averse investors, including Chinese government funds, I understand, have therefore been keen buyers of mortgage securities.

My point is this: in the dot-com boom too much money was chasing assets known to be risky, i.e. shares in tech stocks.  The fact that most investors were in no position to pick winners hardly put them off.  They simply spread their money about, bidding up the price of the latest hot stock to absurd levels.  The idea, of course, was that the overall returns for “New Economy” investments would be (improbably) huge, and by investing in many companies, the overall risk could be reduced.  And this can indeed be mathematically proven to be the case, as long as the risks are uncorrelated.  But what do we mean by correlation?  If we say the game is “winner-takes-all”, then only one search engine, say, could succeed.  But if Google had failed for some random reason – a crippling lawsuit over intellectual property, say – then some other company would have dominated the market.  If I’d invested in several search engine companies, then these investments would have been negatively correlated.  The more companies fail, the better the prospects for the survivors. In fact, the dot-com crash was not a result of correlation of risks – several companies ended up making billions for their shareholders – but of too much money chasing a type of asset, that is, “risky” investments.

Now, in the ’00s, it seems to me that we have had far too much money chasing “safe” investments – either low-risk, or for which it was thought the risk was understood.  All those CDOs, CMOs, CDSs and whatnots were not popular products because they were so clever.  They were successful because there was demand for them.

Ultimately, though, the whole edifice rested on the ability of mortgage-holders to service their debts, and as we have seen in the US, not only has a whole class of mortgage-holders (the beneficiaries of so-called sub-prime loans) proven to be unable to pay their interest, the law (in some states) does not even compel them to do so!

If it hadn’t been mortgages that pricked the bubble, though, then it would surely have been some other form of debt.

It seems that, when all’s done and dusted, the credit crunch has been caused simply by too much money chasing “safe” returns.

This “risk” thing, I’m beginning to think, is something you just can’t get away from.

Too many people have been in risk denial.

Can we escape from this trap?  I’ll have to think a bit more about that…

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