In one state that I worked in, I managed to push a bill through the legislature that modernized that life insurance investment code, bringing it from the mid-50s to the late ’90s. The bill had the D-word in it, and prominently: derivatives. I had structured the bill so that derivatives could only be used for the purposes of risk reduction. We had two investors and two lawyers on our team, and I was the “quant” who happened to have a good handle on economic history. When testifying before the Senate, they asked us three questions:
- How can you make sure that Procter & Gamble doesn’t occur?
- How can you make sure that LTCM doesn’t occur?
- How can you make sure that Orange County doesn’t occur?
Three derivative disasters. I pointed to the protections embedded into the proposed law prohibiting speculation, and the detailed reports that the valuation actuary must submit on interest rate and investment risks, and that all transactions had to be reported to the insurance department, which could disallow transactions.
The bill passed unanimously. Eight years later — no disaster yet.
This brings me to a piece by Bill Gross, and a critique by Felix Salmon. As I have commented before, I am not horribly worried about counterparty risks at the investment banks. Past history shows that they are very good at preserving their own hides while kicking their overleveraged customers over the edge. Unless there are significant losses from counterparty risks, it is difficult to have large systemwide losses, because with derivatives, for every loser, there is a gainer. It’s a zero-sum game. I think Felix has the better part of the argument by a wide margin. Also, PIMCO is a large user of derivatives; they write significant exposures that are the equivalent of out-of-the-money calls to enhance their returns. If large losses are coming, what is PIMCO doing to limit losses, or better yet, profit?
That’s not to say that those that have taken risky positions won’t lose. They very well might lose, but someone else will win. That doesn’t make the analysis easy, because derivatives and securitization obscure what is going on with any one entity, even if the system as a whole is unchanged. Even Moody’s is scratching their heads on the matter. If the rating agencies which have inside information, are puzzled, the rest of us can feel better about being puzzled as well.
Two last notes: CDOs are ugly beasts, and there are really only two places to invest in them: at the most senior level, and at the most junior level. At the senior level, you have some protection, and can control the deal in a crisis. The most junior investors can make a lot of money if everything goes right. Not generally true now, but in the right environment, it can be a winner.
Second, I don’t think CMBS market is as bad off as the CMBX indexes would indicate. CMBS are more carefully underwritten and serviced than other securitized asset classes. The only thing that gives me worry is that recent vintages have relied on rising rental rates, and property values that may temporarily have overshot. Things aren’t great in CMBS-land, but there are other places more worthy of scrutiny. Again, my comments about being senior or being junior (equity) apply here as well.
Securitization and derivatives are tools, and they can be used wisely or foolishly. They can destroy individual companies, but not whole economies.