The Alchemy of Risk

Here is a recurring theme from this blog: “risk can never be destroyed, it can only be transformed and laid off on someone else.”

Or, in the words of the late, great Marty Whitman: “someone has to pay for lunch, and I don’t want it to be me.”

Often people think they’ve destroyed risk when they buy a financial product with a guarantee attached. In finance, “guarantee” is just a fancy word for “promise.” When you buy a financial product with a guarantee attached, you’re swapping market risk for something else. Usually it’s a stream of payments with its own set of risks.

The person selling you the stream of payments will tell you that you’ve gotten rid of your risk. And you have, to an extent. You’ve gotten rid of A risk. You’ve traded your market risk for credit risk (your counterparty might not make good on their promise) and purchasing power risk (your stream of payments might not keep up with inflation).

Some of you will say, “but the counterparty is contractually obligated to keep is promise!”

To which I say, “so are bond issuers and individual borrowers. Yet they default all the time. Sometimes they even commit fraud.”

Others will say, “you don’t know what you’re talking about! The government has insurance funds for deposits and pensions!”

To which I say, “promises, promises, all the way down.”

How does the government fund its promises? With tax revenue, partly. But more importantly, with debt. Like I said–promises, all the way down. Dollar bills are themselves promises. What is the “full faith and credit of the United States government” but an elaborate series of promises?

Anyway, for normal people the most common example of “risk transformation” would be buying an annuity or whole life policy from an insurance company. But there are more exotic examples.

Banks like to sell structured notes to their wealth management clients. These are difficult products for the average person to understand. They usually promise a return based on the price performance of some index, subject to certain limitations. For example there will be a guaranteed minimum return and a cap on the high end.

(Notice that I said price performance. If you buy a structured note, no dividends for you!)

Banks like this opacity because the complexity makes it easy for them to bake profits into the structures, which are literally designed by mathematicians (actuaries). The products are sold based on the guaranteed minimum return, and the chance of modest upside. As the buyer, you overpay for the downside protection (the guarantee). When you buy a structured note, you are basically lending the bank money so it can write options and eke out some trading profits. In return you get a more bond-like risk profile.

Meanwhile, you are an unsecured creditor of the bank. If the bank goes bust, your investment is toast. So much for guarantees. Get in line with the rest of the unsecured lenders. Ask the people who bought structured notes from Lehman Brothers how it worked out for them.

In general, the more complicated the product, the worse a deal you are getting. Of course, there can be good reasons to swap market risk for a guaranteed stream of payments. Just because you overpay for downside protection doesn’t make you a sucker.

But lunch is definitely on you.

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