The Financial Crash - the biggest irony of all

[johnfm]

If you look at why futures, options, credit default swaps, interest rate swaps and insurance exist, the asnwer is risk management.

Futures and options allow risks to be hedge - companies who need, say, wheat can lock in wheat prices into the future. Farmers can lock in prices etc etc.


Insurance evolved when they realised that pooling diverse risks into a large enough pool would provide cover for the statistical numbers that needed to claim. If the pool is large enough and DIVERSE, there is lesser risk of the whole insurance fund sinking in the event of a catastrophic event or series of events.


Ironic then that all these financial instruments designed for risk management should all be allowed to be constructed in a way that completely ignored the basic foundations of risk pooling - diversification.


What a daft idea creating huge mortgage backed investment vehicles stacked full of US property mortgages.

[fido]

johnfm said:

Ironic then that all these financial instruments designed for risk management should all be allowed to be constructed in a way that completely ignored the basic foundations of risk pooling - diversification.

IMO it wasn't diversification that was the issue, but retrocession - this problem occured in the 1980s when reinsurance companies purchase their own reinsurance leading to the infamous LMX spiral - except this time it was the basically repackaging of debt (credit risk) instead of insurance risks.
I'm amazed it happened so soon after this, but then people seem to have relatively short memories (c.20years).

[tinman0]

johnfm said:

Ironic then that all these financial instruments designed for risk management should all be allowed to be constructed in a way that completely ignored the basic foundations of risk pooling - diversification.

Friend in the city a few years ago made the observation "you know it's going to end badly when Thai debt has the same rating as US debt; no one cares about risk ratings any more".

[aceparts]

Why worry about risk if you're (BANKS) are allowed to keep their winnings but get bailed out if they lose?

[12gauge]

I think one of the big issues with CDSs is you could buy the 'insurance' without buying the underlying asset, create massive short positions or manipulate prices and get payouts. Or so im told.

[johnfm]

Yep,, the regulators missed the obvious moral hazard of unrelated parties using the risk management derivatives for profit making.

[anonymous-user]

johnfm said:

Ironic then that all these financial instruments designed for risk management should all be allowed to be constructed in a way that completely ignored the basic foundations of risk pooling - diversification.

Options, futures and swaps are not the cause of the financial woes, and nor is diversification their aim (the aim being to hedge against a particular form of risk - price, default etc). In some cases, their misuse may have caused trouble for some reckless users, but the products themselves did exactly what they're supposed to.

The problem with diversification between different assets is that when everything goes bad, it doesn't work; the low/negative correlations between assets held in portfolios become high/positive and everything moves in the same direction... down.

johnfm said:

What a daft idea creating huge mortgage backed investment vehicles stacked full of US property mortgages.

Not if you're wanting to invest in US property mortgages. Besides, part of the motivation for them was that by pooling mortgages, the risk is shared between investors and each default has a lesser effect on each investor.

[anonymous-user]

johnfm said:

Yep,, the regulators missed the obvious moral hazard of unrelated parties using the risk management derivatives for profit making.

Which is what, exactly? Me buying insurance on your house doesn't make it burn down.

Edited by anonymous-user on Thursday 18th November 15:57

[jdw1234]

ZondaMark said:

johnfm said:

Yep,, the regulators missed the obvious moral hazard of unrelated parties using the risk management derivatives for profit making.

Which is what, exactly? Me buying insurance on your house doesn't make it burn down.

Edited by ZondaMark on Thursday 18th November 15:57

You cant take the policy out because it aint yours.

If you could, you would be more likely to want to burn it though.

Then imagine multiple people could take out multiple policies on the one house.

Edited by jdw1234 on Thursday 18th November 16:19

[anonymous-user]

jdw1234 said:

If you could, you would be more likely to want to burn it though.

And me burning it down would be highly illegal... just like buying CDS and then burning the company's factory down or raiding its bank account to force a default.

More appropriately, I take out insurance on the house because I reckon the owner's likely to burn it down himself. I just have a view on what's going to happen, and have a way to profit from it if I'm correct. [ETA: my interest in the insurance sends a signal to the insurer that something's up, as I obviously think it's cheaper than it should be, aiding the price discovery process.]

Just like with short selling, it allows outsiders to take a view on price, otherwise potentially held artificially high/low by the holders looking to serve their own interests.

Edited by anonymous-user on Thursday 18th November 16:47

[johnfm]

ZondaMark said:

johnfm said:

Ironic then that all these financial instruments designed for risk management should all be allowed to be constructed in a way that completely ignored the basic foundations of risk pooling - diversification.

Options, futures and swaps are not the cause of the financial woes, and nor is diversification their aim (the aim being to hedge against a particular form of risk - price, default etc). In some cases, their misuse may have caused trouble for some reckless users, but the products themselves did exactly what they're supposed to.

The problem with diversification between different assets is that when everything goes bad, it doesn't work; the low/negative correlations between assets held in portfolios become high/positive and everything moves in the same direction... down.

johnfm said:

What a daft idea creating huge mortgage backed investment vehicles stacked full of US property mortgages.

Not if you're wanting to invest in US property mortgages. Besides, part of the motivation for them was that by pooling mortgages, the risk is shared between investors and each default has a lesser effect on each investor.

I didn't say the aim of options was diversification. I said all these instruments evolved as risk management methods.

Diversification is one of the basic foundations of risk pooling - if an insurer only insures against fire in one street, there is a higher risk of failure than if he insures separately against diverse risks - but you know all this. You just misread my post.

In summary - all these instruments were, as you say, hedging and risk reduction inventions.

They didn't work and pooling of us mortgages created a huge problem - where the intent was to minimise risk of default to investors by pooling thousands of mortgages.

[Dr Jekyll]

It often isn't so much risk managemant as risk trading.

You pay me to take your risk and I'll probably make easy money, but then again...........

[anonymous-user]

johnfm said:

I didn't say the aim of options was diversification. I said all these instruments evolved as risk management methods.

Diversification is one of the basic foundations of risk pooling - if an insurer only insures against fire in one street, there is a higher risk of failure than if he insures separately against diverse risks - but you know all this. You just misread my post.

My bad.

johnfm said:

They didn't work and pooling of us mortgages created a huge problem - where the intent was to minimise risk of default to investors by pooling thousands of mortgages.

The risk wouldn't have been lower if they weren't pooled.

Edited by anonymous-user on Friday 19th November 13:02