The theory is that the insurer isn’t then exposed to changes in the term structure on interest rates, only exposed to illiqudity/reinvestment risk to the extent of mortality fluctuations, isn’t exposed to currency risk and certainly isn’t exposed to credit risk. Without complex margining requirements like some swaps and without the need to roll cash investments over, government bonds should allow ALM teams to sleep well.

Now, Solvency II is likely to adopt a swap yield curve rather than bond yield curve. There are some good reasons here, including arguably fewer distortions from temporary supply and demand imbalances, improved liquidity and so on. The same yield curve is used for liquid liabilities so the allowance for an illiquidity premium over and above the swap curve at some times, in some ways and for some products is still under debate.

But what should Greek insurers do in the meantime?

Frankly, Greek government bonds don’t remove credit risk and the huge credit spreads on these instruments will create huge funding gaps and variability in earnings unless a Greek govi yield curve is used to value liabilities as well. It’s not clear at all that Greece will stay part of the Euro, so German government bonds don’t remove currency risk. German government bonds in any case are show signs of nervousness as yields creep up.

The swap market is exposed to the same Euro break-up risks as bonds. Which banks will survive, what happens to currencies in the meantime and what does that do to long-term Euro swaps? What about Euro-Sterling swaps issued by Greek banks (I’m not sure if these even exist though).

All in all, it’s good to be involved in ALM in South Africa, and even the Middle East just at the moment.

He was saying that he doesn’t see the point in investing in debt instruments.  He explained that the return is low and the risk high since if the company gets into trouble, you’ll likely only get a few cents on the dollar back.

Well, he’s wrong.

Risk and asset-liability matching

Fixed Interest investments are often the only investment that makes sense when you need to match or hedge fixed liabilities.  Naively consdering expected return only and not asset-liability risks  gives naive results.

Credit risk premia more than compensate for default experience over time

It’s worth exploring risk a little further. The caller stated that if the company gets into trouble, it’s likely the bondholders will also be hurt, and will likely only get a few cents on the dollar. Well he’s wrong here too.

The historical default frequency for investment great bonds (BBB and above) has been hardly more than a few single digit percent.  The Loss Given Default (how much an investor will typically lose if the bond issuer does default) is anywhere from 35% to 80%, depending on the seniority of the instrument, which estimate you trust, how it is measured and when the estimate was made. It’s because there are so few investment grade defaults that the data is so sparse and the estimates so wide. However, it’s clear that the likely return won’t be “a few cents on the dollar”.

I’m going to hunt round for some references here so you’re not just trusting my word.

Illiquidity premia = higher returns for some

Given the illiquidity of many corporate bonds, the expected returns are even higher if you as an investors are not considered with easy liquidation of your investment. This is a “pure risk premium” that you will earn over time without expected loss.  You could purchase extremely high quality, well-collateralised debt and earn a good return above risk-free as long as you have the patience and resources to hold it for long periods or until maturity.

The jargon that Lewis uses is generally explained and shouldn’t prevent non finance geeks from understanding the role of subprime lenders, mortgage originators and, of course, the Wall Street banks that fed the frenzy with CDSs, synthetic CDOs and bonuses for all.

The story places a few characters at the centre of the story. I wasn’t convinced that these guys were all skill and no luck, but they certainly seemed to have a clearer idea of what was going on in the murky, muddy waters of securitisations of that era than many of the supposed experts.

Overall, it’s won’t be the smash hit that Liar’s Poker is, but it’s entertaining reading all the time. The links to Gutfreund are tenuous and smell a little of name-dropping. If Lewis wanted to remind the reader of his role in toppling the ex CEO of Salomon Brothers he succeeded. If he wanted to somehow project the glory onto the new book, he failed.

The Big Short at Amazon.co.uk

The Big Short at Kalahari.net

Check out Book Finder for prices from several stores (new and used) in your currency including delivery costs to your location.

Parking on the top floor does have a cost. It takes longer to drive up all the ramps and does, perhaps, on average take longer than parking on the most convenient floor every time. This extra time is a premium I pay to reduce the potential for really bad outcomes and thus optimising the parking problem. For example:

• I avoid the situation of attempting to park on a lower floor (trusting the untrustworthy electronic vehicle counter) and, after driving around for a while trying to find parking, having to give up and try a different floor. This much longer time, even if it only happens rarely, is a much worse outcome than 30 seconds on every flight. It can easily be the difference between making and missing a flight.
• I don’t have to worry about remembering where I parked my car. I don’t know that I am more forgetful than the average traveller, but travelling almost every week makes each trip blur into the next. I don’t waste headspace on trying to remember where I parked my car, and I don’t worry about forgetting. I have the peace of mind from having purchased a time of insurance against the risk of forgetting where I parked.

I get no value out of successfully memorising my car location, but gain from removing this risk and this worry from my routine.

If your company has a foreign currency exposure due to imported input components, this is a risk and a worry over which you have no control. Your energies are better expended elsewhere, on the operational and sales issues that you can effectively change. Get rid of these risks and get on with your real business.

The tail of a distribution includes the very bad and very good possible outcomes, that typically have a very low frequency of occurring. Having your house burn down is a very bad outcome, but fortunately happens very infrequently. Winning the lottery is very good, but unfortunately in this case is also very unlikely for any particular individual.

Managing the nasty tail

A rational person who wants to avoid the unlikely but catastrophic risk of  losing their house to fire will be prepared to pay more than just the average cost of the loss of the house in order to avoid the risk. Typically, we humans are risk averse (a wild generalisation given the research into utility and decision making that has led to behavioural finance and behavioural economics, but probably good enough for now). Insurance provides:

• genuine decrease in risk and indemnification of losses against the loss event happening
• peace of mind even if no loss is ever experienced, which has real value in terms of clearing the mind to think about other more important and more controllable personal and business matters
• reduction in the amount of capital / liquid assets individuals and businesses need to keep against unforeseen events. This capital can be better used and invested elsewhere

Contrary to the popular view, insurance has value even if you never claim.

Gearing to the nice tail

Gambling can be dangerous and addictive. It can also be entirely rational to gamble within certain parameters.

Many people with a little mathematical, statistical or economic backgrounds view gambling as foolish because on average, those playing against “the house” will lose. Playing the game has a negative “expected value” since on average more money is spent than is one. (Casions regularly pay out approximately 97% of the money they take in, safe in the knowledge that most of the money they pay out will be return straight to the casino. The casino has several bites at your wallet. Playing ten times over reduces the effective payout to below 75%.)

A negative expected value is not sufficient to make it irrational to play the game. Insurance has a negative expected value for the insured but for the reasons mentioned above it is rational to use an appropriate amount of insurance.

The step that comes closer to making gambling irrational is that the gambler is paying to take on risk. Insurance is all about paying a premium to reduce risk. If humans are naturally risk-averse, how can it be rational to pay a premium to take on risk?

This brings into sharper focus the problems around the generalisation that humans are risk averse. I’ll try to explain how it can be rational to gamble under some parameters as an example of how risk-seeking behaviour (paying to take on risk) can be rational.

Entering the national lottery twice a year (you and your spouse’s birthday, for example) will cost around R7 per year. If you start this when you get married, using very rough numbers, it will almost certainly cost you less than R500 over your entire life. That R500 is not going to change your life in any meaningful way, but it does provide the chance of a completely life-changing event. You could pay off your house and cars, stop working, travel the world, donate to your favourite charities and provide for your children’s health and education. You now have upside exposure to that very unlikely, buy very desirable outcome.

Provided you don’t live your life expecting to win the Big One, and provided you don’t buy a hundred tickets every month to improve your chances at the expense of food on the table for your family, this can be an entirely sensible decision.

Other tails

Gold miners can’t control the gold price. In order to plan operations and capital investment, they should be hedging gold production at some level. The downside tail of very low gold prices is an unbearable risk that limits the ability of the organisation to be an efficient gold miner.

Gold exploration companies, on the other hand, are geared to the upside tail. Expenses are relatively fixed, and the chance of success isn’t great, but the payoff is they literally strike gold is fantastic.

Entrepreneurs are putting themselves out into the risky world, hoping to catch a wild ride up a huge positive tail.

Management diversifying a business because all their personal interests are too tightly focused in a single company, in a single industry, in single part of the value chain are hoping to avoid nasty tail events (or trying to diversify away from a dying business, or simply empire building rather than returning cash to shareholders, but that’s several separate posts altogether).

The lesson

The distribution of what can happen is important. Forget about the MBA mean and standard deviation mirage. Those measures conceal more information than they provide. Understood the most likely events and the extremes, understand how they affect your business and understand how the perception of these issues affects the decisions of those around you.

My original post was to temper the irrational optimism around the currency peg, rather than to say there is bad news around the corner. However, I still feel Moody’s may be slightly optimistic, upgrading a small country’s bonds when the extent of the global recession is not clear.

photo credit: plenty.r.

The Swiss are acting in the market to weaken the Swiss Franc to protect the economy. Given the problems Swiss banks have been having as a result of the credit crisis and pressure on banking secrecy rules out the franc.

The South African Rand? South Africa has a huge current account deficit, significant political risk, serious government spending and a decline in exports and production in our base metals economy.

The Pound Sterling is teetering on the back of a meltdown of the financial system – long the heart of the London and UK economy. I hear Ireland is in horrible shape too.

Some are suggesting the Norwegian Krone. It’s one of the world’s top ten traded currencies, which provides liquidity. Significant oil wealth has been accumulated and diversified in a “pension fund for the country”. However, currencies can be driven for extended multi-year period purely based on fashion. I don’t know that I want to risk being in a currency that simply goes out of favour.

The Japanese Yen has to deal with the worst economic declines in nearly 40 years. The Chinese Yuan is subject to state manipulation, usually pushing to keep it low to sustain an export-driven economy. Not sure I like my eggs  fried in that basket either.

The argument typically turns to Gold. The shiny metal that has been a store of value for several hundred years. Only problem is that gold arguably has less intrinsic value than steel or wheat or oil. The price is driven by demand – demand that is driven by assumed future demand. Flows into Gold ETFs have been strong, and significantly responsible for the current prices. Getting in now at around $900 per ounce might not be smart if everyone else is already in and looking for a time to sell.

So, where’s the safe?

photo credit: amber.kennedy

This actions (quantitative easing) increases the prices of bonds (more demand, diminishing supply) pushing down long-term yields.

Great if you own bonds, not so great if you are an insurer with imperfectly matched long-term liabilities. Given how difficult it is to find assets of sufficiently long term to back long-dated annuities, many insurers may find themselves with assets of shorter duration than liabiltiies. More losses for insurers could follow.

Insurers have started using swaps to match their annuity portfolios, or to simply increase the duration of their assets such that the sensitivity of assets and liabilities to overall changes in the level of the yield curve has a limited effect. This solves part of the problem. When short term interest rates are affected  by desperate monetary policy and longer term yields are set by a perfect storm of future inflationary expectations, recession fears and now central bank intervention in the markets, matching key durations is a minimum requirement not to have large swings in surplus assets.

And this doesn’t even consinder the impact on Guaranteed Annuity Options and Variable Annuities in the US. More fun.

Home prices fell 12.4% during 2008, the largest yearly decline since the National Association of Realtors began keeping comprehensive records in 1979.

As always, averages are a useful measure of overall market movements, but hide some truly enormous declines in individual areas:

Cape Coral-Ft. Myers, Fla., prices fell a devastating 50.8% for the year, to $110,900 from $225,300. That was the most precipitous plunge for any metro area. Saginaw, Mich., prices fell 41.4%; Riverside-San Bernardino, Calif., prices dropped 40.8%; and San Jose, Calif., prices declined 37.7%.

Those who say property prices always go up, or only ever down by a little, meet your awkward facts.

Those who say our property market has done poorly, compare against these figures and against the equity market for an equally troubling view. Our house prices will decline further but (political meltdown excepted) I’d bet serious money that we won’t see these declines in 2009 or 2010.

These aren’t the unlucky few. As I warned in a previous post on how the Make A Million competition is a bad idea and encourages wild speculation and ill-advised risk-taking, the performances of the best and worst entrants is dramatically different after just two months, with rather more entrants looking at poor returns.

The highest return (so far as of about the time this blog is posted) based on the live leaderboard is a massive, impressive return of 735% in two months. That’s over a 30 million percent return on an annualised basis. That is also where the good news ends.

Some more stats:

• Highest return 735%
• Average return -27%
• Median return -53%
• Worst return -107% (yes, someone lost all their fund and more thanks to the geared danger of SSFs)
• Approximate percentage of entrants with negative returns 82%

It’s abundantly clear that entrants have been massive losers in just a short space of time.  The average return translates to an annual return of -85%. Of course, the position would have looked much better had the markets boomed during the period, and it’s still possible there could be a huge rally from now until the competition ends. It’s just that I wouldn’t give any of my money to Bull! or Spitfire or Druggies or even Fantastic.

Not in a million years.