Finance and Risk

Matt Levine and John Cochrane on the UK pension meltdown

Matt Levine writes (I subscribe to his essays by email, for free),

If you have a pot of money that is immune to bank runs, over time, modern finance will find a way to make it vulnerable to bank runs. That is an emergent property of modern finance. No one sits down and says “let’s make pension funds vulnerable to bank runs!” Finance, as an abstract entity, just sort of does that on its own.

He is explaining the problems in the UK pension market that prompted intervention by the UK central bank.

But it also might be a description of the financial crisis of 2008. Repurchase agreements were supposed to be immune to runs. But modern finance found a way to make them vulnerable, by incorporating highly-rated mortgage securities as collateral, and then coming up with ways to structure CMOs so that rating agencies blessed tranches as AA or AAA when they were in fact much riskier than comparably-rated corporate bonds.

John Cochrane also talks about the UK story.

So, you can see that leveraging in to long-term bonds in a time of low interest rates has a quite skewed distribution of returns. You can make a little bit of money most of the time, if interest rates stay low or go down a hair more. But when interest rates rise, you can lose a lot of money all of a sudden. This is a tried and true method of boosting fund performance. For a while. "Write out of the money puts." "Short volatility." "Write insurance." Then of course the grim reaper comes and it all falls apart massively. 

It is easy to fool yourself that when you write out of the money options that you are doing something novel, and to convince yourself that you are brilliant. Like AIG, writing credit default swaps to provide what they calculated to be superfluous guarantees on some mortgage tranches of collateralized mortgage obligations, so that the owners of those tranches could overcome capital requirements or other regulatory hurdles.

Suppose I find a lot of customers who want insurance against a particular form of risk. I find a clever way to provide this insurance that appears to be foolproof. Then some events happen, and people add up all the insurance policies I’ve written, compare that with my assets on hand, and point out that if bad events continue to happen customers will not be able to collect on the insurance. Customers then look at their contracts with me to find ways to establish claims to my assets, just in case. (With a classic bank run, the customers are trying to establish claims to cash by going to the teller to make a withdrawal.) This is what happened to AIG in 2008, when their counterparties started making “collateral calls.”

Writing out of the money options is also known as “picking up nickels in front of a steamroller.” Incidentally, it is also how Enron fell apart. They created special-purpose entities in a way that Enron was writing out-of-money put options on its stock. As it stock started to fall, Enron lost money on those options, which caused its stock to fall further, which caused it to lose more money. . .and so the collapse was swift.

I do not buy the conventional story that Enron executives knew all along that they were running a scam. I think they fooled themselves at least as much as they fooled outsiders. I think that is part of the syndrome that Levine describes.

The sad thing is that Levine’s observation is probably correct. Financiers will always find a way to follow a strategy of picking up nickels in front of a steamroller. And when this goes spectacularly wrong, central banks feel obligated to provide a bailout.