ENDOGENOUS UNCERTAINTY. IF WE’RE ALL IN THIS TOGETHER, WE ALL MAY GO DOWN TOGETHER.

The Author recently read the December 7th, 2007 edition of John Mauldin’s Newsletter entitled “Black Swans and Endogenous Uncertainty." The newsletter engaged many subjects, but the ultimate point was that the more that risk-reducing assets are injected into markets, overall systemic risk rise. Sounds like a mouthful. It is that and also a brain-full. It seems counterintuitive, but when thought through makes a kind of sense.

THE GREATER THE NUMBER OF NUMBER OF CONNECTIONS WITHIN AN ECONOMIC SYSTEM, THE GREATER THE SYSTEM IS AT RISK.

First, the obligatory humorous example. Many readers have watched sitcoms or perhaps movies where one broken commitment can wreak havoc on all of the characters on the show. The Author vaguely recalls this plotline from Mash, Andy Griffith, and other classics. Let’s see how this would work on the 1970’s classic, “Three’s Company”.

Jack owes Chrissy and Janet for this month’s rent. But he is a little short of cash and can only come up with part of the money. So he makes a deal with Janet that he will cook a fancy gourmet dinner for Janet and her new beau. Jack also makes a bargain with Chrissy that he will find a date for Crissy’s sister, Drifty, when she comes into town next week.

So Jack has created two obligations on his part. One to cook for Janet and another to find a date for Drifty. Jack could met his obligations, or, in sitcom like fashion, pawn these tasks onto others.

Janet’s date with her beau is on Friday night, the same night that Drifty is available for a date. So Jack asks Larry to go on the date with Drifty. To get Larry to go on a date, he offers Larry two tickets to a Journey Concert that his boss promised to give to him.

And it gets more convoluted. A new chick, a real fox in 1970’s parlance, will be moving into the Roper’s apartment building, but her apartment will not be ready for two more weeks. However, this new chick, who we will call Valerie, has heard of Jack’s cooking prowess and tells Jack that she would like to come over Friday night for dinner by Jack and “desert” by Valerie.

Jack has to cook for Janet, but also knows that the Ropers play cards at Mrs. Roper’s sister’s house on Friday night. Jack figures that he can entertain Valerie in the Roper’s empty apartment and run back and forth between his apartment to cook for Janet and her new beau and also cook for, and later be desert for, Valerie.

See how the interactions multiply and the risk of cascade default multiply. If one of a dozen things happen, such as Jack’s boss reneging on the Journey tickets, Mrs. Roper’s sister falling ill and not being able to host the Ropers for cards, or Larry weaseling out of the date with Drifty, cascade default ensues.

NOT SO FUNNY IN REAL LIFE.

Let’s look at an economic example. This is the example that Mauldin gives in his newsletter.

Let's say I own a $10 million corporate bond from Big Automotive Company (BAC) in my portfolio paying 7%. I can go into the market and purchase a credit default swap (CDS) for (say) 2% of the face value of the bonds from a large investment bank (LIB). Now I am getting a net return of 5%, but my risk is greatly reduced. LIB has insured my risk. Now LIB has a liability of $10,000,000 on its books, which of course reduces its capital. So LIB, clever folks that they are, buy another CDS from someone else on the same bonds for 1%, and thus their books are even. They own both a put and a call on $10 million in BAC bonds, so they take no hit to their capital structure. However, they do make a neat $100,000 (the difference in the buy and sell price) for making a market in BAC credit insurance.

Now, there are hundreds of investment banks and hedge funds making markets in all sorts of credit markets, buying and selling these derivatives to thousands of various investors and funds. It is quite possible that the CDS I bought has been re-shuffled a few times, so that we could have five or ten times the face amount of my bonds in the actual derivatives. I have seen reports that the total amount of CDs written on General Motors bonds are ten time the actual number of bonds.

Why would this be? If a hedge fund or investment bank thinks that default insurance on General Motors is too expensive relative to the risk, they can sell the CDS and hope to make a profit when the cost of insurance goes down. This provides liquidity to the market, but also creates a lot of connections among unrelated parties. By that I mean that I am exposed to the default risk of all the counter-parties of the firm who sold me the original insurance.

How? you might ask. Because if one of LIBs creditors defaults, then that reduces the capital of LIB. Let’s say that the $10 billion of total debt in that Big Automotive Company goes bad. I call up LIB and ask for my $10 million. Not a problem, they say. We’ll call the person who sold us the protection, who will call the person from whom they bought protection, until we find someone who is “naked long” BAC debt. Then they will pay up. Or we can hope they do.

But if there are several debt events that happen at once, as say generally does happen in a business downturn, there will be funds or banks that may not have enough capital. Why? Because banks and funds do not have to set aside reserve capital for potential losses and can leverage their exposure by a great deal. Technically, they are safe as the assets and liabilities on their books should match. But those assets are only as good as the counter-party who guarantees them.

BETTING ON LARRY, JACK’S BOSS AND MRS. ROPER’S SISTER. CRAPS.

Of course large financial institutions are more stable than Jack’s obligors. But Jack is only into them for a little. CDSs are in for a lot more.

A thousand things could break the chain of Jack’s interrelated obligation. How many things exist to cause breaks in the chains of derivative obligations? What if the top one or two private mortgage insurance companies would fail? What if their reinsurers would be wiped out by a catastrophic hurricane?

It does seem counterintuitive, that spreading the risk can multiply the risk. Transparency is the answer. Know what you are getting into. And know who you are getting in with.

This is a tough post and the Author will probably mull on this post and the underlying materials a bit more. There is too much there and it is difficult translating. But it is what the Author does.

IT DOESN’T FEED THE TABBY CAT OR KEEP THE RIDGEBACK IN DOGGY TREATS. STILL, IT IS WHAT WE DO IN THE DESERT OF THE REAL!