Debt risks are a time bomb set to explode

Risk, and our response to it, has long been something of a puzzle. Sigmund Freud, for example, believed that risk takers were all head cases. And he had such a strong influence on psychology that this was the prevailing wisdom for many years.

We now know more about the nature of risk-taking, and it seems our individual approaches to risk come in a variety of packages reflecting the broad diversity of human behavior. And as investing became a more significant part of our lives in America, risk analysis became important, too.

In the world of finance, risk analysis has one ironclad rule: Risk has to be balanced by reward. For individuals and businesses, there are two corollaries to this rule: Know what the risk actually is and make sure you are comfortable with it; and don’t take on any risks you aren’t being paid for.

Knowing and calculating risk has gotten a lot more complicated in recent years. Markets trade billions of dollars worth of financial instruments that are difficult to explain, let alone analyze. One of the fastest-growing investments, for example, is something called collateralized debt obligations, or CDOs.

CDOs were an invention of the late 1980s, and, according to the Bank of America, there are now more than $500 billion worth of them floating around in world markets along with the rest of the $5 trillion or so of credit derivatives of all descriptions.

What they are, essentially, is a loan that uses other loans as collateral. (Lend me $1,000, and I will pay you back, with interest. You’ll get your money, see, because I’ve got IOUs from these 20 other guys who each owe me $50 plus interest, and when I get mine you’ll get yours, see.)

Does it work? Sure. It is kind of a miniportfolio, a one-time, disposable mutual fund modeled after what the Federal National Mortgage Association, aka Fannie Mae, does when it packages up mortgage loans and sells them to investors. CDOs do much the same thing, but with corporate bonds and other debt as the underlying collateral.

And there is one other significant difference. Unlike Fannie May, the issuer of the CDO isn’t going to stand behind them. Investors are pretty much on their own to determine the risk and see if it fits them.

CDOs and other credit derivatives are marketed as a way for financial institutions, insurance companies, corporations, fund managers and individual investors to take on the level of risk they are comfortable with. They can do that because each piece of the underlying collateral comes with a rating based on the probability of default, and a yield spread reflecting the market’s estimate of quality. If a CDO has all low-yield, AAA-rated corporate bonds as collateral, for example, few would consider it a risky investment. If they were all junk bonds, though, only risk-seekers need apply.

It sounds simple enough, but there is a hitch, and Darrell Duffie has identified it. He is a professor of finance at Stanford University’s Graduate School of Business, co-author of “Credit Risk” (Princeton University Press) and a court-recognized expert in the mathematical models that are used today to manage credit risk.

He says that while credit derivatives have improved liquidity and raised the efficiency of debt pricing in financial markets, “the models used to calculate and manage credit risk have focused on the default risks of the collateral instruments. What is missing is an effective model for capturing the diversification of the credit risk of the underlying loans and bonds.”

But as big as the market for credit derivatives is, we don’t have a model like that. So we’ve got billions of dollars of corporate debt showing up on the balance sheets of insurance companies, mutual funds and other investors, but no real assessment of the total credit risk they represent.

The market’s development of these credit derivatives has clearly gotten far ahead of its ability to understand the real underlying risk. That’s not a good thing for investors, for economic policymakers or for the economy in general.

The market for credit derivatives such as CDOs is expanding rapidly, and the lack of an integrated risk model becomes more critical each day. Our economic policymakers and market authorities need to address this now, before we end up facing the kind of crunch and bailout situation – not unlike the Long Term Capital Management mess – that always seems to occur in financial markets when our enthusiasm overshoots our knowledge.

James McCusker is a Bothell economist, educator and consultant. He also writes “Business 101,” which appears monthly in The Snohomish County Business Journal.

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