Friday, March 02, 2007

The Long Arm of the Laws of Economics

Risk is being underpriced. Can this last?

Since prehistoric times, a simple principle has held true: if you lent money to somebody, you would demand a return high enough to justify the risk of that person defaulting on the loan. As financial systems evolved, this fundamental truth has continued to hold - lending rates are always closely calibrated to the borrower's credit-worthiness.

This principle is so fundamental to the way we think about lending and borrowing that it's disquieting to learn that in the past decade or so, this link appears to have weakened. One measure of this "risk premium" is the spread, or difference in yield, between US treasury securities (generally regarded as the safest kind of debt to invest in), and "junk" bonds, issued by sub-investment grade issuers, and so called because most people don't want the risk of owning them.

There is evidence that the risk premium on junk bonds has sunk to its lowest in 10 years. Last month, investors demanded only an extra 2.69 percentage points in yield on average to own junk bonds instead of U.S. Treasury securities.

There are many reasons for this, including the fact that interest rates in general have fallen world over. However, it does add strong credence to a belief that has been growing in recent times, that risk is being underpriced in the world economy. To be sure, there is a heartening angle to this: financial innovations have thrown up instruments that truly enable risk to be treated in a sophisticated way. But these instruments have also introduced a great deal of complexity, and hence opacity, in the way risk is being priced.

To hear The Economist say it,

"..slicing and dicing of risk using sophisticated instruments such as
collateralised debt obligations and credit default swaps. Banks have used these
to shed credit risk, but it is not clear where all that risk now lies".

Business Week echoes this, saying,

"many are depending on instruments that are highly leveraged, numbingly complex,
and untested by a market downturn".

While underpriced (Cheap) risk is good for borrowers in the short term, in the long term it can undermine the health of the entire financial system. Thus there are good grounds for apprehension as to the robustness of the world's financial markets.

Many subprime mortgage lenders in the US, who have been lending to the riskiest borrowers, are already going belly up.

And there is evidence that world financial markets are jittery. Last tuesday the Dow Jones Industrial average had it's biggest fall since September 11, 2001. This was accompanied by similarly large drops on most of the world's stock exchanges.

That drop was driven by many factors, including a meltdown on the Shanghai stock exchange. But it may just go to show that if you try to defy the laws of economics, the law of gravity may catch up with you.