Risk In Finance

In a departure from my normal themes of Technology, and other useless products, I’m turning my attention to the Financial industry.

As a System Administrator, my job is to hedge risk every day. If something goes wrong, it’s my job to fix it, therefore its in my interested to minimise risk.

The risks I deal with are with real things, with absolute outcomes. If a disk dies in a raid, it needs to be replaced, otherwise data might be lost.

The very foundations of Finance are built on sand

What do I mean by that? Finance is built on the concept of value, or worth. “How much is this gold worth?”, “how much is the client willing to pay for this service?”

The concept of value and worth are subjective. They are in the eye of the beholder:

If you ask a thirsty backpacker stranded in the middle of the Sahara:
How much are you willing to pay for a 2 litre bottle of water?
The answer, most likely is many monies & possible limbs.

Now trying flogging the same water to city trader in a champagne bar.

I can hear you scoffing, “Oh but that’s a silly example, the backpacker was practically dieing” Correct, worth is subjective. Its based on your circumstances. There are many other examples, the Turner painting in a jumble sale, the sale of a sports car when the wife becomes pregnant, etc, etc.

Yes, but you’re still talking bollocks.

Your observations are correct. Let me explain a little about the sub-prime mortgage crisis.

Sub-prime

First, lets get a glossary:
* Mortgage: A loan secured against a house
* Sub-Prime Mortgage: A high risk loan issued to a person who is at a high risk of default
* Asset backed Security: A contract that provides regular income, derived from the assets attached to it(either a loan or rent)
* Derivative: A contract used to provide a specific price or income for any given condition. (see futures)
* Futures: Selling a future product or service at a price agreed today, (for example buying potatoes at £5 a ton, even if there is a drought)
* Mortgage-backed security: a group of mortgages bundled together

The origin of the sub-prime crisis is simple. Mortgage lenders realised that they could make more money by selling off Mortgage backed securities than holding the mortgages themselves.

Instead of holding on to the mortgage for its entire lifetime, and profiting from the monthly income, they realised that they could bundle up a bunch of mortgages, and sell them off to other investors looking for a product that provides a monthly income. These bundles are known as Asset Backed Securities.

The mortgage company now gets a lot more money up front(all its original money, plus a commission). Not only allowing more mortgages to be sold, but drastically limiting the exposure to long term risk. This means things like honeymoon offers make much more sense, especially if your not holding the debt when the interest rate suddenly spikes.

Pick and Mix

Obviously no-one in their right mind would buy a bunch of mortgages for people who have no chance of paying them back. The solution? Pick and mix. The solution is brilliantly simple: mix high quality, low risk & yield mortgages in with some high risk, high yield as well.

This is actually a good idea, its a way to hedge against local problems. (factory closures in one town etc.) It allows the investor to limit the risk they are exposed to, whilst potentially gaining at the same time. Much like homogenised milk, a small percentage is bad, but its blended in with the rest so you don’t really taste it.

Those of you who are sysadmins, will instantly see this as a RAID type arrangement. In the finance world it comes under the broad term of Derivative.

Trust me, its good eating.

To help investors root out the wheat from the chaff, ratings agencies rate products according to a few factors; risk, long term outlook, etc. The general idea is that the ratings agency digs deep into each product and looks at the makeup to see how risky or valuable the product is.

However, because the people paying the ratings agency were also the people selling the product. There was a conflict of interest. It wasn’t in the interest of the agency to actually bother to give a true rating.

This meant that derivatives made up of mostly sub-prime chaff were given a rating only meant for high grade/low risk investments.

Do some research.

Now, if these derivatives were being sold directly to grannies, I could have some sympathy. However, the people buying them were professional investors. The whole point of their professional life is to seek out investment opportunities and exploit them. This involves research, and crucially balancing risk.

The Crux

Its hard not to draw the conclusion that people trading in these financial instruments fall into three categories:

  1. To lazy/stupid to bother doing research
  2. To greedy to balance the risk
  3. Knew full well what was going on, and was playing a very large game of “cheat”

The outcome of all three is still the same. These instruments were traded until people started to figure out that they were effectively horse shit. When people lost confidence the value dropped. Because so many were sold, and the values were so vast, it undermined the value of many other products. Whats worse, the products that were supposed to counter the risk of sub-prime derivatives were also similarly floored.

Conclusion

Money, Gold, Shares & handbags are only worth something because people are willing to spend money on them. The value attached is subjective. The Financial “Market” is a glorified game of “cheat” where traders exchange cards pretending that they are worth a certain amount. Most of the time everyone agrees, however every now and then, with depressing regularity someone twigs that its all a bit silly.

Take for example currency. The value of the dollar relative to the pound fluctuates based on the collective whim of those who trade. Elections, scandals, GDP data all of these affect value. If value was anything other than subjective, one could argue that the relative price would never change.

This partly explains bubbles. Like good stories, bubbles require the suspension of disbelief. Twitter loosing $162 million on $436 million of revenue in just one quarter justifies a market capitalisation of ~$23 Billion(as of 09 June 2015)

Snapchat, a service with no revenue, is rumoured to be worth $10 Billion. It literally pisses money away.

Logic would say that this is a bubble. However the traders might be lucky, they might be able to place a 4 of clubs whilst shouting about how they’ve just laid a Queen of diamonds.

Leave a Reply

Your email address will not be published. Required fields are marked *