oftwominds-Charles Hugh Smith

Risk

You read a lot about risk nowadays--as in "falling risk premium" and "thirst for risk." Why is risk "falling" and why is everyone "thirsty" for more of it? To outline the global nature of the situation, let's look at a story in the May 8 Wall Street Journal: Asia Taps Thirst for Risk:
Onetime Asian corporate basket cases are seeking investors, and foreigners are lining up to buy their stocks and bonds, as hedge funds and institutional investors -- many sitting on cash piles -- scour the globe for new ways to deploy their money.

Leading the way: Family-owned conglomerates whose borrowing binges a decade ago gave them a starring role in the Asian financial crisis of 1997-1998. Among the most recent is the family of Indonesian tycoon Eka Tjipta Widjaja. In 2001, one of its companies, Asia Pulp & Paper Co., was responsible for the largest emerging-market bond default in history: $13.9 billion.

Investors are still trying to get their money back. Nevertheless, last month another Widjaja company raised $540 million in a share placement on the Singapore stock exchange. After the placement, the Widjajas have a 48.5% stake in Singapore palm-oil company Golden-Agri Resources Ltd."

Allow me to summarize. Here are folks with a track record of defaulting on debt, and people are lining up to throw more money at them. Huh?

The reasons why the world is "awash in cash" are numerous--the yen carry trade, the U.S. trade deficit which dumps $800 billion into foreign coffers every year, the high savings rates in Asia and Europe, etc. But this does not explain the complete abdication of caution which now characterizes global financial markets. Here is the reason in a nutshell: free money.

The global money supply has grown by 18% a year for the past four years, even as global GDP growth has averaged about 4%. Clearly, money is being created a rate far exceeding actual economic growth. As a result of all this "liquidity" (cash, cash to lend, cash to borrow), then rates are low.

Let's say you could borrow $1 million for $1,000 a month. Would you be tempted to do so? Hey, why not? Couldn't I just park the million in Treasuries and earn $3,300 a month? That's the "Yen Carry Trade" in a nutshell.

How about buying a "spec home" with no money down, no closing fees and a monthly payment of $750? I mean, what have I got to lose? Nothing! If I can flip this house in six months, I've risked absolutely no capital and stand to pocket a hefty gain. That's the speculative housing market in a nutshell.

What if someone handed you $100,000 in free gambling chips at a casino. Would you play the "safe" game of blackjack, or would you be tempted to "try your hand" at the high-risk, high-return games like roulette? Most people would feel free to "risk" some "free money" on high-risk games because the perceived risk--hey, it's not even my money! If I lose it all, so what?--is near-zero.

When anything is free, it's wasted, squandered and risked without caution. Garrett Hardin's classic paper The Tragedy of the Commons, (Wikipedia entry) outlines how "the commons" of air and water become polluted--they're "free" to each individual. Those with gold-plated healthcare insurance pay nothing for every doctor's visit and every drug prescription, and lo and behold, they go often and take a staggering amount of medications. Those who pay cash for care and medications go rarely and use little.

We as a people have squandered $1 trillion in Iraq and hundreds of billions of borrowed money--"free" because you don't get the interest bill--on one fiasco after another. Frequent contributor Michael Goodfellow sent in this interesting blog on Iraq and New Orleans: New Orleans Isn't Very Different from Baghdad!

So how long can the global orgy of "free money" "invested" in risky bubble markets continue? That is unknown. We do know one thing: the misallocation of so much capital on such a stupdendous scale is setting the stage for financial losses on a scale previously unknown and currently unimaginable.

We are seeing the very first tentative tremors in the inverted global debt pyramid. Here in the U.S., it's the meltdown of subprime lenders--and those who bought that risky debt. For a look at the aftermath of one subprime mortgage lender, frequent contributor U. Doran recommended this article from The New York Times: A Cross-Country Blame Game: (free registration may be required)
"Visitors to Ownit Mortgage Solutions’ offices here are met by an abandoned reception desk and three dying potted plants that appear to have gone months without water. How appropriate.

Ownit filed for bankruptcy protection late last year; since then, several companies that specialized in loans to people with weak, or subprime, credit have followed it into bankruptcy as the once-thriving business has withered on the vine. Gone are the lavish parties, the extravagant trips and the executive salaries and sales commissions that routinely topped a million dollars.

Lenders like New Century Financial and Ownit, many of them based in Southern California, have cut an estimated 12,000 mortgage jobs in California since the start of 2006, according to MortgageDaily.com, a trade publication. Nationally, 16,000 jobs have been lost. What used to be a profitable partnership between subprime lenders and Wall Street banks has now degenerated into a cross-country blame game."

For another expose on how little risk management was performed by subprime lenders, Michael Goodfellow recommended this article from The Washington Post: Pressure at Mortgage Firm Led To Mass Approval of Bad Loans.

If you want to see an actual prospectus for a derivative, U. Doran kindly sent in the description of the beach-party-fun named Surf 100 AAA/AaaCPDO: A Breakthrough in Synthetic Credit Investments and this dated but still incisive report from the Brookings Institution: Somebody Turn on the Lights (November 1999).

Several readers (U. Doran and Cheryl A.) recommended this piece as well: Derivatives: Glowing Revelations.