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Risk Management

12:20 PM

The 27-Year-Olds Are Taking Us Down (Again)

The young financiers making the mistakes change but the flaws in the incentives and risk models at the heart of the global financial system remain basically unchanged.

The 27-year-olds making the mistakes change but the flaws in the incentives and risk models at the heart of the global financial system remain basically unchanged.

Calling them 'mistakes' is charitable, as they are actually systematic and predictable exploitation of loopholes by employees without sufficient skin in the very risky game they are playing.

Here is the game, as it was played in 2008 and as it is being played now: work for a financial firm, sell insurance against an event the probability of which, while rare, is underestimated by your firms' models. Sit back, collect the premiums, appear to be "beating the market", and be paid accordingly. If the rare event does happen, and it likely will before your firm has been fully compensated, off you go with your pay, leaving investors and regulators to clean up the mess.

If you think that model is all in the past, get a load of what billionaire hedge fund manager Kyle Bass has been buying from banks which ought to know better.

Bass, speaking at a forum last week at the University of Chicago's Booth School of Business, detailed how he has been making large bets with banks, at very cheap prices, which will only pay off if Japan's creditworthiness disintegrates disastrously within a year of when the wagers were made.

Bass's thesis about Japan - that its debts are unmanageable and new policies will backfire - is interesting but not what I want to consider here.

Let's concentrate instead on Bass's account of what he is buying and why the banks are selling.

"I have 27-year-old kids selling me one-year jump risk on Japan for less than 1bp - $5bn at a time. You know why? Because it's outside of a 95% VaR, it's less than one year to maturity, so guess what the regulatory capital hit is for the bank? I'll give you a clue - it rhymes with hero," Bass said.

Unpacking that, Bass is saying he's buying contracts which only pay off if Japan jumps to default, or something very near, within the next year, paying only 1 basis point, or $0.0001, for every dollar of potential payoff. The bank is making the bet, Bass says, because its own and its regulators' risk parameters consider the possibility to be vanishingly small (where have we heard that before?) and so allow it to make this kind of bet without putting aside any extra regulatory capital.

That kind of bet is very profitable from a return on equity point of view because extra revenues don't create any extra capital costs.

"If the bell tolls at the end of the year, the 27-year-old kid gets a bonus, and if he blows the bank to smithereens he got a paycheck all year. We are right back there. The brevity of financial memory is about two years," Bass said.


Is Japan going to jump to default in the next year? Probably not, but I'd argue that the answer is almost irrelevant. It doesn't have to be Japan and it doesn't have to be this year. As long as banks allow employees to create a stream of income for themselves by collecting premiums on low-likelihood events as if they were impossibilities we will have systemic risk, we will have added taxpayer burdens and we will have the systematic picking of shareholders' pockets.

The same thing is true with hedge funds, many of which are essentially playing the same game, but to their credit it is generally only their clients who get stuck with the bill.

Bass, by the way, says he's bought $500 billion of this kind of thing from various sellers and that recently a bank counterparty, having thought better of it, was encouraging him to sell some risk back.

Federal Reserve Governor Jeremy Stein mentioned essentially the same dynamic in a speech last month, explaining that a fund manager can appear to beat a benchmark, like the S&P 500, by selling insurance against it falling sharply, creating steady income so long as we don't have a crash.

"Of course, put-writing also introduces low-probability risks that may make you, as the end investor, worse off, but if your measurement system doesn't capture these risks adequately, which is often difficult to do unless one knows what to look for, then the put-writing strategy will create the appearance of outperformance."

The brilliant thing about this strategy is that many of the people employing it don't actually understand that is what they are doing; they simply think their risk model is more accurate and are all too willing to cry "100-year storm" when it all falls to pieces. That's why so few of the people who profited from the good times can see how they helped to create the bad ones.

To judge by Bass's account the measurement systems haven't improved since the great financial crisis and the incentives haven't really changed.

It may not be this year, and it may not be Japan, but sooner or later we non-27-year-olds will be paying the price. (At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at [email protected] and find more columns at https://blogs.reuters.com/james-saft)

(Editing by James Dalgleish)

Copyright 2010 by Reuters. All rights reserved.

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