Agcapita Update
December 2011
Agcapita Update
“Never, ever take counterparty risk. It is the one risk you are almost
never rewarded for taking.” Joshua Brown summarizing a recent
presentation by bond guru Jeffrey Gundlach. Sage but largely
unheeded advice as the emerging winner of the “Unexpected Risk
of 2011” competition is surely counter-party risk.
For the longest time, counter-party risk has not been something
that the average investor gave much consideration. State backed
financial insurance schemes and the ostensibly strong balance
sheets of financial service providers combined to create an
unwarranted sense of safety. Lets address these two supposed
bulwarks in turn.
– State backed financial insurance schemes are insufficient
to protect depositors/beneficiaries from a systemic crisis,
particularly a crisis of sovereign solvency. If state funded
schemes could protect from a sovereign default we would have
discovered something akin to perpetual motion in the form of
the insolvent bailing out the insolvent.
– It is increasingly apparent that many financial intermediaries
only appear to be well capitalized because risks, where
apparent, are thought to be hedged/offset via a range of
derivative instruments - CDS, interest rate swaps - the list goes
on. Via such hedge transactions, intermediaries argue that net
exposure, rather than gross, is the key measure for investors to
consider.
Though not entirely accurate, I would suggest that this reasoning
is akin to building a larger and larger pile of gunpowder kegs while
at the time stock-piling fire extinguishers so as to try to make the
argument that while a large pile of gunpowder might be unsafe by
itself, a large unsafe pile behaves like a small safe pile if you can
put out the fire in time - maybe, maybe not.
If recent events have taught us anything it should be the obvious
principle that hedging cannot eliminate risk, it can only re-allocate
risk - an important distinction. Whether because this has been
conveniently forgotten or perhaps willfully ignored, there has been
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Agcapita Update (continued)
a tendency for some entities to take concentrated capital goods, and the greater the need for liquidation
gross positions in certain risks with the view that of these unsound investments. When the credit
any unwanted/excess risk can be reduced at any expansion stops, reverses, or even significantly slows
time via hedges rather than an outright reduction down, the malinvestments are revealed. [Ludvig
in the underlying position itself. However, recent von] Mises demonstrated that the recession, far
events prove that where there is a concentration of from being a strange, unexplainable aberration to be
risk in critical counter-parties (e.g. AIG), in a world of combated, is really a necessary process by which the
high positive correlations across markets and asset market economy liquidates the unsound investments
classes, hedges can fail leaving catastrophic gross of the boom, and returns to the right consumption
rather than net exposure behind. / investment proportions to satisfy consumers in
the most efficient way. Thus, in contrast to the
When losses arise - e.g. Greek defaults - some interventionists and statists who believe that the
participant(s) in the system must ultimately suffer government must intervene to combat the recession
those losses. In such a structure if a critical counter- process caused by the inner workings of free-
party fails - and of course they do - the concentration market capitalism, Mises demonstrated precisely the
of risk starts to increase unexpectedly and the opposite: that the government must keep its hands
magnitude of the true losses is revealed suddenly. off the recession, so that the recession process
can quickly eliminate the distortions imposed by the
Financial entities continue to report on net rather government-created inflationary boom.”
than gross exposures for risk purposes. Investors
need to be alive to the issue that the net position So by preventing the timely and orderly liquidation
may not reflect the true risk if there is tendency to of mal-investments, government intervention
strong themes amongst both the entities’ and their allows them to accumulate to catastrophic levels
counter-parties’ positions - e.g. we don’t think Italy creating the raw material for a highly unstable
will default. Ask account holders of MF Global how and discontinuous financial system. In such an
they feel about unexpected counter-party failure and environment “sudden and unexpected losses” occur
the efficacy of financial risk reporting. with alarming frequency.
Why are apparently solvent institutions suddenly It is because we believe that counter-party risk
subject to failure? The late economist, Murray remains opaque and non-trivial that a key part of our
Rothbard provides a simple and compelling answer investment approach is to find assets that capture
with the concept of subsidized malinvestments our desired returns but as much as practical eliminate
accumulating in the system: or reduce counter-party risk - e.g. direct ownership
of a diversified pool of physical commodity production
“The longer the boom of inflationary bank credit assets rather than the commodity futures to capture
continues, the greater the scope of malinvestments in those returns.
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