Repricing of risk is a fig leaf. Or how the suits ravaged the financial markets — yet again

Is this ‘Risk’?

My question is: is this fall really about risk repricing or is the phrase merely a fig leaf? Going back to Finance 101, I recall that risk is something that can be priced. Our friends in the insurance sector would vouch for that and deliver complex equations to show just how. If the industry can sell health, earthquake, keyman, kidnapping or currency fluctuations, it can well insure — and price — any risk, including the current one. “Risk,” as Frank H Knight noted as far back as 1921 in Risk, Uncertainty, and Profit, is when “future events occur with measurable probability”. The keyword here is ‘measurable’.

The next question, therefore: was the subprime mess and the resultant meltdown measurable? I think not. Does anyone know the extent of the subprime fallout? No. Experts put the figure between $50 billion and $500 billion. As a corollary, does anyone know its impact on house price crash? No. According to research by international macroeconomics expert Nouriel Roubini, professor of economics at New York University’s Stern School of Business and chairman, RGE Monitor, the fall could be 10 per cent. Others throw different numbers.

Or ‘Uncertanity’?

What are we dealing with? The answer: uncertainty, defined by Knight as the likelihood of future events being “indefinite or incalculable”. When the impact of an event is incalculable, it can no longer be priced. Generally, ROR is a calculation by global funds to see how much risk they can take to get the higher returns from emerging economies like India, Brazil, China, Turkey and Russia. If the FED raises rates, ROR is calculable. At 5.25 per cent, the US risk free return is higher than India’s 5 per cent India’s markets are offering (risk, in this case, defined as the inverse of PE which stands at 20).

The question these funds will be asking is: why should a leveraged investor borrow money at over 5.25 per cent to invest in an asset (Indian market) that’s sub-5 per cent? The answer can be given only by those investors, but when the money is borrowed, it’s not answers lenders look for but returns or at least returns-free capital. This repricing began over the past two years when the FED raised interest rates to control liquidity and other central banks followed. Repricing was possible, ROR was calculable.

It worked like this. When borrowed funds entered asset markets like real estate or equities, the risk these funds carried was significantly higher than that of a long term investor. That’s because every day, the interest meter was running. Which was fine as long as the markets were rising. But at first sign of trouble, short term volatility often meant losses for these funds. They could not afford to hold on to equity assets when they fluctuated downward by 2-6 per cent a day. To long term investors such a fall is an opportunity to buy; for short term investors it is time to sell. The maths for the two investors is not only different but often in the inverse.

Mission impossible

But how do you calculate the extent of damage you don’t know, can’t know? We are in the realm of uncertainty, says Roubini, where not only do we not know the extent of subprime losses, but equally about its impact: “The current market panic has to do with unpriceable uncertainty rather than measurable risk.” This uncertainty is impacting the financial sector, one sub-sector at a time — hedge funds, banks, asset managers. The uncertainty is about geography as well, one country at a time — beginning with US, then France, Germany, UK, Asia… every day a new landmass. Show me a person who can price that.

The market as a whole might as it assimilates crumbling bits of information that flow as an aftermath. But again, either real-time or on hindsight — not as a forecast, as the suits pretend. All this and then some is what the suits who took risk with other people’s money are banding about and repackaging as ROR. My opinion: the big boys of finance stepped a little too far, hid a little too much and after edging their way out of this crisis, as they have in the past, will return with new-fangled ‘innovations’ to smother public money and memory with. A forecast: be prepared.

Lesson for regulator

There are lessons for global regulators too. They need to allow each and every innovation – howsoever inane or exotic it may sound — to come through, but insist on the one word that will drive ‘uncertainty’ out of the market and bring in a tamer animal called ‘risk’: Transparency. Much of the current problems are because of the opaque nature of CDOs (collateralised debt obligations) that allowed bad debt to be packaged as good and lack of information about the underlying.

Meanwhile, do not assign a moral motive to this fall. Smart banks lent to those who shouldn’t have been borrowing — seeking a higher return (SAHR). Smart suits packaged that lending into financial products — SAHR. Smart rating agencies rated them as AAA —SAHR. Smart money bags bought those products — SAHR. The only thing that seems certain in this immensely uncertain financial universe: whether risk can be repriced or not only time will tell, but smartness has a cost.

Coming to India, what will a fund that has borrowed cheap do when because of bad structuring or mis-rating of the underlying debt, the bank calls the money back? The short answer is sell — if its portfolio has doubled in the interim it would sell half the amount to make good; if it has grown 50 per cent, it would sell two-thirds and so on. It is not that overnight, Tata Steel, Hindalco, Reliance Capital or over a 100 companies that have lost more than a fifth of their values in this carnage, have become a less attractive. Ask the sellers and many will bemoan

the sell calls.

Opportunity for investors

Long term investors, who can hold on to their investments as they fall since there is no tearing hurry to sell, can turn this meltdown into an opportunity. Fundamentally, there is nothing in this fall for Indian investors to be worried about – the economy is doing very well and as it creates and rides infrastructure investments, growth is likely to continue for many years. This growth will be driven by efficiencies that will get created through faster movement of goods on better roads, faster turnaround time at ports, cleaner and more predictable power and so on. These efficiencies will finally show up in the balance sheet.

The current problem is liquidity-led. Since liquidity is determined by speculators and leveraged investors, it is and will remain a short-term phenomenon. But this is also a good time to understand the role of and give credit to speculators — it is they who provide the much needed liquidity to markets and the current fall will show us just how important these economic agents are to the smooth functioning of markets. This fall in liquidity may last two to six months, during which the importance of speculators will present itself through yet another entity called spread, which is the difference between a buy-sell quote — it will rise during this period. And once uncertainty has been replaced by risk, global money will return to India.