How can you dislike any column which includes the word "importunate"?
John Kay’s latest
column is yet another salvo in the war against securitization, however,
and despite his eloquence I’m afraid he’s misguided. Here’s the nut of his argument:
The risk characteristics of a bet can never be eliminated, but can be changed
by division and aggregation. In every B-rated bond, there is A- and C-rated
paper waiting to get out. Discard the C and your B has become an A.
This scheme works, but at a cost: in an efficient market, the value of the
risk reduction will be precisely offset by a reduction in return.
Kay compares the investment banks behind securitizations to alchemists, who
"created" more gold in the world than had ever been mined. "And
so it came to pass," he says, "that the volume of investment grade
securities far exceeded the value of investment grade credits."
And there he leaves it. But in fact, his conclusion is the very reason why
securitization does work.
Think, for a minute, about your average bond investor. There are many fewer
bond investors than there are stock investors, so you might not know very many
of them. But they’re not typical investors, by any means. They’re extremely
risk averse: if they buy a bond at 99 and it falls to 97, that constitutes a
catastrophe in their world, while it would be completely normal volatility for
a stock investor. What they are looking for is safety, and guaranteed returns.
Now the main skill of bond investors is to manage interest-rate risk. When
rates rise, the value of bonds falls – so a bond investor’s biggest fear
is always that yields will go up. And bond investors are typically so concentrated
on managing interest-rate risk that they often don’t want to worry at all about
other risks, like credit risk – the risk of default. As a result, there’s
enormous demand for AAA-rated securities – bonds which have a negligible
probability of defaulting. Indeed, that demand vastly oustrips the natural supply
of such securities – bonds issued by a handful of large industrialized
nations, and a few other entities such as the World Bank or UPS.
When you have a systemic excess of demand over supply, that’s precisely the
point at which markets are no longer efficient. And indeed that’s what’s happened
in reality. AAA-rated bonds, it turns out, yield much less than the mere reduction
in credit risk can explain on its own. If you take a small increase in credit
risk, and buy AA-rated bonds instead, then you have historically been able to
get a much higher return – even after accounting for defaults.
Enter the alchemists. By splitting a B into an A and a C – or, more to
the point, into a AAA and a C – you get to tap the demand for AAA-rated
securities, which is unquenchable by natural supply. Because your synthetic
AAA is hard to understand and illiquid, it will yield more than a natural AAA
like a Treasury bond. But even so, you’re taking advantage of a natural market
inefficiency, and everybody wins. The investors get the AAA debt they crave,
and you get more for your AAA and C combined than you would for just the B on
its own. Sometimes the parts are worth more than the whole.
Now the investors are taking on risks, buying synthetic AAA bonds, which are
not present in natural AAAs. The main one is market risk: the risk that the
value of those bonds will fall dramatically. And there’s also the risk of human
error: that the people who carefully structured the AAA bonds to be bankruptcy-remote
got confused, and made
mistakes, and ended up creating a security with a higher risk of default
than they originally intended.
But the underlying arbitrage – the reason why it makes sense to create
AAA securities in the first place – remains. The bond market, dominated
as it is by risk-averse bond investors, is simply not a perfectly efficient
market. And securitization can help to arbitrage some of those inefficiencies.