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| Restating your PnL? WTF!!! |
We all know (or should
know by now) that when the revolution finally comes all manner of folks will be
put against the wall. Now, the big fear I have is that no one is going to
ensure that risk managers are rounded up and get their dose of revolutionary
fervor. The problem is that it’s just that is an occupation so obscure that the
average neo-communist revolutionary / not-so crypto idiot with an AK-47 will
simply fail to spot what reactionary fiends of the night / capitalist
technocrat lackeys risk managers really are.
But why the special
attention to risk managers I hear you ask? What makes them so deserving of
revolutionary wrath? Well, basically because they don’t really do their job!
The point of a risk managers’ existence is ostensibly to ensure that a bank’s
risk book is run within parameters that ensure the risk reward ratio is
acceptable and that book is actually valued sensibly in accordance with a
pricing policy. And that’s exactly what I’m going to moan about today. The fun
and games that kept all manner of financial type and politicians awake over the
last couple of weeks have given ample illustration that these risk books are
still very much marked not to some rational or even just explicable standard
but basically marked to some make believe figures that ensure we all get paid
at the end of the year.
The proof? Enter the
retardedness that is the inverted CDS curve. Basically, in financial market
parlance an inverted CDS curve is taken to be a reasonably sure-fire sign that
a financial entity (i.e. the one the CDS in question relates to) is in DIRE
TROUBLE and likely to IMPLODE. Why? What does that all mean? Well, a CDS curve
consists of a series of points (spreads) that express the expected default risk
of a financial entity between now and a future point in time. In more orderly
times a CDS curve is upward sloping, that is the spreads (and with it the
implied likelihood of default) increase the further your time horizon reaches
into the future. Which kind of makes sense. All things being equal the second
law of thermodynamics (among a few other things) would indicate that the longer
something goes on the more likely things are to fall apart. So what happens
when markets are in distress? The reality is that when sentiment turns against
somebody (like the US Government during the unspeakably childish debt ceiling
squabble in Washington DC) you’ll find it hard to execute trades with longer dated
maturities. People simply don’t want to take on the risk of longer maturities.
At the same time the nearer dated maturities (that you still can get a
quote for) will command a higher risk premium, so the spreads will rise. Now,
by convention the maturities for which you can’t get a new price will be simply
be staled (carried forward from whenever you last got a quote for them) while
the shorter maturities for which you still can get a quote will rise. So what
can happen in this particular scenario is that you can get an ‘inverted’ CDS
curve, where the nearer dated maturities have a likelihood of default that is
higher than the further dated ones. Fair enough you say? You might think so;
after all it would look like you are making use of the most recent data that
you have to build that curve. So what’s the harm? The harm is that those curves
are used to price existing CDS transactions on banks’ books and that’s just
plain retarded. Think about it: the risk of a default occurring between now and
a future date as expressed by a CDS spread is a non-Bayesian event. The
timeline observed for the determination of a credit event (default) is
continuous and once the event occurs it will trigger ALL Credit Default Swaps
that are referencing this particular reference entity. So there is something
deeply and disturbingly wrong with a situation where you have a curve that
would imply that the one-year default risk of a company is lower than the five-year
default risk of the same company. While I agree that this topic has distinct
overtones of needless sophistry / intellectual masturbation about it, it
actually is a pretty good indication of what is wrong with modern finance. It’s
a bit like that early morning nose-bleed so prevalent among punk bankers and
almost-made-it rock stars; not exactly shocking in its on right but clearly
indicative of a big old problem. Something is indeed rotten.
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| James Hetfield totally rocks! |
So, to come back to my
point about why risk managers need to be brought to the front of the queue when
the masses rise up against the system: What does that have to do with inverted
CDS curves? It’s simple, it’s those guys that are using just those curves to
value the credit books, thus plainly misstating the true value of said book (or
lack thereof!). Strangely enough there is zero outcry over such egregious use
of sleight of hand accounting to give the illusion of greater stability in the
financial system than there really is. I doubt that is because the issue is too
difficult to grasp. It really isn’t. But it is sufficiently obscure to be swept
under the carpet. It’s not exactly something Robert Peston will be able to
blitz the BBC Newsnight viewers with in a 90 second sound bite designed to
excoriate bankers and whip incredulous middle-class viewers into a frenzy of
polite incredulity. In a nutshell, if your job is to manage risk, you probably
shouldn’t be in the business of downplaying the volatility of a risk book. But then
again that’s probably saying more about the way incentive compensation is
calculated than what is truly sane. Never mind. Move on, nothing to see here. Go back to shopping for some Apple products.
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