Monday, May 3, 2010

Risk avoidance vs Risk spreading

By now there is every chance that you have heard of credit default swaps, the instruments at the heart of the financial crisis of a year and a bit ago. Unless you are like me and the Tamil movie scene, that is – surely I must be the only Tamil in the world who hadn’t heard of Asin (for non Indian readers, this lady seems to be the Tamil equivalent of Zhang Ziyi/ J Lo (?) ). So I can’t say that there you cannot, but, have heard of that silly acronym CDS.

All derivatives, like credit default swaps, spread risk around; they don’t reduce or eliminate it. Most derivatives are fiendishly complicated, so much so that the most simple and basic derivative, which would surely tax the intellectual powers of the aforementioned Asin, is called “plain vanilla” by the geeks. But all they do, for their incredible complexity is play pass the parcel – they simply pass the risk to somebody else. Or chop it into individual bits and toss the bits around. Or find all sorts of devilish ways to spread it. But its all just a form of pass the parcel.

There isn’t enough done to avoid or mitigate the original risk in the first place. The analogy is one of taking a fire insurance in your house, feeling very safe and secure and then stuffing it with propane and smoking next to it. What about fire avoidance; what about fire fighting equipment; what about safety measures; what about fire alarms ……

Derivatives bring a false sense of security to the people who take the risk in the first place. Just because they have passed the risk around, they feel safe. And since the original transaction has been decoupled from the derivative, the focus of risk avoidance on the original transaction seems to fall. Therein lies the great danger. Risk has actually increased because of a false sense of security of having passed it somewhere else. The risk has not gone away, its just floating in bits and bobs all over and if it bursts, its effect overall would be almost the same as if it hadn’t been spread around.

Having spread the risk, you are tempted to take more risks, on the security of being able to pass that around too. This creates a domino effect and the total risk in the system exponentially increases. Under normal circumstances , this doesn’t matter – some punter wins and some other loses. But if a tsunami starts, it becomes a massive destructive force that can almost destroy nations, as the crisis in 2008 demonstrated. Little wonder that the inimitable Warren Buffet called derivatives as weapons of mass destruction some years ago.

It’s a little bit like this. Lets assume the fabulous Asin decides to produce and star in a new movie – lets call it “Gilsa Zenova” – just for illustrative purposes, OK ? There’s a high probability that the movie will flop and that the two featured gentlemen will write a review in their blog praising her beauty but panning the movie. So what does the lady do ? She goes out and buys an Movie Flop Swap – a derivative that says RamMmm, Ravi, Kiwibloke and such other wealthy punters shall pay her $1m if the movie flops (added bonus; she’ll have dinner with these three before they write the cheque). Now that the damsel is safe (at least monetarily), it does not mean that she should not make some attempt at getting a decent story, some attempt at getting a passable hero (a slimmer version of Vijay, I am told, will fit the bill), put a little vigour in the dance, a little more speed in running around the tree, a little more rouge on the cheek, bat the eyelids a few more times, perhaps shed a few pounds despite the fondness for buxomness ……….

Get the picture (pun fully intended) ?