Financial Innovation

The Risk Business December 30, 2006; Page A10

The Dow Jones Industrial Average closed yesterday near an all-time high, up 17% for the year. Long-term bond yields rose this year but remain remarkably low given the Federal Reserve's short-term rate ratchet to 5.25% from a low of 1%. Economic growth has slowed but remains solid. And by some measures financial market volatility is at lows not seen in a decade -- the Dow, for example, is still adding to its longest stretch (910 days) without a one-day decline of 2% or more since 1900.

All of this stability naturally fills people with dread. It has led to a round of questioning about why, in an undeniably dangerous world, risk premiums seem to have drained out of whole classes of financial assets. Has Mr. Market become complacent, and so set himself up for a fall? What is everyone missing?

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Financial Risk: Where Has It Gone?¹

When someone tells us that the old rules don't apply anymore, we tend to check our wallets. But this is not to say that nothing ever changes. One of the things that has changed over the past 30 years is the extraordinary extent of financial innovation. When it comes to the decline of risk premiums and financial stability, securitization and the use of derivatives have both played an unsung role.

The very word "derivatives" produces a remarkable range of reactions, not all of them polite or rational. Warren Buffett has long described them in apocalyptic terms. Regulators think "risky" and dream of untilled pastures to monitor. The average newspaper reader, meanwhile, sees the word and understandably moves on to the next story.

Derivatives can be very complex, but they are fundamentally a tool for hedging financial risk. Say your business has borrowed money with a floating interest rate. Rates go down, and you decide you'd rather lock in today's rates than risk having them move against you in the future. You could borrow new money at a fixed rate and pay off your debt.

Or you could engage in a form of derivative known as a "swap." In a swap, you exchange your obligation to pay a floating rate for a commitment to pay a fixed rate of interest. Your actual debt doesn't change, but the other party in the swap has contracted with you to pay you the difference between the floating-rate interest and the fixed rate you've agreed upon -- if rates move higher. Likewise, if rates go down further, you would pay your swap counterparty the difference.

Through this basic mechanism, all kinds of risk in an economy can be shifted around, often to everyone's benefit. The risks haven't disappeared, but almost by definition they tend to shift toward whoever feels they can best bear them. Perhaps, in the example above, the counterparty has a reason for wanting exposure to interest-rate movements. Perhaps he has a risk of his own he is trying to mitigate. Perhaps he simply disagrees about where rates are going.

Take another, very real, example of a small-town bank in the mortgage business. By the nature of things, it is heavily exposed to the shifting fortunes of the local economy. If a plant nearby closes, it could be hit with defaults that could overwhelm its capacity to lend. To compensate for this risk, it may raise interest rates, or lend less, or both. But suppose it can sell the mortgages on its books to another bank or some other party. It gives up the income from the mortgages, but it gets new capital in return while also lowering its exposure to the local economy.

The purchaser may then hold the mortgages, or package them into securities with thousands of other mortgages and sell them to investors. These "securitized" mortgages are less exposed to any one town than that small bank was, which may make the security less risky overall. The small bank, meantime, has more money to lend, or to invest in assets that are less likely to crash along with the local economy. The buyers of the securities get the income from the mortgage interest and the bank gets money to lend.

The sum of a myriad of these transactions over the economy means that everything moves a little faster. Credit becomes marginally cheaper and more plentiful. Risk is dispersed to those who feel they can better afford it. Thus does the supposedly non-productive financial sector of the economy provide fuel for future growth. Seemingly obscure transactions lower the cost of capital to businesses and consumers and spread risk in a way that decreases the danger of catastrophic financial accidents.

None of which means financial accidents won't happen. Market players sometimes bet wrong -- there are always two sides to a transaction, and one party can always miscalculate its ability to withstand an adverse event. Just ask the investors in Amaranth Advisers, which bet wrong on energy prices.

More broadly, danger always exists from abrupt government policy shifts, especially from monetary mismanagement; think of the Asian crisis of the late 1990s. Another such danger can come when government subsidies push too much risk from a single sector such as housing into just two companies (Fannie Mae and Freddie Mac). Two of the biggest current risks, in our view, are the chance of U.S. tax increases and that the Fed may still have underestimated the inflationary pressures it let loose in 2004 and 2005.

But these are not reasons to fear derivatives and other financial innovations. Risk is still out there. But as we leave a successful financial year and enter a new one, take comfort in the fact that all that buying, selling, swapping, trading and securitization of risk has actually made the financial system less risky.

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