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Saturday, 6 November 2010

Losing the Lender of Last Resort

Governments Aren't Risk Free

One of the carefully nurtured ideas that sits at the heart of most modern finance is the idea that there’s a risk-free asset that we can retreat to when we lose our nerve. This is the financial equivalent of the philosopher’s stone, capable of saving us when nothing else is.

Almost by definition the lender of last resort is the government and the risk-free asset usually ends up being government backed debt. The only slight fly in this magic ointment is that not only is government debt not risk-free but neither are governments themselves: it turns out they have a nasty habit of not being there exactly when you need them most.

Correlated Chaos

One of the things that became starkly visible in the economic crisis that erupted during 2008 was exactly how much of modern financial theory was built on a single, bad premise. The idea was that by mixing and matching different sorts of financial assets to ensure that they were “de-linked” such that if one sort of asset fell in value another sort would rise, or at least not fall as much, it was possible to manage risk. Ensuring that this so-called correlation was carefully managed would, it was theorised, ensure that impacts on one part of a portfolio would have limited effects on others.

Unfortunately, when the black swan hits the fan, this isn’t true. There are times when nearly everything falls together and the only apparent safe haven is the risk-free asset. This has happened many, many times in the past. In This Time It’s Different: A Panoramic View of Eight Centuries of Financial Crisis the authors, Carmen Reinhart and Kenneth Rogoff, carefully draw out the lessons to be learned if you’re prepared to look beyond the tiny bubble of time in which each of us spends our existence

Frequent Failure

What they find isn’t encouraging. As they show (have a look at Appendix A.3) banking crises happen with alarming regularity – around 120 of them in the last 210 years. Indeed, years without bankers blowing up some economy somewhere in the world are rarer than those with one. Furthermore they suggest is that these problems seem to happen more frequently when it’s easier to move capital around the world: essentially the easier banks find it to invest their funds offshore the more likely something is to go wrong.

The net result of all this global largesse is usually that a government ends up defaulting on its debt as it borrows too much while it’s easily available and is then unable to meet its repayment obligations when times get tougher. It’s harder to find governments that haven’t defaulted than those that have. Some countries have spent more time in default than not: Greece being a particular offender for any visiting Eurocrats wondering where it all went wrong.

Commodity Cycles

This cycle doesn’t seem to change. As the authors remark:
“Capital flow/default cycles have been around since at least 1800 – if not before. Technology has changed, the height of humans has changed, and fashions have changed. Yet the ability of governments and investors to delude themselves, giving rise to periodic bouts of euphoria that usually end in tears, seems to have remained a constant.”
So why does this matter? Well, other than it warns us not to put too much faith in governments – especially those dependent on commodities as Reinhart and Rogoff show that high commodity prices are a prime predictor of future government defaults – it blows a nasty hole in the idea that there’s a risk-free asset that we can all rely on in times of crisis. Moreover, as Aswath Damodaran has beautifully explained in Into the Abyss: What if Nothing is Risk Free? this also does damage to many of the theories behind modern finance.

Risk Free's Risky

At issue is the idea that there’s such a thing as a risk-free asset. Damodaran does a top-notch job of explaining why this is so, and in passing explains modern portfolio theory and derivative pricing into the bargain. This is a rare academic paper that doesn't need deep interpretation, for anyone interested in digging further. In essence, however:
“The existence of a risk free asset is central to modern portfolio theory and the pricing of derivative securities. It affects how companies make investment, financing and dividend decisions and how investors make asset allocation and investment choices. Finally the absence of a risk free investment is unsettling to investors and can have far reaching effects on not only capital markets but also the real economy”.
At root, if there is a risk free asset that yields a return then this is the baseline against which everything else is measured. If an corporation makes an investment which yields less than the risk free asset then it’s a waste of money. Similarly, if an investor doesn’t have a safe haven to retreat to, or a basis against which to measure their returns, then it’s likely that, psychologically, they’ll be far more risk adverse, likely to run for cover at the slightest provocation. As for its impact on portfolio theory … well, read the paper.

When the Printing Press Stops

Now, of course, the default risk free asset is the government bond. Ultimately, the reasoning goes, a government can just print money if it needs to, so an investor can guarantee getting paid even if the value of that money is devalued. The problem is, that as Reinhart and Rogoff have shown, this ain’t necessarily true.

Indeed it’s not even the case that all defaults are on foreign currency debt. Nations will default on their internal debt to their own people if they deem it necessary – sometimes owning the printing presses simply isn’t enough: no less than 23 countries have stopped paying interest on their own domestic debt in the last 40 years, thus beggaring their own people. Unsurprisingly this is less common in full democracies, where voters tend to take a dim view of having their savings purloined by politicians moonlighting as catburglars.

Generally there are a couple of reasons countries choose to default on their domestic debts. Governments don’t always have control of their money supply. Greece, for instance, is now paying the price of delegating financial management to the European Central Bank. They can’t print more money to pay off their own internal debt obligations. Sometimes, however, countries decide to default on internal debts rather than debasing their own currency because it's the lesser of two evils.

Behavioral Risks

Of course, an investor looking for a risk free asset would most likely choose the bonds of their local country. The nasty truth is that such assets aren’t risk free. Now this needn’t destroy the nice models that use the concept of a risk free asset as a basis: it’s perfectly possible to create synthetic versions of such an asset. From a modelling perspective that’s fine, but in the real world where real people make real decisions it’s not so good.

Damodaran suggests a range of possible behavioural effects on investors. Firstly, it’s harder to create a properly diversified portfolio to meet the specific risk profile of an investor – portfolios become more idiosyncratic and, often, less diversified. In essence you end up with more risk even if you don’t want it. Secondly, without having a safe bolt-hole to retreat to investors will generally be more risk adverse anyway – leading to high volatility and lower prices for more risky assets.

Gold Rush?

Intriguingly, it’s also suggested that the lack of a risk free asset won’t stop people looking for one. The consequence of that is that anything that is perceived to be risk-free – and manipulating perception is at the heart of the deceiver – will end up being priced irrationally. There are plenty of people who'd argue that investing in gold is pure speculation, largely triggered by concerns about whether rock-solid government bonds are quite as secure as they seem.

Also, if there’s no risk free asset for a corporation to invest in while it’s twiddling its thumbs wondering what to do with its cash pile it’ll come under greater pressure to give the money back to shareholders. The conclusion is fascinating: if the perception is that there’s no such thing as a risk free asset then investors will want more dividends and less debt in their stocks: suggesting that when governments crumble and bonds default we should see corporations delivering and raising income returns as a response to investor perceptions. Which, frankly, already seems not so far from the current situation.

Related articles: Gold!, Dear Auntie, Why Are My Bonds Bubbling?, Alpha and Beta: Beware Gift Bearing Greeks


  1. -Has anyone ever lost a single penny in U.S. Treasury bills?
    -2008 S&P 500 -37%, bonds +5.2% "...There are times when everything falls together" ?

  2. Has anyone ever lost a single penny in U.S. Treasury bills?

    To quote Reinhart and Rogoff:

    "Several of the sovereign default virgins, notably the United States, qualify as such only because we are excluding events such as lowering the gold content of the currency in 1933, or suspension of convertibility in the nineteenth-century Civil War".

    2008 S&P 500 -37%, bonds +5.2% "...There are times when everything falls together" ?

    Precisely the point: when extreme events occur the only safe haven is the lender of last resort. Supposedly ...

  3. Another pillar of modern finance that holds even less water than the "risk-free asset" is beta. I'm not going to tell you which business school's investments class where I tried to point this out, except to say that it's spelled W-H-A-R-T-O-N. The professor thought I was an idiot, but it turned out that the Nobel Prize winners who dreamed up MPT and EMH were the real idiots.

    Well, maybe not. They made a lot of money. But their ideas were pretty stupid. Oh well, it's beta that's the biggest sin. "Past performance doesn't guarantee future results," but that's just boilerplate, right?

  4. So Carmen and Rogoff are saying that the U.S. didn't default because they took actions that prevented a default? So again...t-bills were risk free.
    If bonds were up 5.2% then everything didn't fall together. So I take your meaning to be that all sectors of the stock market fell including domestic and international.

  5. So Carmen and Rogoff are saying that the U.S. didn't default because they took actions that prevented a default? So again...t-bills were risk free.

    I think they're saying that as far as T-bill investors were concerned they did default, it's just that technically it doesn't appear as such. Either way the investors took a haircut.

    If bonds were up 5.2% then everything didn't fall together. So I take your meaning to be that all sectors of the stock market fell including domestic and international.

    OK, OK, I get it. No, the intention was to point out that in times of crisis the only apparent safe haven is the risk-free asset but that this may be temporary sanctuary. I've modified the text slightly to (hopefully) make this clear. It's actually more complex than this as the last couple of paragraphs make clear: when investors start fretting about the safety of their risk-free assets then stuff like gold starts to soar.

    Generally, though, this blog is regularly read from around 60 countries: not everyone has the default of Treasuries. Sitting in the UK at the moment as the government here engages in austerity measures just as Bernanke floats QE2 I'm not too confident that the purchasing power of my T-Bills is going to hold up, in the short-term, at least. If I was living in the US I'd probably view things differently.

  6. purchasing power, repeat until you get the concept.......

  7. Any government which is fully sovereign in its own currency (meaning it is the sole issuer of currency which is freely floating in the markets), can not default for economic reasons. Any default can happen only for political reasons. This economic fact is the basis for economic models. You can outlaw all rating agencies as criminals. They have no clue as to how to rate political risk in a sovereign country. Nobody knows. And R&R are as clueless as rating agencies. NO, I repeat, NO single country fully sovereign in monetary sense has ever defaulted on its debt denominated in national currency.