Another paradox: risk aversion is easily solved

The FT's Market Insight column from a couple of days ago contained a reference which at first I skimmed over with barely a glance:
"[bankers] feared that public sales would produce painfully low prices. That is a valid fear. After all, there are very few investors in the system right now with any appetite or capacity to take risk."
A rather orthodox assertion and hardly worthy of note, thought I.

And yet - a little thought shows that the riskiness of an investment is not only a characteristic of the underlying asset itself. Recall that, just a year or two ago, lots of not-very-risky assets with unexciting yields were being converted into riskier, high-return instruments by the simple trick of leverage. Borrow £200,000 at 4%, bung in £10,000 of equity, buy £210,000 of property or shares yielding 5%, and your £10,000 of cash magically earns a return of 25%, in return for a vast increase in risk.

But the same trick is even easier to do in reverse. Let's say you are offered the same £10,000 investment described above - returning 25%, but with the capital at a 30% risk of total loss. Buy it, and simply acquire £200,000 of Treasury bonds too, returning 1%. Now your risk is only the potential loss of 5% of your capital, with the other 95% safe. And the return is 2.14%, more than double the return on Treasuries alone. This is exactly the opposite of the leverage tactic used in happier days; a simple unleveraging, available to anyone who wants to derisk any asset.

Now the arithmetic in this case implies that you'd pay less than £10,000 for the risky part of the asset - the proper price is around £8,000. So the asset has suffered an impairment in value. But this is very different from being unsaleable due to risk aversion.

So if any investor who is risk-averse can solve the problem by unleveraging their assets, why would risky assets be underpriced relative to their expected return? There are five possible answers:
  1. Investors are irrational and are wrongly avoiding some assets when they could follow the strategy described above
  2. Most investors actually require zero risk - an extreme case which can only be achieved by 'infinite dilution' of the risky asset, in other words a portfolio fully made up of government debt, with no other components
  3. There are not enough risk-free assets in the market to dilute the risky assets to the extent that investors demand
  4. The market underestimates the expected return on the assets
  5. The assets are not actually underpriced, but correctly reflect the expected return
Scenario 5 is the scariest: this would mean the CDO assets discussed in the FT article really are of near-zero value, and the market in full fear mode has been valuing them correctly all along. The FT article implies that scenario 1 may have held originally, but scenario 5 is replacing it. If so, the hope that banks will become solvent again through asset price recovery - or that governments will make a profit on their financial rescues - is forlorn.

If scenario 3 is the real one, the continuing massive issuance of government debt in coming years will resolve it.

Scenarios 1 and 2 should resolve themselves in time as savers start to accept small amounts of risk in return for substantially higher returns.

And scenario 4 - philosophically harder to analyse, as it requires a definition of 'expected return' that is not the same as 'the return the market expects' - might be our best hope.


Dat To said…
Amazing article. Never heard of reversing risk before. Stumbled on your site looking for Canadian small business info. Thank you anyways.

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