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:
- Investors are irrational and are wrongly avoiding some assets when they could follow the strategy described above
- 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
- There are not enough risk-free assets in the market to dilute the risky assets to the extent that investors demand
- The market underestimates the expected return on the assets
- 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.