you gotta diversify your bonds
November 19, 2015 8:21 AM   Subscribe

The Bonds of Catastrophe - D. Graham Burnett
It is perhaps not widely understood (outside the specialized domains of risk modeling and property insurance) that the last twenty years have seen the relatively rapid growth of a new kind of financial instrument: the catastrophe bond. I aim in what follows to offer the reader a brief introduction to these innovative money-things, which sit at the precarious nexus of mathematical modeling, environmental instability, and vast sums of capital.
posted by the man of twists and turns (37 comments total) 9 users marked this as a favorite
 
be warned that cat bonds almost always exclude events of clandestine cucumber placement
posted by indubitable at 8:53 AM on November 19, 2015 [9 favorites]


Wu Tang Financial ain't nothing to fuck with.
posted by Steely-eyed Missile Man at 9:07 AM on November 19, 2015 [3 favorites]


From the FPP link:
On the one hand, there is something undeniably unsettling, I think, about cliques of billionaires placing large-stake bets on mass death.
Well, at least the investors are betting against death and destruction. Of course, an insurance client is betting for it. And insurance companies are playing both sides.
posted by Mental Wimp at 9:08 AM on November 19, 2015 [1 favorite]


Indeed, some specific corporate entities are large enough in themselves to be meaningful drivers of such changes. Upon which those same entities are now in a position, potentially, to capitalize, by means of well-placed cat bond bets.

This is a very eloquent way of summarizing his central premise: there are a handful of people in the world who have long held the means to inflict massive death and destruction on the unsuspecting populace, but have only recently been given the motive to do so. Now that your average multi-billionaire might actually be incentivized, let's see how long it takes for a bona fide Bond-villain-in-a-volcano-lair to emerge.
posted by Mayor West at 9:15 AM on November 19, 2015 [6 favorites]


Related: In Nature's Casino by Michael Lewis

The devil is in the details, or in this case, the triggering event, which can vary. Is it triggered by the size of the event (however it's measured), a predetermined payout, an industry-wide loss? It could be any of these and one would hope they make clear in their offering docs (not just the prospectus).

From the FT article: But they have another attractive feature: they are seen as “uncorrelated” with other asset classes. This is highly prized since the 2008 financial crisis, when many markets fell in tandem, making it hard to hedge risks.

This seems like an odd statement. Yes, uncorrelated or negatively correlated assets are prized, but 2008 is a shining example of how the principles of correlation that so many people rely on so heavily utterly failed. Everything, and I mean everything fell in 2008 with one notable exception - plain vanilla bonds. In the years leading up to 2008, all the newish investments (like hedge funds) trumpeted how uncorrelated they were with other assets and how they'd provide protection to the downside and of course this all fell apart as soon as we hit a global liquidity crisis and everyone wants their money. I mean, the hedge funds maybe fell only 15% - 20% as compared to stock markets, which fell 30%+, but I'm not sure investors were very comforted by "only" a 15% loss, especially since they probably could have gotten something similar in a basic, transparent, highly liquid, low-fee 60/40 stock/bond split.

Anyway, correlation. Some investments are uncorrelated - until they aren't.
posted by triggerfinger at 9:36 AM on November 19, 2015 [3 favorites]


Well, at least the investors are betting against death and destruction. Of course, an insurance client is betting for it. And insurance companies are playing both sides.

That's not true. It's not like the insurance companies get to "keep" the money if these things happen. Sure there might be more money in cat bonds then they end up paying out, so they make a "profit", but on the other side, there might not be enough, and their company still face massive losses. (Also, who knows what kind of provisions are in these individual bonds. I would bet a lot of them aren't even all or nothing and have provisions for partial losses.)

The interest they pay on the bonds can be considered an insurance premium. Just like a lot of people pay life insurance or health insurance premiums stand to receive a lot of money, they don't really want them to pay out.

there are a handful of people in the world who have long held the means to inflict massive death and destruction on the unsuspecting populace, but have only recently been given the motive to do so.

Again, I don't get who would have the motivation to do this and how you would somehow turn a cat bond firing into a profitable exercise. It's certainly not the investors.

I mean, I'm sure there's some way to make a profit when one of these fire*, it is the financial market we're talking about, but it just seems to me there's so many easier ways to make money off of human misery and disasters.

*Some how shorting the bond in a secondary market?
posted by mayonnaises at 10:12 AM on November 19, 2015 [1 favorite]


Some investments are uncorrelated - until they aren't.

Or, more clichéd, in a crisis all correlations go to 1.
posted by PMdixon at 10:16 AM on November 19, 2015 [3 favorites]


Reading the actual article: this seems like a good thing, probably. While the devil's always in the details, it looks like this moves risk from implicitly or explicitly government backed entities to parties without such a guarantee. Of course, the idea that the government(s) won't bail out the cat bond holders in a circumstance where they would have the insurance companies is untested.
posted by PMdixon at 10:25 AM on November 19, 2015 [3 favorites]


Perhaps it will have to suffice, in a short essay like this one, merely to state that the moral-cum-financial problem at issue in these instruments affords an interesting touchstone for any theory of wealth and social welfare. The problem is left to the reader.


Thank you for this lovely article. I had very little idea that there were these gigantic piles of money moving around based on computer models of risk and catastrophe. Knowing how bad some of these models are ... sigh.
posted by RedOrGreen at 11:36 AM on November 19, 2015


Knowing how bad some of these models are ... sigh.

In this case - I would tend to expect the risk to be underpriced. If (big if) these aren't being held by calpers etc, but rather by small-enough-to-fail hedge funds and prop shops, that means risk to most of us, via the public fisc, goes down.

It really depends on who ends up holding them.
posted by PMdixon at 12:55 PM on November 19, 2015 [1 favorite]


Paging Mr. Blofeld! Mr. Ernst Stavro Blofeld to the red courtesy phone.
posted by Megafly at 4:13 PM on November 19, 2015


Now that your average multi-billionaire might actually be incentivized, let's see how long it takes for a bona fide Bond-villain-in-a-volcano-lair to emerge.

The Koch brothers have been around since the 60s.
posted by T.D. Strange at 5:23 PM on November 19, 2015


So, like daily fantasy, this is absolutely, definitely not gambling, huh?
posted by ob1quixote at 9:05 PM on November 19, 2015


definitely not gambling, huh?

Depends on who you think the house is.
posted by PMdixon at 9:13 PM on November 19, 2015


So, like daily fantasy, this is absolutely, definitely not gambling, huh?

It's not gambling like insurance itself isn't gambling. All these insurance companies are doing is transferring risk, which is a basic tenet of insurance. Sometimes they transfer it to other insurance companies and sometimes they transfer it to a group of "investors". The gamble is on who's model is going to be the right one.
posted by LizBoBiz at 6:08 AM on November 20, 2015


A quick google shows little reference, but I was told that in the late 1980s Lloyds reinsurance finally made a substantial call on their "Names" after virtually a lifetime of not doing so. Link
These, typically high net worth individuals, had been the equivalent of issuing bonds to Lloyds for reinsurance. The idea being a Name could guarantee X million pounds to Lloyds if things went to shit, but would receive small x every year as a payment as long as they didn't.
They guy I knew was a son of a 'Name' who failed to meet his obligations when Lloyds required the cash, to the distress of the family who had been quite wealthy, and were suddenly broke.
Wikipedia suggests there was a lot more to it, with various tax lurks, but it was a good lesson for me in counter party risk. I believe that the 'Names' were largely made up of establishment people who looked quite wealthy, but I can imagine over time how it could happen.
Year 1 you agree to guarantor $100,000 pounds and are delighted to receive a cheque for 1000 pounds at the end of 12 months. So you double down and happily receive the 2000 pound cheque. How tempting to stump up for a million or two! Or four! And your friends had also made the same bet - after all, no claims of any size had ever come up over generations - money for jam.
It was my first lesson about counter party risk. I hope it will remain the largest, but I suspect that everyone will learn a lot about it in the years to come, when they find that some of the end parties to many transactions are flimsy.
posted by bystander at 6:03 AM on November 21, 2015


It was my first lesson about counter party risk. I hope it will remain the largest, but I suspect that everyone will learn a lot about it in the years to come, when they find that some of the end parties to many transactions are flimsy.

Some version of this (CDO/CDS) led to the meltdown of 2009, no?
posted by Mental Wimp at 11:22 AM on November 21, 2015 [2 favorites]


Yes
posted by triggerfinger at 11:28 AM on November 21, 2015


Yeah the financial crisis was almost entirely driven by counter party risk.
posted by PMdixon at 7:25 PM on November 21, 2015 [1 favorite]


after all, no claims of any size had ever come up over generations - money for jam.

It wasn't just counterparty risk, it was that and thinking that a black swan event couldn't occur.

(I just took a big exam that was all about risk management and these two things were major focus points so its really neat to see people talking about it here)
posted by LizBoBiz at 7:43 AM on November 22, 2015


It wasn't just counterparty risk, it was that and thinking that a black swan event couldn't occur.

Isn't counter-party risk itself often a black swan event?

I had a whole fictional thing written up about CMEGroup ceasing to exist, and then I realised exactly the thing I was talking about when SNB ended the peg: A bunch of forex shops with, say, 1% margin requirements were suddenly looking at a 16% move. They're on the hook for the rest of the 15%. A bunch of brokerages ceased to exist. Time Worstall link.

Counter-party risk or black swan? (I don't think the SNB ending the peg can be called a black swan -- unexpected and poorly done, sure, but the fact that at one point there was not a peg would seem to put "they end the peg" well inside the space of contemplated outcomes)
posted by PMdixon at 9:58 AM on November 22, 2015


Damn you, missing 7 minute edit window. Tim Worstall, of course.
posted by PMdixon at 10:05 AM on November 22, 2015


Not always. Companies deal with routine counterparty risk all the time, like banks and mortgagees. Companies who hold assets in corporate bonds estimate their counterparty risk based on the bond ratings. Black swan events are going to be the scenarios where a significant portion of your counterparties cannot fulfill their obligations or, as in ghe case of AIG, an significantly large counterparty cannot fulfill its obligation.

The Tim Worsall link seems to be an under estimation of counterparty risk on the part of the brokerages as well as poor risk management in general in allowing themselves to become so over leveraged.
posted by LizBoBiz at 12:42 PM on November 22, 2015


If we're going by the original definition, black swan events are unpredictable, unexpected and have a major impact. I agree that 1) counterparty risk is a normal type of risk (which may not be properly evaluated), and 2) the end of the SNB peg wasn't really unexpected (though no one knew the timing of when it would happen).

Counterparty risk is a normal type of risk that needs to be properly evaluated, just like all the other types of risk in financial markets. But I think there's another layer added in when we're talking about the rating agencies (upon whom so many institutions rely) and their past failures to properly evaluate credit risk heading up to the financial crisis. What kind of risk would we call this? It's interesting to me to watch the steps being taken by regulators on an ongoing basis to prevent these kinds of risks, and to see what the impacts will be.
posted by triggerfinger at 1:37 PM on November 22, 2015


Counterparty risk is a normal type of risk that needs to be properly evaluated, just like all the other types of risk in financial markets. (emphasis added)

Surely this depends on the counterparty? How do you evaluate the counterparty risk of a T-Bill in any meaningful way?
posted by PMdixon at 1:38 AM on November 23, 2015


I would say rating agency failures are probably parameter risk, which is the risk that variables in your model or assumptions are wrong. There could also be fraud risk if the rating agencies are acting in ways that prevent them from giving honest ratings.

And yes, counterparty risk varies depending on the credit-worthiness of the counterparty. Before all these debt ceiling shenanigans, the T-bill was assumed to pretty much have no counterparty risk. Treasuries are even assumed to be the "risk-free" rate (and still are even though the US has been downgraded). Bonds and other instruments are assumed to pay a return of the risk-free rate plus a pad for accepting the risk, which is pretty much the counterparty risk. This is why lower rated bonds pay higher returns--because there is more risk that a lower rated bond will default.

If you're really interested, here's the text I had to read for that risk management exam. It provides really good analysis of counterparty credit risk and all the things that effect it.
posted by LizBoBiz at 5:57 AM on November 23, 2015


How do you evaluate the counterparty risk of a T-Bill in any meaningful way?

The same way you'd evaluate any other sovereign debt - by looking at the government's ability and willingness to pay. You'd look at things like political stability, a stable currency, tax collection, the overall level of debt and other things. In the case of US treasuries, the chance of default is basically zero. The US cannot default, and technically, neither can any other nation that issues its own currency (such as Japan or the UK); the reason being that they can always "print" money to cover their debts. There is more inflation/currency devaluation risk than there is default risk for the US. In any case, US debt has been, and will continue to be in very high demand, even after being downgraded.
posted by triggerfinger at 4:42 PM on November 23, 2015


In the case of US treasuries, the chance of default is basically zero.

Right, but my point is it's not actually 0. Presumably there is some decision problem in which it matters whether it is .03%/year or .000001%/year, but there's no particularly good way to choose between the assumptions that lead to different very small numbers. But this is now I think getting into the problem of estimating the chances of very rare events with a time series that we know to be extremely non-stationary, which is different from 'black swans.' And then there's the Daniel Davies perspective which is that the whole idea of a distribution to draw from is just barking up the wrong tree, and there's just a bunch of individual events that happen for individual reasons.

Epistemology of uncertainty is hard.

Thanks for the rec LizBoBiz; I'm probably doing a little autodidact's disease here and I should go fix that.
posted by PMdixon at 4:59 PM on November 23, 2015 [1 favorite]


Avoiding the temptation to abuse the edit window:

Need to add a bit here to make this a true statement:
The US cannot be forced to default, and technically, neither can any other nation that issues its own currency. Obviously, the debt limit is a conditional default, but one that's self imposed.
posted by PMdixon at 5:02 PM on November 23, 2015


Although the other reason that people point to as their rationale that the US cannot default (apart from our ability to print money) - and this specifically comes up over every debt ceiling fiasco - is because of the constitutional angle (and of course there's been debate as to both the scope of the 14th Amendment as well as what actions could be taken to enforce it).

But yeah, risk measurement is a very inexact science that relies on a lot of assumptions. To use one common measurement, standard deviation is something that is both measurable/quantifiable and standardized, but there are a lot of problems in using it as a measure of actual risk, and (in my opinion) there are far too many people putting way too much reliance on it as such. And I think this generally applies to most risk measures (that I can think of). People in finance love models and data and hate uncertainty, but I think the negative byproduct is that a lot of people who don't have the same kind of expertise put more credence into these numbers than they should.
posted by triggerfinger at 6:40 PM on November 23, 2015


...there's no particularly good way to choose between the assumptions that lead to different very small numbers.

There is a growing field of study about this very problem! Usually, there's some stochastic modeling, maybe with assumptions that are themselves stochastically modeled. There is the problem of distribution that you mentioned, but we can't just throw up our hands and say "whatever happens happens we cant do anything to mitigate it". So you have to pick something, usually based on historical or observed data.

triggerfinger: during my training as an actuary it was drilled into us that the model is always wrong, the important part is by how much. We will never be able to perfectly predict the future. Finance people rely too heavily on metrics/models too (see Black-Scholes and the 2008 crisis) so I wonder if in their training they didn't receive such a strong message about not relying too heavily on the models. The fact that people without the expertise are also relying on the numbers is the nature of people though. People can't read everyday statistics correctly so there's not much we can do about more complicated ones.
posted by LizBoBiz at 6:24 AM on November 24, 2015


LizBoBiz, yes, sorry if I wasn't clear, but I was definitely referring to finance people as the ones who can sometimes be over-reliant on models. And yes, they are taught about this in their training, but the industry is so fragmented that the quantity and quality of training can vary wildly. And I agree with you on the human nature aspect of wanting some certainty where there isn't any.
posted by triggerfinger at 7:10 AM on November 24, 2015


But yeah, risk measurement is a very inexact science that relies on a lot of assumptions.

The biggest problem is that you can only assess risks you can imagine. Then something you never imagined comes along, i.e., the black swan.
posted by Mental Wimp at 10:58 AM on November 24, 2015


> The biggest problem is that you can only assess risks you can imagine. Then something you never imagined comes along, i.e., the black swan.

The aliens arrive, demand to be taken to our leaders, and offer abortions for some, miniature American flags for others. What happens to your Gaussian copula model now?
posted by RedOrGreen at 4:08 PM on November 24, 2015 [1 favorite]


Well, I'm pretty sure the fact that my bonds are going to be defaulted on is the least of my problems at that point.
posted by PMdixon at 4:44 PM on November 24, 2015


The biggest problem is that you can only assess risks you can imagine. Then something you never imagined comes along, i.e., the black swan.

The thing is, there is plenty of data on seriously bad things happening: the great depression, the gas crunch of the 70s, the savings and loan crisis of the 80s, dot-com bubble. "Unimaginable" things happen fairly frequently and we can use the knowledge of past events to help prepare for the future.

This is also a big difference between traditional risk management and "Modern" risk management (modern as in mid-late 2000s, not old enough to be used by everyone but old enough that alot of firms and regulators are catching on). Traditional risk management pretty much only examines the risks that you see every day and there is more focus on the more frequent and routine risks. Modern risk management sees frequent and routine risks as more of the daily operations of the business and is more interested in what happens at the extremes.
posted by LizBoBiz at 7:17 AM on November 25, 2015


Everything, and I mean everything fell in 2008 with one notable exception - plain vanilla bonds.

so if you ride counterparty/default risk (and recovery upon default) all the way up the great chain of monetary being you'll find TBTF 'primary dealers' (who else to buy the govt's debt?); now usually, to move higher up the chain and gain access to the fed -- through the discount window[1] -- you need to be a deposit taking institution that holds reserves, but when shit hit the fan in 2008 the fed created a primary dealer credit facility just for them (with this term sheet) and the central bank became analogous to a pawnbroker of last resort...

How do you evaluate the counterparty risk of a T-Bill in any meaningful way?

but if you want to move even higher, and further abstract to a money view, where say t-bills and cash can be seen as interchangeable, reserve notes are still backed, no longer by gold, but by the full faith and credit of (alexander hamilton's)[2] treasury and, more specifically, the IRS' ability to levy taxes, which just collects cash from people, thus reflecting and transmuting their efforts to acquire said cash into tokens of 'value' subsequently transferred into public coffers... to be dispensed with wisely for the public good and the general welfare?

or in the words of 'jesse' in that nick rowe thread questioning whether money is a liability: "Fiat money is an equity, redeemable for relief of state taxation [tax credit], whose value is a fine balancing act between confidence and compulsion."

---
[1] where you'll find a sheet listing acceptable collateral (and what haircuts apply) so that one may (proportionally) exchange their 'securities' with cash overnight at the discount rate; note that 'plain vanilla bonds' even those of long duration have negligible haircuts...

[2] Public Credit has been well defined to be, "a faculty to borrow at pleasure considerable sums on moderate terms, the art of distributing over a succession of years the extraordinary efforts found indispensable in one, a means of accelerating the prompt employment of all the abilities of a nation and even of disposing of a part of the overplus of others."
posted by kliuless at 2:22 AM on December 12, 2015 [2 favorites]


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