Wednesday, 19 September 2018

When will they ever learn?

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SwissInvest strategist Anthony Peters takes aim at longevity swaps.

Anthony Peters

Anthony Peters SwissInvest strategist

SOMETIMES I GET a bit bored with playing the grumpy old git, but far too often I pick up some story and groan. Oh dear, here we go again.

The most recent one was in fact on that thorny subject of longevity swaps. The line that struck me most was something to the effect that life insurance companies can use these products, both in swap and option format, to hedge their risk of … well, rising longevity.

My memory was cast back to the mid-1990s when I read a piece in the Economist, a magazine to which I had until that point ascribed biblical status, outlining this new-fangled thing called a credit default swap through which banks would, according the writer, be able to hedge their credit risk and thus protect themselves from losing money. Really?

Whether I sell somebody a quantity of risk in the underlying or in the derivative form, the risk remains the same. As we learnt in physics at school, energy can be converted but it cannot be destroyed. The same principle can and must be applied to credit risk and pretty much all other forms of market risk.

Yes, CDS did let the banks take credit risk off their balance sheets but it either became credit risk on someone else’s balance sheet or – as often as not – it was flogged off to vehicles that were funded by the banks, which left them with the same risk, albeit at arm’s length and hence not visible to the regulator. In its cleverest form, credit risk was swapped by banks in regulatory capital trades that did all kinds of clever things but never reduced the underlying credit risk.

Swapping such abstracts gives me the willies

THERE IS A little bon mot in English that asks, rhetorically of course, why a dog licks its unmentionables. The answer is – quite obviously – because it can. I’m afraid that I have come to the conclusion that most, though by all means not all, derivatives fall into the same category.

I can understand a forex or rates hedge where there are natural users on both sides of the trade for whom the trade is of equal value as a hedge. But longevity? I can see a life insurer benefiting from a hedge against rising life expectancy but who has the natural trade that benefits from a hedge against it falling?

To me that suggests that one of the two sides of the longevity swap is not hedging but entering into a punt where the key to making the trade work is that the buyer of protection might be bidding above where the seller expects the market to go. Somewhere, someone is trading around an unknown outcome that has precious little to do with hedging. Betting on a horse placing rather than betting on it winning is still a simple gamble.

The rise in human longevity is not a matter of speculation but where actual (as opposed to actuarial) life expectancy will be at any point in the future is anybody’s guess. I can hear the sound of the longevity swap community hissing at me and sticking pins into my effigy but if hedging risk were such a simple and self-fulfilling game, we wouldn’t have had a credit and banking crisis.

I WILL NEVER forget the “scandal” a couple of decades or so ago when Lufthansa had cleverly hedged its fuel cost, only to get caught in the clutches of falling oil prices. The company was castigated left, right and centre for having locked in prices far higher than those that prevailed on the world market by the end of its financial year. The mark-to-market loss was substantial and suddenly every financial journalist in Germany had known for ages that the price for hydrocarbons had had to fall.

The greatest failing of the structured credit boom was that people who did not truly understand the risks on offer were purchasing them because they were there and because they were being told that they could buy a pound of sweets for the price of a quarter.

I am not quite sure who is selling protection against longevity to the insurers but I am pretty certain that in one way or another it is either people who don’t understand the risk they are taking or those on the Street who will, when things get untidy, be on the “other side” for anyone wishing to unwind.

Swapping such abstracts gives me the willies and brings to mind the immortal line from Pete Seeger’s wonderful and arch-pacifist song “Where Have All The Flowers Gone?” He asks “…when will they ever learn?” I wonder if it might not be time to form something of a pacifist movement in global banking.

PS. I WAS lunching with a senior banker this past week when the conversation turned to the old structured credit days. He reeled off the names of all those characters who had driven the correlation business in his bank and who have since totally disappeared from view.

He commented that they, the guys who had been in the driving seat had been the ugly swots who had been bullied at school because they had been very clever but not very personable and not at all part of the alpha male community. Suddenly they found themselves in positions where they could cock a snook at all those they had previously envied and who had in turn looked down on them. The more complicated the swots could make a product, the less the smooth operators understood of it – and the better and the more empowered the swots felt.

I’m not sure that this form of social profiling is accurate but, then again, we had a jolly good giggle, for where there is smoke there normally is fire.

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