When Hedging Doesn’t Work

Sometimes hedges just don’t work.  I don’t mean that sometimes they don’t limit your risk enough.  I mean that sometimes they actually backfire and add risk.  That’s what happened this past weekend with several of my friends during the East Coast’s Hurricane Irene.  Here’s how it happened:

Before the Hurricane

Leading up to the arrival of Hurricane Irene in the Northeast of the US this past Saturday night, officials were sounding the alarm bells in New York City and surrounding areas.  New York City has some very low lying areas that can easily flood during storm surges, which were predicted to be particularly bad unless the hurricane changed course.  The city itself has very little experience with hurricanes since they don’t usually come this far North, but all indications were that this was going to be bad.  Mayor Bloomberg ordered mandatory evacuations of low-lying areas and the entire city’s public transportation system shut down to move the trains and buses to higher elevation.  In New Jersey, where I live, we knew that most of our rivers would overflow like they usually do during bad storms.  Predictions were for over 12 inches of rain in about as many hours.  Flood-prone towns in New Jersey and the entire New Jersey shoreline were evacuated.  Most residents of New York city stayed in the city.

Several of my friends in New York and New Jersey decided to ride the hurricane out in their vacation homes in the Catskill Mountains, about 2 to 3 hours north of New York City.  At the time, this made all the sense in the world.

What are Credit Ratings Good For?

On the front page of today’s Wall Street Journal (well, the on-line version anyway), there’s an article about how the major credit rating agencies ‘failed to see defaults coming.’  You can read some of the article on their public site, but you’ll need an on-line subscription for the entire text.  The point of the article is that a given country’s or company’s official credit rating usually severely underpredicts the real probability of default.  This is not news in the industry.

A few years ago as the credit crunch was getting underway, several of our business partners asked if we could model corporate bond credit risk using the official ‘big three’ credit ratings as inputs.  While this initially sounded pretty straightforward, my crack team of financial engineers showed me why it really doesn’t work.  Basically, there is supposed to be a relationship between the credit rating and the chance of default.  S&P claims that a rating of ‘single B’ means there is a 2% chance of default within 1 year.  But if you look at 100 different companies rated ‘B’, far more than 2 of them defaulted in the coming year.  Given how poorly the ratings predict what they are supposed to, my quants emphatically refused to build a system that used credit ratings as the basis of default.  But at the same time, many of our competitors were selling exactly that type of system – one that estimated how much money a fund could lose based on the credit ratings of their investments.  And these systems were selling very well.  The only problem was that they, just like the big credit ratings, severely underpredicted the real risk.

When does AA+ = F?

I’m not going to add to the litany of voices predicting how much interest rates will rise in the  days and weeks following the the US downgrade.  Nor am I going to write about whether or not S&P was justified in downgrading the US (I think they were).  But I am going to write about a more insidious issue resulting from this downgrade: the fact that AA+ is simply not good enough to pass many funds’ investment governance requirements.

Many different institutions – from Mutual Funds to Pension Funds to Money Market Funds (and even some Hedge Funds) – publish guidelines and restrictions on what types of securities can be held in the portfolio.  The US government’s various authorities limit what kinds of investments can be made by different types of funds – for example, mutual funds have to go through a detailed process to check their concentration limits in a number of different ways.  One of the most common ways for an investment fund to project safety, high quality and an image of low-risk is to limit fixed income investments to ‘AAA’ credit rated securities.  Even if they allow lower rated securities into their portfolio, they often limit their exposure to fractions of what is permitted for AAA bonds.