Ovaltine...Why Do They Call it Ovaltine?

Risk Management is a fraud. Well, ok, that's a bit of an overstatement. But generally when it comes to risk you either avoid it or you take it on in the hopes of a big payoff. For example, I don't do anything dangerous - outside of blogging and driving on Route 22 - so I face little personal danger but also miss out on any thrills (aside from what limited rush one gets from weaving around debris-flinging dump trucks inexplicably clogging up the left lane). Financially, it's the same thing - you can go for the big time and risk all or play it safe with low, steady returns.

So "risk management" has the air of trying to have your cake and eat it too. Insurance is an obvious exception. Insurance allows you to avoid unforeseen losses so you don't have to worry about more-or-less random risks. Insurance works best when there is a loss risk that is common (so there's a large pool of contributors) but uncorrelated (so one event is not tied to other events), has a low probability of occurrence, and where the probability in any given instance is near random but can be well judged in the aggregate.

So what's wrong with insuring financial instruments? Simple - the risk of a financial instrument is already built into its price (or the spread). Thus, there's nothing to insure against - you've effectively insured the product by the very act of purchasing it - unless the value of the instrument exceeds your loss capacity.

If you're a small bank and you've underwritten a $1million mortgage, then you are probably at some risk however sound the mortgagee's credit might be. This of course was the idea behind CDO's - securitizing a book of mortgages so that no single default would pose a threat. So then why the need to buy credit default swaps to cover these already securitized loans?

There are only two rationales I can imagine to justify financial risk management (as in the hedging of investments whose risks are well understood and priced into the asset itself). One is to make one's returns look more impressive than they actually are by using hedges to understate the actual risks of the underlying assets. The other is to defeat regulatory capital requirements by shifting the risk off to another entity (the hedge) which presumably does not have these capital requirements. This sounds to me what went on between the banks and AIG - AIG's CDS bets essentially allowed banks to pretend that their riskier CDO's were safe because AIG was insuring them. But since the riskiness of the CDO's was already built into their higher returns, what could AIG have possibly been insuring? Well of course now we know the insurance was fraudulent, but the fraud is built into the very concept of "risk management."