Wednesday, September 24, 2008

More On Fallacies of Composition In Risk Management: Counterparty Risk

Recently, I wrote pieces here, here, and here regarding risk management and, in two of the posts, the role of 'the fallacy of composition.'

One comment I wanted to make in this piece is an unintended consequence, by way of the fallacy of composition, of the transformation, via structured financial instruments, e.g., securitized mortgage paper, of default risk into counterparty risk.

When individual instruments are traded on a desk, their risk is generally viewed as the sum of the price risk, expressed by volatility, and the counterparty risk, which measures the probabilities that the other party will default, or fail, to deliver on the contract, whether that be interest, principal, or some other security or payment.

As I noted in earlier posts, when instruments are structured from underlying instruments, such as securitized mortgages, and a counterparty to some other trade is suspected of holding large amounts of securitized instruments of dubious, or unknown value, then counterparty risk can be quite significant, although the direct price risk of the positions may not be.

To go further, if a financial services firm is suspected of, or known to be holding large amounts of securitized instruments, continuously-priced markets for which do not exist, then the entire firm's risk as a counterparty may be affected, leading to downgrades by credit rating agencies- S&P, Fitch or Moodys.

Here we have an unintended consequence affect the situation, due to the fallacy of composition.

Such a downgrade leads each counterparty of such an affected, downgraded firm to require more collateral on each position held with that firm as a counterparty. Thus, in the blink of an eye, or the stroke of a pen at a rating agency, the financial collateral requirements for a firm's book of positions with other trading partners rises significantly.

This is what actually drove AIG into ownership by the US Treasury. Its downgrading by a credit rating agency caused AIG's counterparties to require more collateral for swaps and other insurance arrangements it had sold than the firm had capital available to provide for such needs.

Do you suppose any of the quantitative, computer-based risk management systems of any of AIG's counterparties had the capability to model, forecast and integrate into their risk estimations such an occurrence? Did any of AIG's counterparties have enough knowledge of AIG's exposures to allow it to reasonably estimate the effects on that firm's capital position, and, thus, its risk as a counterparty, if it were downgraded?

I doubt it.

Thus, in yet another perverse way, the individual, similar actions of many financial service players, collectively, lead to a result which causes more risk and uncertainty in the system, even as each individual party seems to act to reduce its own risk to its positions and its counterparties.

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