conservation of risk: how hedging increases risk

[sniglet]

As I ponder the causes of our current credit crisis, I wonder how big a factor the craze for hedging was in exacerbating it. Over the last 25 years financial wizards have made huge strides in creating mechanisms, and markets, for insuring and re-insuring all manner of investments (e.g. credit default swaps, etc). On the one hand, the ability to reduce your risk by means of an insurance contract makes sense. However, when even the people writing insurance policies keep re-insuring their own risk with numerous other counterparties in an endless chain, the probability of a system failure increases dramatically (i.e. if any one of those counter-parties fails to make good on their obligation everyone suffers).

It almost as if there is some law governing the conservation of risk, just as there is a law around the conservation of energy. Moreover, I wonder if all these insurance policies don't lead to even riskier behavior than might otherwise have been the case. When everyone feels they are "protected" through insurance, then why not make even riskier investments than ever?

[rose-colored-coolaid]

This American Life had an episode a couple weeks ago that discussed that very thing. Their take on it, was that there were two major problems with hedging.

1) Hedging for non-insurance problems. While some of the hedge derivatives were used by people managing their own risk (buy a bunch of oil stocks, why not purchase CDS in case the price of oil drops too low), the majority of it was used merely for speculation.

2) Just as you pointed out, the overuse was a major problem. What TAL explained was that there are two types of hedges. I can't remember the names, but they were something like exposed and covered. The difference was, from the point of view of the party selling the fund. I'll try to explain.

If you want a $1M contract against a decline in real estate, I might have $1M and be willing to sell you the contract for a 2% annual fee. My position is exposed, because if the price drops I lose all my $$$. Now, let's say that decline starts looking more likely, you could get a 4% annual fee by selling a new contract to a third party. Your position would be called covered, because if prices drop you just pay out the $1M I pay to you, and either way you collect 2% (4% you collect - 2% I charge) on the $1M.

Sounds like a win, but here's the rub, the contract I sold was unregulated. I said I'd pay you $1M, but I only have $100,000 on hand. When the contract unwinds, I go bankrupt and you only get $100,000. Meanwhile, you also had $100,000 on hand, meaning you also go bankrupt and pay $200,000 to the third party.

In short, these covered contracts were supposed to be safer, but like Sniglet suggested; they end up unwinding in dangerous ways.