Friday, July 7, 2017

Risk Neutral

An expansion on some thoughts in response to a comment by Kevin Erdman on Arnold Kling's blog.

Kevin highlight's a point about risk which is valuable, that people who buy debt (ie bonds) are generally risk averse and people who buy equity (ie stocks) are generally risk tolerant.  The conclusion though is incorrect because he looks only at the buyers, and not the sellers of the assets.  If buying bonds is risk aversion then selling bonds should be seen as risk tolerance, with the opposite relationship for equity, let's look at both how this is true and the implications.

First why are bonds less risky than equity?  First it is because they (typically) have a claim on the underlying capital.  If you buy equity in Ford and they go belly up then your equity will be wiped out.  If you buy debt from ford and they go belly up your debt will be converted to equity and you are now a proud new owner of a fraction of Ford's physical capital, their manufacturing plants, their patents, and anything else worth selling or using.  So you have this natural buffer where even if the overall business fails there is some value to be extracted from the ruins, which an equity holder doesn't have.  Secondly it takes a much larger blow to the company to decrease the coupon payments.  A decline in sales will take a whack at the equity, and the market value of bonds, but the actual income stream won't be effected until the blow is large enough to interrupt the coupon payments.

That is from the investor's perspective, now from the companies perspective this is reversed.  When a company sells equity they give up a ownership stake in exchange for cash, if the stock price falls afterwards the company doesn't have to give part of that cash back.  A stock issuance is low risk from the companies perspective, the total market capitalization could fall to a single penny and they don't have to repay a cent of it, the investor takes on all of that risk.  Now a bond issuance, they borrow money and promise to pay it back with the company assets as collateral.  If they cannot make the payments the entire company is potentially forfeit.  Any risk that the investor is insulated from must be passed on to the company.

This inverse relationship is pretty straightforward.  If Ford wants to build a new assembly line they can fund it through debt or equity, but funding from one or the other doesn't (shouldn't) alter the risk inherent in that capital expenditure, what funding from one or the other does is shift the risk and reward profile.  If they issue through debt and it is a huge success the bondholders get their coupon payments and Ford gets all the upside of a major and profitable investment.  If they fund through equity the shareholders get the upside of that profit stream.  If it is a failure Ford has risked the company's assets and will have to sell them off to make their bondholders whole.  If it fails and they have funded through equity the share holders take the (majority of the) loss, and the company retains all its other assets.

In a perfect world/market these things balance out perfectly every time.  Total risk is constant, and distribution of risk is matched with compensation for exposure to it.  Where it is a problem is when one group can offload risk onto a third party without compensation.


  1. You're not accounting for the effect of sentiment on the asset base. In the aggregate, when risk aversion rises, we get more Fords and fewer Teslas. In fact, it would be reasonable to expect that this would lead to a retraction in "Tesla" type of assets and an increase in "Ford" types of assets, and that even if there was more debt in the aggregate, Ford might be less leveraged than they were.

    1. This is a large leap from "aggregate risk" to distribution of risk. You can have less overall risk taking but more overall Teslas. This can happen for two reasons. First is that risk taking doesn't lead to more X, it leads to more attempts at X, which is not the same as outcomes. Final success will be influenced by the total attempts, but that direction isn't always more attempts -> more success. Secondly the distribution of risk is important. Lots of low risk investments with one or two home run swings could have the same "aggregate risk" rating (Whatever your metric) as a portfolio entirely comprised of moderate risk, but they will have different outcomes in terms of Tesla to Ford ratio.

    2. There were lots of home run swings in 2000. It was equity based. And the contraction was manageable.

      What were the home run swings in 2006? People buying leveraged homes? Then why couldn't they find enough willing borrowers to fund standard RMBSs?

    3. My point was that it isn't the amount of debt, but distribution that matters. If you want X risk units in your portfolio and you already are at that limit buying regular securities then you aren't jumping into high risk investments. Total debt (to change the direction) will increase systemic risk and increase the baseline risk of all investments (even if interest rates don't move). Total debt is the current problem having been to high in 2005-06 and is even higher now because the Fed and US government have been absorbing market risk.