Wall Street may be repeating the mistakes that felled American International Group Inc, which sold the equivalent of cheap lottery tickets in the belief that no one ever would hit the winning number.
These tickets are credit default swaps, derivatives that insure against a company default on its debt. The problem is banks and brokers look as if they are selling these swaps too cheaply, at least for a raft of industrial companies.
The willingness to gamble like this may be symptomatic of the exuberance that has gripped markets this summer. And although the risk is likely far less than that faced by AIG, it shows Wall Street has a tendency to forget the lessons of a crisis as soon as they are learned.
Consider the US government, Campbell Soup Co and JPMorgan Chase & Co. An investor would pay roughly the same to insure against default on bonds issued by Uncle Sam or the world's largest soup maker, according to Bloomberg data. It costs about three times as much to protect against trouble at JPMorgan.
It's true that the US government has big problems, especially spiraling deficits, while soup is a pretty recession-resistant business. And no bank has been immune the past two years to the credit crunch and housing crisis.
Yet the US government can do a lot more to stave off a meltdown than any private company. And the government has made clear that it won't allow too-big-to-fail institutions like JPMorgan to go bust.
Holders of Campbell debt, meanwhile, might theoretically wake up to find the company was subject to a massive fraud or that executives had made bad bets that left it insolvent. Don't hold your breath waiting for a bailout there.
That's not to suggest anything of the sort is likely to happen at Campbell. It's just that blow-ups can happen at the most staid of companies. Remember boring milk maker Parmalat SpA?
Credit default swaps on many hum-drum, recession-resistant companies such as Campbell, though, don't seem to price in this danger, known as fat-tail risk or black-swan events. While prices aren't back to pre-crisis lows, they are in many cases close to five-year average prices.
This is a different risk than is usually associated with credit default swaps, which some legislators believe were a destabilizing force during the market meltdown. The rap on these instruments, a $26 trillion market, is that they let speculators bet against a company and, some allege, manipulate markets.
Yet as AIG showed, the real danger often lies with firms selling swaps at prices that underestimate or ignore one-off risks. That in large part is what felled AIG.
The insurance giant sold billions of dollars of swaps on debt products, in many cases backed by subprime mortgages. For each swap, AIG collected a small annual premium. The insurer wasn't worried because its models said the risk of loss was minuscule. In the meantime, the money rolled in.
As taxpayers now know all too well, the insurer's models were deeply flawed. When the housing crisis hit, it was as if the firm had sold millions of lottery tickets with the same number, which suddenly came up.
Banks and other financial firms selling swaps today may not be as exposed as AIG. In many cases they probably are selling default protection as an offset, or hedge, against other positions. Even if that's the case, many investors are happy to take advantage of what they see as cheap insurance.
Investors can buy protection on stalwart companies like Hewlett-Packard Co, International Business Machines Corp, Sara Lee Corp or Kraft Inc for less than $40,000 a year to insure $10 million. Many investors find that an appetizing trade-off for protection against a cataclysmic event.
Clearly such companies have a low risk of running into trouble. Then again, who ever thought that Wall Street investment banks would disappear over a weekend or that the government would end up owning a big chunk of Citigroup Inc?
Although swap prices for such companies are often double levels seen two years ago, they are down in some cases as much as 75 percent from peaks seen last fall or this spring.
That's not to mention that unforeseen risks are especially tricky to gauge five or 10 years out for companies such as Microsoft Corp.
While the software giant has only small amounts of bond debt outstanding, it is possible to purchase credit protection for slightly more than $30,000 a year to insure $10 million.
That may sound reasonable given that Microsoft has a near monopoly in its Windows operating system, generates significant operating cash flow and has a rock-solid balance sheet that garners a AAA rating.
Who can say, though, where the future of tech lies? Ten years ago this summer a start-up named Google Inc had just issued its first press release announcing that it had raised $25 million in financing. Who knows what start-up today is moving out of its own garage on a march to upend the industry?
If unforeseen events take place at seemingly safe companies, Wall Street firms selling cheap protection may again find themselves singing the blues.
Source:China Daily
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