What asset is safer for investment: illiquid bonds issued by a foreign country, or bonds backed by American subprime mortgages?
That might have been a tough one once upon a time but today, every Tom, Dick and Yossi would answer without even thinking about it, bonds issued by a foreign country, even if they're illiquid (which means, you can't just up and sell them).
In fact, in a world where structured financial instruments managed to destroy the entire industry of investment banking as well as the biggest insurance company in the world - blind instinct would counsel that almost anything is better than derivatives on debt.
The thing is, the person who manages your pension find may not see things that way. Nor is it his fault, poor thing. The rules governing risk among Israel's institutional investors state that when it comes to liquidity risk (meaning, you may get stuck with the merchandise), illiquid government bonds are as hazardous as weird derivatives.
Now, when it comes to rating the liquidity of bonds issued by foreign companies - never mind whether they're the biggest, most blue-chip companies in the world - the rule for institutionals is that they are inferior in grade to bonds issued by Israeli companies with bottom-crawling ratings of BBB.
If you're hopelessly lost in the intricacies of risk rating and its ramifications, it isn't your fault, poor thing. Risk rating rules were written in a way that only experts could possibly understand. If pressed to the wall, they don't understand them either. The subprime morass exposed the bitter truth: the people who are supposed to have the greatest understanding hadn't understood anything at all.
Some even claim that the present mess was born of sheer embarrassment - the embarrassment of directors unable to admit they were baffled by the convoluted derivatives their young employees were pushing.
No executive can admit that he's less clever than some junior staffer and can't understand the statistical models underlying the kid's product. Thus directors and executives allowed junior employees to get into activities they couldn't comprehend and therefore couldn't possibly supervise.
So the next time you read a report by the manager of some structured note you were persuaded to buy, saying something like "As stated in the pricing statements of the respective series of notes, Lehman Bros is the guarantor under the swap accord which the issuer had entered into with Lehman Cousins Special Shoelaces. The issuer entered into the swap pact to enable it to meet its payment and other duties under such notes. Under the swap agreement the fact that Lehman Bros Holdings has filed for bankruptcy protection gives the issuer the right to decide to terminate the swap transactions which will in turn trigger early redemption of the notes" and it's Greek to you - don't be embarrassed.
No: Feel angry. Feel very angry at the regulators whose ass-covering mechanism called "proper disclosure" enables companies to issue gibberish as statements to investors that nobody could possibly understand.
The fact that you can't understand the announcements that companies issue to the stock exchange, and that you can't really understand the risk level at which your pension money is being managed, says nothing bad about you. It does say a lot of bad things about the supervision of the capital market.
Your inability to understand the jargon being spouted enabled market players to play you.
It enabled them to sell you bad assets at bad prices without you understanding. But you weren't the only victim. The incomprehension and obtuseness rose to the highest levels of Wall Street and ultimately brought down the monsters that created it: the investment banks, the commercial banks and the hedge funds.
At the end of the day it was the sheer inability to understand that brought down Wall Street, and that has almost brought down the entire global economy.
The pride and inability of managers to admit that they simply couldn't understand, mushroomed from a human frailty into a macroeconomic hurricane that required the intervention of global authorities.
Ascertain that the people responsible for pricing assets use good judgment and don't rely solely on technical means to evaluate the assets, counsels the Institute of International Finance, which is the umbrella organization of the world's banks, discussing the roots of the present crisis.
In July the IIF issued a document that relates to the human element behind the crisis. The roots of evil were opacity and poor understanding, it concluded. Everybody relied on mathematical models to price risk instead of using common sense when evaluating the assets. The result was that the global capital markets turned into a sort of pyramid scheme: Everybody passed on high-risk assets that nobody thoroughly, fundamentally understood and finally, everybody fell down together.
Following that train of thought, the IIF decided that it should be the responsibility of mortgage lenders to apply the same credit checks on borrowers, whether the lender kept the loan or sold it onward through securitization. One cause of the crisis was that this very basic rule was not followed.
In the same spirit, the IIF ruled that institutional investors around the world had relied too much on the risk ratings of assets. They bought and sold assets relying solely on assessments of credit rating agencies, without checking the merits of the assets themselves. The IIF therefore recommends that institutional investors actually study assets they're thinking of buying, and develop their own risk evaluation models.
Nor does the IIF spare its contempt from the capital market supervisors, who handed down rules and standards that also relied on risk ratings from credit rating agencies, which induced institutional investors to do the same - to rely on the credit rating agencies - without actually analyzing the securities themselves. The IIF recommends that supervisory regulations no longer rely solely on credit ratings.
To sum up, the IIF is saying that risk models shouldn't only be based on statistical models. They should factor in actual underlying risk, the risk of the borrower, on which all these structured notes were based.
And finally, the IIF acknowledges that to restore investor faith in the market, transparency has to return. The public must know what it's buying and why. To achieve that, the IIF suggests improving proper disclosure. That doesn't mean requiring more reports - too much information can be confusing, the IIF says. The whole point is for reports to be relevant and useful, it points out, providing clear qualitative and quantitative information about a company's risk.
It all sounds quite trite, yet it took the umbrella organization of the world's banks and the worst capital market crash in 80 years to remind us that common sense and simple understanding are the only way to run a business properly.
Want to enjoy 'Zen' reading - with no ads and just the article? Subscribe todaySubscribe now