Monday, September 28, 2009

Repricing Risk vs. Reappraising Risk

Eighteen months ago no one would have argued that a triple A rated CMO was a riskier investment than Brazilian or Indonesian corporate debt. Eighteen months ago, no one would have claimed that the equity securities of Lehman, Citibank or AIG were riskier than those of Banco Itau or China Life. It was established to the point of truism, well grounded in any review of recent financial history, that, independent of the returns required to compensate for risk premia, that the relative riskiness of various kinds of investment were well quantified and the relationships presented opportunities for arbitrage and relative return strategy that could be safely based on the immutable and unchanging relationships between the various investment alternatives.

At the same time--eighteen months ago--a great deal of ongoing handwringing was in progress about the extremely low levels, on a historical basis, of risk premia generally. Spreads to risk free returns were at historically compressed levels. Barrels on ink were spilled on paper, and electrons beyond count sent zipping through the blogosphere, on the subject. Since then, a similar amount of descriptive time and effort has been spent on the mispricing of risk, in light of the untoward subsequent developments.

Risk can be priced, or mispriced. Risk can be mispriced in insurance markets, even assuming competent underwriting. Risk can be mispriced in financial markets, when for regulatory or other reasons the attractiveness or ugliness of an asset distorts the buy side or the sell side. But in all circumstances, the pricing of risk needs to be distinguished for the appraising of risk, even though realistically misappraised risk will almost always also be mispriced.

I suspect emerging markets debt and equity have been misappraised (at least on a relative basis) as well as mispriced for the last decade or so--since the Russian and Asian debt crises late in the last century. Even assuming that all financial assets have been overvalued during most of that timeframe (i.e., until late 2008 risk premia had declined only to reprice violently at that time), as an asset class, the riskiness of emerging markets securities was also mis-appraised. And, I suspect, as far as emerging markets securities were concerned, the errors were offsetting rather than reinforcing. Because of losses in the relatively recent past, the riskiness of emerging markets assets was overestimated. Because the tendency of market participants to drink the current koolaid, the riskiness of highly-rated structured products created by the rocket scientists was significantly underestimated. The end result--seriously skewed relative valuations.

What does this mean for the future? It suggests that near term, the prospects for structured product are bleak indeed, since history suggests markets are none too kind the detrius found in the vicinity of ground zero of the latest serious embarassment. It'll be a long time before the yield hogs can be slopped with structured product.

I don't think, near term, that the prospects are high for a blissful trip on the rocket ship are in order for the emerging markets. Short term, there will be a great deal of pitching and yawing as the reappraisal of the riskiness of those securities proceeds. But, in the longer term, if those economies perform as anticipated, and those issuers generate the growth to be expected in tandem with that performance, there is likely to be a postive outcome to that reappraisal. And that, in term, will result in a repricing of those securities.

And that repricing will occur without regard to the prevailing levels of risk premia. If risk premia remain elevated and the price levels of financial assets are generally impaired, the securities of emerging markets issues will record subdued performance (though perhaps relatively less weak as compared to alternative investments). If risk premia stablize, the performance of the emerging markets may be less subdued, and the potential for a bubble may be realized.