Underwriting risks

Foreword

When you enter a financial position, either by buying or shorting an asset, you are, very literally, underwriting the risks associated with that position, whether you care to or not, and whether you know/understand the risks or not.

As usual, a reminder that I am not a financial professional by training — I am a software engineer by training, and by trade. The following is based on my personal understanding, which is gained through self-study and working in finance for a few years.

If you find anything that you feel is incorrect, please feel free to leave a comment, and discuss your thoughts.

Matt Levine

One of my favorite financial journalist, Matt Levine, wrote today about Evergrande. That’s kinda related, but it’s really the after effects, when it is way too late. What’s really important, I feel, is captured by this paragraph from Levine:

But another lesson, one that I think about a lot around here, is that the way to reduce systemic risk and potential bailouts is for everyone to know how much risk they are taking, for risks to come with clear warnings and accurate labels, and for the risks to be taken by people who can handle them. If you must have big interconnected companies, it is good to know in advance whose claims are senior and safe and who is taking a big gamble in the hope of a high return. It is fine for a company to fund itself by selling speculative investments to retail gamblers, and it is fine for a company to fund itself by selling safe-as-houses investments to retail retirement savers, but either way it is important for people to know which one they’re buying. Much post-Lehman financial regulation is about this sort of labeling: The way to prevent after-the-fact government bailouts is by making sure that risk is borne by people who bear it knowingly and can afford to. When companies fail, people will lose money, and you want to be able to say to whoever loses money, “well, you knew what you were getting into.”

Matt Levine, Bloomberg. https://www.bloomberg.com/opinion/articles/2021-09-21/evergrande-borrowed-from-everyone

In short: Know what you are getting into.

Subtext: And no, your BFF probably isn’t the best person to listen to about this. (1)

Risks

Very literally, every financial position has some sort of risk. Some of these risks are big and obvious — like buying far out the money calls expiring today at 4pm Eastern. Yes, you may 10x your money in 1 day! Or, you know, you may not.

Some of the risks are hidden. Like buying financial assets that are unsecured, and only backed by the balance sheet of some entity that is based in another jurisdiction. Yes, maybe they pay 4% or 6% or even 12% interest rates, but how confident are you that they’ll continue to pay long enough for you to even get back your capital? And if they decide to stop paying, then what? It’s really hard to sue a company in another jurisdiction — maybe what they are doing is totally legal where they are based! Maybe starting a new Ponzi scheme is just what everyone in that jurisdiction does after breakfast — it’s a ritual, a national sport, a traditional passed down from parent to child since time immemorial! You probably don’t know, and in many cases, you probably don’t want to be in a situation where you need to know.

Some of the risks are due to fraud. Like you bought a bond backed by commodities in a warehouse… that doesn’t exist. Oops! Easy mistake to make, Schrödinger and all that — how do you prove that the commodities don’t exist, if you can’t find the warehouse to observe it?

Some of the risks are due to technical issues. Like you invest in a company that is going to disrupt finance by introducing a new type of checking/savings account combo! But they don’t have a banking license. They can try to tweak things a bit so it’s not technically a banking product, but what if the SEC then comes and tell them the product is a security, and, you know, has the bad manners not to give them the secret cheat code to make it not a security. I mean, why wouldn’t a regulator teach just anyone the secret ways of avoiding regulations. The world will never know.

Some of the risks are due to just bad execution. Like the CEO decides to publicly blog about their misadventures when potentially (almost) breaking the law. Oops! Too late to claim plausible deniability now.

No matter the exact nature of the risk, know that there will always be risk. And if you think the only risk is “the price moves against me”, then you are probably underthinking it.

Investing as underwriting risk

When you enter into a long term financial position, e.g.: investing, you should take some time to understand the risks involved in that position. Just looking at their financial statements and fancy projections is not enough — if nothing else, there are the risks that the projections are too rosy, the financial statements are inflated (either legally or not), or an asteroid drops out of the sky and obliterates the company’s headquarters. Crazier things have happened.

Only when you have a good understanding of the major risks involved with a position, can you honestly say that you are making an informed decision to invest in something; It is almost a truism in finance, that there is never return without risk. So just because there are risks, doesn’t mean you should turn away. Instead, seek to know the risks, understand the risks, and be able to honestly say to yourself that you are willingly taking on the risks, in exchange for the potential returns (2).

A non-obvious corollary of this, is that if someone comes to you with a potential risk in your investment, and your first reaction is “FUD!” or “he’s a hater!”, then maybe you are getting too emotionally tied to that asset, and maybe that is clouding your judgement.

Footnotes

1. Unless you happen to be BFF with someone really financially savvy. No, that Rolex does not prove that they are; Some may make the case that that Rolex proves they are not.
2. Because returns are never guaranteed. The return may be highly probable, but if anyone tells you that something has a “guaranteed return”, they are probably scamming you and/or doing something illegal.