Gambling against catastrophes

Sunday's New York Times has a fascinating article on How insurance companies vastly underestimated the costs of the Hurricane Katrina catastrophe. The challenge: how do you properly the costs and value of insuring losses that are so unlikely, there is no historical record that can guide you? Insurers thought they had good models of those costs and values, and then Hurricane Katrina proved those models to be extremely weak tea. It turns out that risks they thought were simply bad were more catastrophic than they believed.

The article is fascinating reading, if for no other reason that to realize that many insurance companies actually had no means to pay off the actual catastrophic damage they might be insuring up prior to Hurricane Katrina. They just didn't understand their own risks and liabilities. They just assumed they were reasonable and prudent because they had always capitalized their risks in a certain way, not because they actually understood those risks and liabilities.

Our market-based processes for buying and selling risk are complex systems, and as any complex system, they aren't well understood except in the most ordinary situations. They are usually orderly, but once every so often, they run into insightful discoveries or catastrophic failures that completely upset them. When those upsets happen, they stop being numbers on a computer screen; they become crises of bankrupted companies, decimated investors, unpaid insurance claims, and thousands left to fend for themselves. And some of this happens because institutions and instruments for moving risk hide behind secrecy and overpriced illiquid assets. Said another way, it's the process of marketing risk without actually disclosing it.

Ben Stein's column in yesterday's Times Business Section makes the same point in a different way:

It's about the fees. Hedge funds are largely a fraud. A hedge fund is supposed to hedge against market movements by unhedged instruments. In a very simple example, they are supposed to go short when the market is falling and thereby make money to hedge against losses in long positions.

I am sure that some were doing that recently, but from what I’ve seen, many were just highly leveraged bets on long positions. When the market turned sharply against them, they not only lost, but also sometimes had to sell under the compulsion of margin calls and thus hastily and for a loss.

These are not what I could call hedge funds. This is just gambling. Now we see that, at least for many funds, it’s not about investing prowess or sharp insights. It is, as my idol, Warren E. Buffett has said so many times, about “fees, fees, fees.” The model hedge fund is not a means to outperform the market. It is a means to outcharge the investor.

Sounds a bit like the insurance business described in the previous article, doesn't it? In summary, hedge funds have found new ways to duck risk. They aren't any smarter than mutual fund managers -- they've just come up with better marketing to sell off their risks while accepting less risk to their own incomes.

There's an old saying that if you sit down at a poker table and don't know who the sucker is, you are it. The same rule seems to be guiding the creation and marketing of new financial products, be they CDOs or hedge funds. As the Hurricane Katrina incident illustrates, even armies of Ph.Ds and billion dollar bankrolls can't eliminate risk, no matter how many credit rating agencies and investment banks say they can. So the next time you hear someone at a cocktail party touting the 20% risk-free return they got from a hedge fund, think of it like a big win at the poker table in Las Vegas. They think their investment is risk-free, but they'll think otherwise when the casino operator of their hedge fund has a bad run of luck.

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