Compressing the Risk Pyramid

It is indeed Thursday at last! After the last power outage I paid for a 10Kw natural gas generator tonight and look forward to the installation in a few weeks. No more loss of power here!

Tomorrow is Friday night and I should be good to go for the usual festivities. Requests are always welcome!

Compressing the Risk Pyramid
Pyramids for some reason command a large usage in finance, and not just the ponzi scheme type. I was thinking about this post most of the week and I think I have what I want to say straight in my mind. Now let's see if it comes out that way!

I would think all the readers are familiar with the visual representation of various things by a pyramid diagram. Maybe the best known is the food group pyramid. Money and finance has plenty of similar graphics and I think it may be time to re-think some of them.

I found the following pyramid on this site and I give full credit to the author:
Investment Risk Pyramid

Any time you have made 401k selections you have seen this type of chart.

A more detailed pyramid from Oppenheimer Funds splits things up even better and will form the basis for the discussion:
Default Risk Pyramid


On February 8, 2010 I penned a missive titled "The Total Miss Pricing of Risk" and in the piece I noted:

-I came to the following idea as I watched the reaction to the possible Greece bailout over the weekend:
Instead of being scared or fearing the need for another large scale bailout of an entire bankrupt country the reaction was one of joy over another financial rescue.

-What a miss pricing of risk allows is distortions. Just like a bubble causes capital to be invested in non productive ways, the bailout bonanza has made all assets be treated as of the same risk regardless of underlying fundamentals. There is no price discovery in this way and thus right now may be a time where true "value" of many instruments are unknown.

Those ideas apply here.

Consider the Oppenheimer Pyramid:
-The first step up from ultra safe US bonds are shown as Agency Bonds. From Wikipedia:

Agency debt
Agency debt is a security, usually a bond, issued by a U.S. government-sponsored agency. The offerings of these agencies are backed by the government, but not guaranteed by the government since the agencies are private entities. Such agencies have been set up in order to allow certain groups of people to access low cost financing e.g. students and home buyers. Some prominent issuers of agency securities are Student Loan Marketing Association (Sallie Mae), Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac).

I guess it is true, Wikipedia does have outdated information!

There is no doubt anymore that Agency debt is now fully backed by the US government. We can now slip that level into the US Government bond section.

-The third step up the default risk pyramid is noted as Mortgage Backed Securities. Usually a very safe mode of investment but unless you have been in a cave for 3 years that is not really true anymore. In fact, over the last 8 months perhaps as much as 80% of ALL MBS has been originated by government AGENCIES like Fannie, Freddie and the FHA. Calculated Risk offers this FED balance sheet chart:

So again, we have to move the third step back into the Government section. Makes it simple I guess!

-The fourth step up from the US bond level is High Grade Corporate Bonds. Thanks to the ratings agencies such stellar high grade players have included: AIG, GMAC, GM, BAC, and C. All such bonds now enjoy an explicit backing of the US government via bailouts and backstops. Many others are included by association (the whole too interconnected to fail idea). Yet another level moves back into the US government base plate.

-The second step up is noted as Non-US Developed Markets Government Bonds. While lists vary (here is a bunch of lists) most include such performers as Greece, Italy, Spain, Ireland, and Iceland. All safe havens to be sure. While I cannot slide this one into the US base section, these countries all have had IMF and/or Eurozone help or implied help to make them as safe as the greater whole. One for all and all that.

I will stop there as this presents plenty to digest.

What I present here is the compressing of the risk pyramid. At the same time that the US has severely deteriorated their balance sheet the borrowing costs for the government are at all time lows never seen before. This is a fundamental economic disconnect if you will.

If borrowing costs in the 7 year time frame were at 7%, what would this mean? Some may argue that borrowing costs are low due to fear or lack of any inflation, but that makes no sense. I believe borrowing costs are low because this cannot work any other way. It is a leap of faith that all of this will be sorted out. That time frame continues to extend every day. If the base of the pyramid cannot hold, US Government Bonds/Debt, the whole thing comes apart. I believe all risk has been herded into that level of assumed protection because that is the last game in town.

Leveraging the United States sovereign name to such things as home flipper mortgages in Phoenix, AIG contracts to Goldman Sachs, and US car makers that fell way behind the competition curve seems like a poor choice, but things are the way they are. Is any of this priced in?

Risk has been effectively removed from the market in an attempt to foster growth. At this point the only thing playing along is the stock market.

There is a line of thought that the US, with relatively low taxes, could simply raise taxes to close funding gaps. That is a nice idea. Talk to a real family and you will see that even so called upper-middle class folks are just managing to get by. Raise taxes by the amount needed and I think serious political change will happen and/or a monster pullback in spending will occur. Is this fact priced in?

I welcome all thoughts and feedback on this one as I think it is important.

Required Reading
Zero Hedge has a great compilation post with all the usual comments made right before a country had a default issue. It is like reading the news today. I cannot embed the Scrib visual, so see it here:
Sovereign Default Time Capsule: What People Were Saying In Real Time As Debt And Currency Crises Played Out

Have a good night.