Beware of 27-year olds selling protection

Finance Lab students who have been to my lectures on tail risk, VaR, selling optionality, etc would appreciate the following recent comments by a leading US hedge fund manager making a bet on Japan getting in trouble:

“I have 27-year-old kids selling me one-year jump risk on Japan for less than 1bp – US$5bn at a time. You know why? Because it’s outside of a 95% VaR, it’s less than one year to maturity, so guess what the regulatory capital hit is for the bank? I’ll give you a clue – it rhymes with hero”

Of course, the 2007-08 crisis happened for similar reasons (substitute “Japan” with “Subprime bonds”). The risk was also considered impossible to materialize, the capital charge was also zeroish, the VaR was also negligible. It looked like free money. It looks like free money again. Like infinite ROE for the banks selling the protection.

Current 27-year olds saw/have heard about how their predecessors made a killing killing their employers through the unfettered sale of “no problem” tail risk. They know about Fabulous Fab. Why, they ask, should they show restraint now that it´s their chance to make dough by employing the simplest trick in the financial book, namely selling ”unlikely” risk in massive amounts. A one-eyed monkey can sell “long odds” options and credit swaps. It doesn´t take much ingenuity or smartness. All it takes is a willing employer with the cah to hire some Russian Physics PhDs willing to declare that the premium collected upfront is free money with 99,999999% probability.

Of course, the key is to find someone eager to buy that optionality and protection. The best way to do that is to sell it very cheaply. And the best way to justify that is to have Boris and Nikolai build a computer model that yields a zero VaR.

And now you know why banks hire folks like Boris and Nikolai.

 

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