Tuesday, November 22, 2011

The Implicit Assumption

The issue of risk measurement and the relationship of perceived risk to expected return has been a principal occupation of finance theorists for the past several decades. It is received wisdom that as risk rises, return must also rise, and vice versa (perhaps with a lag).

That admittedly simplistic formulation suggests that when a risk-reducing element is added to an investment opportunity, the rationally expected return should fall.

We’ve all witnessed repeated failures of the rational-investor hypothesis, the efficient market hypothesis and of modern portfolio theory over the past decade.

We’ve witnessed the well documented flame-outs of risk pricing models demonstrating that the “greek” factors of financial math, when stressed, can be as reliable as Greek bond ratings.

So the question of the day is: when is it NOT rational for expected returns to fall when new risk-reducing conditions are introduced?

The answer… (drum roll, please)…is: when risk wasn’t being rationally priced PRIOR to the application of the new measures.

When returns fall in the face of new risk-mitigation measures, the implicit assumption is that pricing prior to the introduction of the new measure already correctly reflected risk.

The extent of the decline should rationally be a function of the gross risk reduction less the cost of the risk reduction, modified by the confidence that can be placed in the “before and after” risk measurements.

New risk-mitigation measures have been applied to some TRE transactions in recent days.

It is too early to draw conclusions about their long-term impact.

In the short term, though, the reaction has been clear. Returns have fallen sharply.

If the reduction in returns was observed only in the cases where risk mitigation measures have been introduced, the problem of analysis would be made more straightforward. But that has not been the case.

The deterioration in expected yields that we commented on in our last post has persisted. So returns had already begun to fall; apparently as a result of excess liquidity; before the reaction to the risk-mitigation measures began.

And there is not yet enough data to support an analysis allocating the overall decline between the two apparent sources.

On a preliminary basis, though, it does not appear to me that the extent of the initial price reaction can be rationally supported as a reflection of the net value of the risk mitigation measures.

And it is far from clear to me that risk was being appropriately compensated BEFORE this latest development.

Having written a rather lengthy series of posts on the subject of Appropriate Compensation, which is really all about risk; and having not yet proposed a definitive conclusion on that question; I can understand that Buyers of TRE auctions will and do analyze appropriate pricing differently.

But all Buyers and, indeed, all observers of TRE, suffer from a similar impediment in their assessments of risk i.e. lack of disclosure of actual TRE experience in sufficient detail to make reasonably informed risk assessments.

I have previously stated that the actual early experience of TRE might not be an appropriate basis on which to analyze current or forward-looking risk. And I continue to believe that.

Because TRE has responded in meaningful ways to its early experience I believe that risk today is lower than it was 2 years ago.

But a RELATIVE shift in risk says nothing particularly useful about the ABSOLUTE level of return necessary to compensate for that risk. And the absolute level of average expected return to Buyers has fallen far more over the last 2 years than warranted, in my opinion, by the change in auction risk profile.

It might be that the current price action is a temporary condition and that we’ll see an adjustment of the sort that occurred earlier this year. In that case we might look back on the current period as a temporary overreaction.

If that does not occur, and the current conditions persist, my guess is that we’ll see reactions within the Buyer community that will drain some of the current liquidity from the market.

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