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December 14th, 2010 | Institutional Investor

Better the Risk You Know Than the Risk You Can’t Know

Risk is not the enemy. It is the obsession with eliminating risk that creates problems. Anyone following the fallout from the market crisis of 2008 and its most recent milestone, the passing of the sweeping financial reform bill, could be excused for associating financial risk with smallpox, polio and other scourges against which we have found a way to inoculate ourselves. That’s a dangerous mindset.

In reality, the crisis is the perfect example of what happens when financial professionals try to engineer “risk-free” investment products. The flight from risk at all levels of the financial landscape drove the growth of insurance in finance, with banks and financial institutions reduced to mere intermediaries, or marketers of complex risk-reduction products.

Consider the rampant growth of the Credit Default Swaps (CDS) market in the run-up to the crisis. The gross market value of CDS contracts, which were designed to insulate investors against the risk of a corporate bond default, grew 178 percent in the second half of 2007 versus 53 percent during the first half of that year. Just as the credit derivatives markets were about to implode, institutional investors were piling in at record numbers in the hopes of erasing risk. But risk doesn’t just disappear — it simply gets redistributed…..

By: Gregg S. Fisher and Charles S. Tapiero
As Published On:  Institutional Investor

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