Dr. P.V. Viswanath

pviswanath@pace.edu

Exotic instruments are not for everyone

May 17th 2007
SURVEY: INTERNATIONAL BANKING
Les fleurs du mal, From The Economist print edition

WHEN investment banks talked about exotic assets in the 1990s, they generally meant tiger-cub or puma economies such as Vietnam or Peru. Today the frontiers of finance involve anything from weather to mortality risk, from emissions to catastrophe insurance.

Now that technology and financial engineering have made it possible to isolate and trade all manner of risks, the insurance industry is marching ever more eagerly into the capital markets. Last year AXA, a French insurer, issued so-called mortality catastrophe bonds to protect itself in the event of large death tolls caused by, say, avian flu or terrorism. The bonds were put together by Swiss Re, a reinsurer, which had hired Jacques Aigrain, a former JPMorgan Chase investment banker, as its chief executive. It expects the market for insurance-backed bonds to leap from $25 billion now to at least $150 billion by 2015.

The investment banks are not standing idly by. ABN Amro, a Dutch bank now in a takeover battle, late last year led a collateralised debt obligation packaging the natural catastrophe risks of Catlin, a Bermuda-based insurer. Deutsche Bank is experimenting with markets in “event-loss swaps”—natural-disaster versions of the debt market's credit-default swaps. The risks of less unexpected deaths are also being packaged and traded. According to Fitch, a ratings agency, bonds linked to life insurance and mortality rates and sold to hedge and pension funds reached $5.4 billion last year, from next to nothing a few years ago.

So far, so ghoulish. But the principle could be extended to all walks of life. Perhaps farmers will be able to buy weather products at their local bank as a hedge against a poor harvest. Or emissions trading, which investment bankers love to discuss to display their green credentials, might become a vibrant global market.

Not so fast, says Tim Roberts, head of McKinsey's financial-institutions practice in London. This being a risk-taking business, investment bankers are naturally testing the boundaries. But it takes two to make a market, and many more to create a mass market. Hedge funds have emerged to hold some of the more exotic risks, perhaps waiting for markets to develop. Insurance products, unlike mortgages, are not standardised, says Mr Roberts. Even the mortgage-backed securities market in Europe has developed in fits and starts and has yet to be fully integrated. It takes time for legal frameworks and market infrastructures to adapt. Catastrophe bonds which offer protection against severe environmental shocks have been under discussion for at least a decade, explains Mr Roberts, but have only recently started to take off: “There's collective agreement that the capital markets have been slow to deliver to the insurance industry.”

For those who see themselves as pioneers in these new markets, there is an unhappy precedent. Charles Sanford, who from 1987 to 1996 was chairman of Bankers Trust, an American bank, was a visionary when it came to risk. He developed the concept of “particle finance” in which every form of risk could be isolated and sold to the buyer with the biggest appetite for it. But during his tenure Bankers Trust was hit by huge lawsuits over sales of derivatives, which it was forced to settle with clients such as Procter & Gamble. It never quite recovered its standing before eventually falling into the arms of Deutsche Bank in 1999.