Q&A: Hedge Fund Advisor Says Greece Still Poses Systemic Risk

Jun 14 2010 | 12:19pm ET

Global risk manager Ari Bergmann’s firm, Penso Advisors, is named for Joseph Penso de la Vega, a successful 17th century Amsterdam merchant who wrote the first ever description of the workings of the stock exchange – a book called Confusion of Confusions. Senior reporter Mary Campbell asked Bergmann, who began in exotic derivatives at Banker’s Trust in the ‘90s and now advises hedge funds and large asset managers on hedging strategies, to walk us through some of the confusion in the 21st century financial markets. Campbell reached him by phone in London.

How do you define systemic risk?

We define systemic risk as a risk which cannot be diversified away. Portfolio theory allows you to diversify risk. The systemic risk is a risk that affects all strategies, all instruments and all asset classes. You cannot get away from it through diversification.

Does what is happening in Greece constitute systemic risk?

Greece is starting to become systemic. As you see, every market was affected and the correlations went basically to one. So it does fit the bill. But this Greek issue is what’s called an early systemic risk. It did not fully develop yet and I believe that it will do so.

It will do so?

Yes, but not now – I believe the market [has] quieted down. But in the beginning, systemic risks are such that they have fits and starts and then they develop into full-blown risk. But you don’t go from zero to systemic – you have fits and starts.

Do the fits and starts give you the chance to do something to prevent full-blown systemic risk?

The fits and starts give you the opportunity to source very efficient and cheap hedging. Hedging mitigates but does not eliminate the risk. For policy makers it’s always possible to eliminate, but most of the time it’s already too late.

So, your concern is helping investors hedge against such risks?

Exactly, how portfolios can basically insure against them. Not, of course, against total loss but having a very, very efficient payout to provide returns and liquidity when systemic risk takes place.

So when clients coming to you looking for ways to avoid fallout from the Greek crisis, what sort of things do you recommend?

Well, I can’t tell you our hedging strategies [laughs], that’s what people pay for. But let me give you a few basic components…First of all, let’s look at the problem of systemic risk. The problem with systemic risk is that you can’t hide away, it will affect you no matter what – it’s systemic. Non-diversifiable. That is the issue…Now the advantage and the beauty is that you can find hedges throughout the system, because anywhere in the system will pay you. So you don’t have to address the risk, you could address the first, second and third derivatives. And you have to look in the markets for what’s called ‘misprice’ risks…[where] people don’t see the risk yet. Because people tend to focus on the epicenter, they do not focus on the aftershocks…If you want to buy protection today in Greece, it is extremely expensive and it is inefficient…But there are so many parts of the system, because if Greece becomes systemic it will affect everything, so there are many other issues that are priced much better. So the key is, number one, you have to focus on the risks before they appear. Once they appear, once the house is burning, it is too late to buy insurance. So you have to be always looking for those opportunities. Number two, you can never buy obvious insurance – any risk which is obvious, the insurance is ineffective and too expensive. And the beauty of systemic risk is that you can be very creative in crafting a hedging strategy.

You say you expect the Greek situation to become systemic, do you see it spreading into Portugal, into Spain, into Ireland as many fear it will?

Let’s talk about it step by step. I think that Greece, inevitably, will have to restructure. And once they have to restructure, the debt restructuring, rescheduling, which is default, will spread like wildfire. Because once a country takes away the stigma, it realizes that it’s a lot easier to default on your payment than to go ahead into austerity measures to create social unrest…For once somebody defaults, you could have basically a chain effect of defaults and rescheduling. So that will affect the countries which will find it more expedient to reschedule than to suffer.

You know, there is a very nice saying…when they had the Latin American defaults, the saying that was prevalent at the time of the fallout was, “If you borrow a million bucks from the bank and you can’t pay it back, you have a problem. If you borrow a billion dollars from the bank and you can’t pay it back – the bank has a problem.” So these countries, they’re not individuals. They’ll say, ‘You know something? I’m not going to pay back in two years, I’ll just reschedule the loan, and instead of having to pay back in two years I’m going to pay over 15 years at a very below-market interest rate and I’ll use the money from the ECB or the SPV …as new financing, not to pay old debt.’ Because you realize what’s going on is there is a trillion-dollar package, but that package [is] to be used to roll over old debt…that’s number one, so in other words you’re bailing out investors. Number two, you have to accept austerity measures which are very, very difficult on the country and have a lot of social costs. And number three, you might create a never-ending loop, because the more you cut in austerity, the more you deepen your recession. By deepening your recession, your debt problem doesn’t become better, it actually becomes worse. For two reasons – your tax revenues are lower, and your GDP, which is your denominator, also becomes lower. So, basically, you’re gaining nothing. So, it’s easier to reschedule and use the money for new financing.

What do you make of Germany’s recent ban on naked short selling? Will we see more of these types of regulations and will they help?

I think that this kind of legislation will be inevitable, you’re going to see more and more quote unquote “dirty plays” and this will require hedging managers like ourselves to be even more creative because if you design the wrong hedging strategy, it will backfire on you.
Listen, I have experience of 20 years doing this. I’ve seen every game in the book, and therefore I know how to protect ourselves…But it’s not a joke, because [you have] a political strategy, where the government creates a ban – like Germany or like the US did – and then you are forced to liquidate at the worst time possible, and then your hedging strategy causes you a lot of damage. So, that is extremely important to know that this is going to be the rule of the game, and I think that this is going to be very prevalent.

The second thing is, it does not help. It will not solve the problem. …The first book ever on the financial markets, the first book about derivatives...puts, calls, volatility, futures…was published in 1688. It was about the stock trading of the Dutch West India Company in Amsterdam… and the name of the book is Confusion of Confusions…interestingly enough, the book describes the Friedrich Law. When the West India Company was losing its colonies, they also outlawed and banned naked shorts. You had to deposit [stock] in the stock market, with the stock authorities, to be able to deliver on shorts. Naked shorts were unenforceable and illegal. It was called the Friedrich Law. And it did not work. So in 1688 they tried, and the West Indies Company still went to zero and it went bankrupt. It did not help. It only made the pain a lot longer and there was a lot more suffering... Instead of creating a clean decline which was liquid, they created a messy decline which just prolonged the agony. So you can see from history – it didn’t help 300 years ago, it ain’t going to help today.

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