The Debt-Ceiling Debate: The Death of the "Risk-Free" Investment

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There's an old investing axiom that says "there's no such thing as a free lunch" – which basically tells us we can't earn a profit without taking some risk.

And whether or not the United States defaults on its debt when the federal government hits its debt ceiling on Tuesday, the threat by Standard & Poor's to downgrade the United States' top-tier AAA credit rating means there will also be no such thing as a "risk-free" investment.

This new financial reality will alter the global-investing landscape forever.

And though it will put a hurting on hedge funds, investment banks and the rest of Wall Street, the death of the risk-free investment may prove beneficial to those of us who are America's ordinary retail investors.

Let me explain …

Modern Portfolio Tomfoolery

A central assumption of modern financial theory (also known as "modern portfolio theory," or MPT) is about to collapse: From Aug. 2 forward, there will no longer be such a thing as a "risk-free" investment. Banks and hedge funds will be turned upside down, but even those of us who regard modern portfolio theory as mostly rubbish will discover that the financial markets have started to function in very different ways.

Modern financial theory was originally developed at Carnegie-Mellon and the University of Chicago in the 1950s, and since then has become a dominant element of every Wall Street operation (helping Wall Streeters make boatloads of money, as a result).

One of the core precepts is that there are such things as "risk-free" investments, in which an investor's principal is 100% safe – not 99.5% safe, but 100%.

For example the Capital Asset Pricing Mode (CAPM), a central theorem of modern financial theory, says there is a "frontier" of optimal investments, and that investors can achieve any mix of risk and return on that frontier by combining risky and risk-free investments (or, to increase risk, leveraging themselves).

Similarly, the Sharpe Ratio, used by professional investors in hedge funds and pension funds, evaluates securities and portfolios by the "excess return" generated over a risk-free investment. That helps money managers determine whether they are paid sufficiently for their risk. In options theory, the Black-Scholes model assumes the ability to "delta hedge" an option by buying or selling the underlying security, and borrowing or investing the proceeds at the same risk-free rate.

Finally, risk-management theory assumes the possibility of eliminating risk from portions of the portfolio, so that the Basel bank regulatory systems, for example, weight Treasury securities of Organisation for Economic Co-operation and Development (OECD) governments at zero. That allows banks to hold unlimited quantities of Treasuries, without having to allocate capital to those holdings.

The Death of the "Risk-Free" Investment

If U.S. Treasuries are not AAA-rated, then they are not risk-free – pure and simple.

The market may disregard this problem initially, believing that AA-rated U.S. Treasuries offer adequate security, but eventually it will have to take notice, especially if Treasuries continue to weaken and are threatened by another downgrade.

Outside U.S. borders, Japanese debt has already been downgraded from AAA, and Eurozone countries have been threatened with downgrades because of the costs of the Greek bailout. Even if a few small countries like Norway, Singapore and the Isle of Man manage to keep their AAA ratings, there won't be enough "risk-free" paper to go around.

If there are no risk-free investments, then market participants will have to adjust. The adjustment will be largest for money-center banks, which will find it is no longer profitable to hold their current $1.7 trillion in Treasury and agency securities. The reason: Regulators will force those banks to raise new capital.

That's a good thing: If those banks can't make brainless money by borrowing at short-term rates below 1% and investing in 3%-yielding 10-year U.S. Treasuries, they will have to get off their butts, play the role they're supposed to play, and make loans to small businesses. Small-business loans have rebounded a little from their bottom, according to U.S. Federal Reserve data. But loan volume is still 25% below the level of 2007-08.

If banks are forced to lend to small businesses instead of to the Treasury, some jobs may be created – you never know.

Another big loser from the disappearance of "risk-free investments" will be the hedge-fund sector. Hedge-fund strategies that involve levering up like crazy to take advantage of tiny price discrepancies in "risk-free" investments won't work anymore.

But this was nothing more than pure "rent-seeking" anyway: Hedge-fund operators made themselves rich at the market's expense, so the disappearance of highly leveraged hedge funds will again be a net benefit to the economy.

The derivatives markets will also be affected. The Black-Scholes options-valuation model won't work properly without "risk-free" investments, so options markets will become more expensive and illiquid. "Risk-free" leverage strategies won't work in these markets either, and regulators will be tougher about capital requirements. Leverage will thus be lower and so will the truly frightening totals of derivatives contracts outstanding.

Why You'll Be a Winner

For ordinary investors like you and me, the disappearance of "risk-free" investments will be mostly good news.

We will hold fewer Treasury bonds in our portfolios, since their increased risk will make their lousy returns unattractive.

Conversely, stocks that pay high dividends will be even more attractive: The extra risk of dividend-paying stocks over bonds will be unimportant compared to the additional returns these stocks will provide.

We will avoid the stocks of banks and other financial-sector companies. The super returns these firms earned in the decades of low interest rates and leverage will likely not be replicated, so their stocks will do badly.

All in all, the playing field will become more level, benefiting those of us who can't borrow billions and trade based on computer models.

Thus, for most of us "ordinary investors" – as surprising as it might first seem – the U.S. debt downgrade and the death of the "risk-free" return will turn out to be a good thing.

[Editor's Note: If there's a lesson for us to learn from the past five years, it's this: A shrewd, fast-moving and greedy Wall Street is going to outfox an indentured, corrupted and gridlocked Washington ... every time.

As an investor, the only way you're going to survive such a stacked-deck environment is to have the kind of top-shelf investing insights and intelligence that the investing masses don't have.

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  1. Vinay | July 28, 2011

    From whom are the banks borrowing at 1%? Do you mean the Fed discount window? Isn't that supposed to be emergency borrowing only? Surely they can't be borrowing billions at 1% and investing in long dated treasuries at 3%?

  2. Bob | July 28, 2011

    Vinay,

    The banks are borrowing from their depositors. The rates on demand deposits and CDs have been hovering below 1% for a couple of years now.

  3. William Patalon III | July 28, 2011

    Well done, Bob…

    William Patalon III
    Executive Editor
    Money Morning

  4. John | July 28, 2011

    I am new to the market, and i was wondering what to do with the stocks in my 401K. Should i change them over to bonds or leave them put?

  5. Pawel | July 29, 2011

    Just wonder why S&P is so relevant considering its poor performance before 2008. Do we really Have to wait for S&P to figure out anything about markets? Or is it just a way to say: we are helpless?

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