Thread by @Sanjay__Bakshi

Don’t take credit risk. Stick to quality companies. Hmmmm

https://twitter.com/iradhikagupta/status/1404456227875131395

Are HDFC Bank and Kotak Mahindra Bank quality companies? If so, then did they become so without taking credit risk? Answer: No.

There is risk in everything. If, for example, you refuse to take credit risk while investing in bonds, you will only buy treasuries. But treasury bonds are highly risky in the sense that they almost guarantee a long term mediocre (or even negative) real return after inflation.

So, when you try to reduce credit risk, you take on another risk: that of decimated real returns in a world of inflation. Risk, therefore, should be seen from a system point of view.

Often the “form” changes but total risk does not. This is analogous to the law of conservation of energy.

In the world of business, it’s very common to feel protected by taking some actions against some risk but to later find that one had merely substituted one form of risk with another.

For example, when a steel company enters into a long-term, fixed price contract with an iron ore mining company, it may feel that it’s profits are protected from a rise in the price of iron ore.

But in the absence of an exchange traded contract (which guarantees all trades) the steel company has merely replaced “commodity price risk” with “credit risk.”

If the price of iron ore goes up a lot, then the mining company might renege on its contract (with proper excuses of course) to supply the ore at fixed price which is much lower than spot price. That’s credit risk.

And even if the contract to buy and sell the iron ore was executed on a commodity exchange, the steel company is relying on the net worth of the exchange to protect it from counter-party default. And when there are large scale counter party defaults, the exchanges go bust.

That’s because the net worth of exchanges are never sufficient to deal with large scale counter-party defaults because, by definition, they are asset-light models which don’t hold sufficient cash on balance sheet to meet with obligations that will arise in a black swan event.

This happened in so many cases including NSEL. The key point of this thread is that when one looks at risk, then it’s important to look at it holistically and be aware of how it can change “forms.”

😊