Nouriel Roubini, on his RGE Monitor, discusses the distinction between risk (variability in outcomes that can be estimated) and uncertainty (unknown or unmeasurable outcomes). Risk can be priced; uncertainty can’t (or at least can’t be priced by rational agents).
Roubini argues that part of the panic in the markets stems from the fact that investors are now facing uncertainty, as opposed to mere risk:
Economists distinguish between “Risk” and “Uncertainty”: the former can be priced by financial markets while the latter cannot. The distinction between the two was made by the famous economist Frank H. Knight in his seminal book, Risk, Uncertainty, and Profit (1921). In brief, “Risk is present when future events occur with measurable probability” while “Uncertainty is present when the likelihood of future events is indefinite or incalculable”.
This distinction between risk and uncertainty helps to explain the recent market panic and turmoil. Today, the FT cites a market economist at Lehman who said: “We are in a minefield. No one knows where the mines are planted and we are just trying to stumble through it”. A few days ago another market participant put it this way: “It is not the corpses at the surface that are scary; it is the unknown corpses below the surface that may pop up unexpectedly”.
Unknown minefield; unexpected corpses: this is “uncertainty” rather than “risk”. Risk can be measured and priced because it depends on know distributions of events to which investors can assign probabilities. Uncertainty cannot be priced by markets because it relates to “fat tail” distributions and extreme events that cannot be easily predicted or measured.
Now one could wax philosophical and say the world is full of uncertainty. Earth could be hit by a big comet chunk in the next six months. We could have a bird flu pandemic, or the Second Coming. But if you thought like that, you’d be a terrible bond salesman.
Roubini argues that opacity has increased uncertainty. That makes sense; investors are spooked because they have no basis for knowing or estimating what is going on:
This increased lack of transparency in financial markets is much broader: thousands of hedge funds that not only are unregulated but whose activities are opaque and not measured by any supervisor; shift of the corporate system from a public to a private one via LBOs and private equity transactions; increased size of unregulated over-the-counter trading in derivative instruments rather than on regulated exchanges; development of complex financial instruments whose correct pricing and rating is increasingly difficult; mis-rating of these new instruments by credit rating agencies saddled with severe conflict of interest as a large part of their revenues come from rating these new structured finance instruments; a laissez faire attitude among US supervisors and regulators that allowed reckless lending to foster.
Here are two examples of how uncertainty and opacity has vastly increased in financial markets.
First, you take a bunch of shaky and risky subprime mortgages and repackage them into residential mortgage backed securities (RMBS); then you repackage these RMBS in different (equity, mezzanine, senior) tranches of cash CDOs that receive a misleading investment grade rating by the credit rating agencies; then you create synthetic CDOs out of the same underlying RMBS; then you create CDOs of CDOs (or squared CDOs) out of these CDOs; and then you create CDOs of CDOs of CDOs (or cubed CDOs) out of the same murky securities; then you stuff some of these RMBS and CDO tranches into SIV (structured investment vehicles) or into ABCP (Asset Backed Commercial Paper) or into money market funds. Then no wonder that eventually people panic and run – as they did yesterday – on an apparently “safe” money market fund such as Sentinel. That “toxic waste” of unpriceable and uncertain junk and zombie corpses is now emerging in the most unlikely places in the financial markets.
Second example: today any wealthy individual can take $1 million and go to a prime broker and leverage this amount three times; then the resulting $4 million ($1 equity and $3 debt) can be invested in a fund of funds that will in turn leverage these $4 millions three or four times and invest them in a hedge fund; then the hedge fund will take these funds and leverage them three or four times and buy some very junior tranche of a CDO that is itself levered nine or ten times. At the end of this credit chain, the initial $1 million of equity becomes a $100 million investment out of which $99 million is debt (leverage) and only $1 million is equity. So we got an overall leverage ratio of 100 to 1. Then, even a small 1% fall in the price of the final investment (CDO) wipes out the initial capital and creates a chain of margin calls that unravel this debt house of cards. This unraveling of a Minskian Ponzi credit scheme is exactly what is happening right now in financial markets.
As a matter of intellectual tidiness, leverage adds to risk, not uncertainty. There are measures of leverage: margin loans outstanding, gearing ratios of financial intermediaries, notional amounts of derivatives outstanding. Yes, it is messy and difficult to put it together, but one can come up with reasonable (at least order of magnitude) measures of leverage. By contrast, it is much harder to measure risk or risk distribution on a more granular level (who holds that crappy structured credit and how much leverage have they piled on top of it?).
The uncertainty about counterparty risk is what is making investors afraid to trade with each other and could in turn produce a systemic event.