Saturday, December 08, 2007

Roubini: Uncertainty and Risk

This was posted a few months ago, but it is a great read discussing risk and uncertainty in today's financial markets. Direct Link
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”.

Indeed, for many reasons the current market panic has to do with unpriceable uncertainty rather than measurable risk.
This increased financial uncertainty is in part due to the increased opacity and lack of transparency in financial markets.

As pointed out by Gillian Tett in a January FT article the opacity of financial markets vastly increased in the last few years thanks to the rise in credit derivatives...

But it is not just credit derivatives that create market opacity. 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.

So combine an opaque and unregulated global financial system where moderate levels of leverage by individual investors pile up into leverage ratios of 100 plus; and add to this toxic mix investments in the most uncertain, obscure, misrated, mispriced, complex, esoteric credit derivatives (CDOs of CDOs of CDOs and the entire other alphabet of credit instruments) that no investor can properly price; then you have created a financial monster that eventually leads to uncertainty, panic, market seizure, liquidity crunch, credit crunch, systemic risk and economic hard landing. The last two asset and credit bubbles in the US – the S&L real estate bubble and bust of the late 1980s and the tech stock bubble of the late 1990s – ended up in painful recessions. The latest credit and asset bubble was much bigger: housing, mortgages, credit, private equity and LBOs, credit derivatives, corporate re-leveraging. So, the current bust and de-leveraging of the financial system is likely to lead to another painful economic hard landing.
It has been my own observation that this is true. Many financial companies can just not be valued and have to be thrown into the "too hard" pile. It is not that there is just uncertainty- it is that there is very highly leveraged uncertainty that could very easily wipe out many of these companies. The risk to investors can not be measured, and there is no comfortable margin of safety.

Some financial companies were better and more transparent than others (Wells Fargo, Bank of America come to mind), but they're stock prices have also been only very minimally affected. It has mostly been the most opaque and complex institutions where prices have fallen the most.
Credit derivatives, level three assets, low loss reserves, unmentioned counter-party risks... investors can not value these themselves with the information given in financial statements. An investor would be forced to trust in management's estimates, but these are the same management's that were doing some really silly things a few months ago.

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