Friday, January 23, 2009

When Probability Becomes Uncertainty

One of the main dichotomies in Peter Bernstein's study of risk profiled on Monday is the difference between probability and uncertainty.
If I toss a coin in the air and let it land on the table, over a period of time (law of large numbers) I would expect a high probability of a 50/50 distribution of heads and tails (mean reversion). I can calculate these probabilities using a variety of algorithms because I'm "certain" that gravity will operate and the coin will actually land in one of 2 alignments.
What if I tossed the coin and it didn't come down, but instead continued out into the cosmos?That would be a huge surprise and mess up my probability calculations, and if I were a betting man, and had I placed a wager on the outcome of the coin toss, I'll be more than a bit befuddled. That was an outcome that was completely off the chart, unexpected and unprepared for. Or what if the coin simply landed on its edge 50 % of the tosses and stood erect? That would also be a big surprise, one that I really hadn't anticipated and would lead me to be very uncertain about future coin tosses.

Within the context of the financial markets there is a constant flux between trading markets and trending markets and between mean reversion and random walk patterns where volatility serves as one measure of implied risk. JP Morgan is frequently cited for his explanation of stock market prices: "It will fluctuate". Yes, we expect prices to go up and down, we do not expect them to go to zero, we do not expect $50B ponzi schemes to wipe out net worth of hundreds of individuals and companies , we do not expect a highly respected lawyer and investor to issue $100M in counterfeit promissory notes, we do not expect (previously) low beta banks like WAMU to literally implode and disappear from existence. We do not expect Lehman Brothers to become insolvent and be delisted. And, perhaps most frustrating, nothing happens to these guys. Nobody goes to jail. The execs just say "our risk management models failed . . . so sorry." And then Congress just doles out more dollars.
Along the path of carnage that has ensued for the past 14 months many probabilities that were previously quantified with risk management tools have become utter uncertainties, as reflected in the the current level of volatility in the VIX and other tells as well as the pervasive mood of despair and helplessness. The number of "zombie" companies, both overt and covert, has increased dramatically and this does not bode well for the markets. As traders (and investors) we would like to maximize the probability of profitable outcomes and reduce the level of uncertainty. Today's market climate makes these goals problematic and there are few indications that the worst is over.

A couple of years ago, when Nouriel Roubini predicted that U.S. financial-system losses would total $1 trillion, everyone thought he was insane. He has since revised his estimate. Now he's looking at an even grimmer forecast.

Bloomberg: U.S. financial losses from the credit crisis may reach $3.6 trillion, suggesting the banking system is “effectively insolvent,” said New York University Professor Nouriel Roubini, who predicted last year’s economic crisis.“I’ve found that credit losses could peak at a level of $3.6 trillion for U.S. institutions, half of them by banks and broker dealers,” Roubini said at a conference in Dubai today. “If that’s true, it means the U.S. banking system is effectively insolvent because it starts with a capital of $1.4 trillion. This is a systemic banking crisis.”.

Now, Roubini's just one guy, although I personally I like the way he thinks and suspect he may be on to something. My own feeling is that there an utter lack of oversight and accountability on the part of the Congress doling out taxpayer dollars to "troubled" financial institutions, car makers, home builders, etc, etc, etc. and the companies themselves, who somehow manage to continually reward upper management at the price of the guys who actually do the work. I didn't know whether to laugh or cry when I heard Barney Frank of the Senate Banking Committee say "Well, we expected them (the banks) to do the right thing" when asked why there were no controls on the money doled out and when the banks just sat on the money rather than loaning it out, as had been "intended".
Whether Obama will be able to have any positive and productive impact remains to be seen. I'm not sure HOPE is the right message as it seems pretty vague, has a built-in failure excuse and, well, is not really a plan. Having survived 8 years of the previous "faith-based" administration of robber barons, I'm more inclined to favor something like "let's clean house, create an empowered SEC and Justice department with some teeth that will actually do something, develop some performance metrics and get some accountability from those we choose to help survive". But that's just my naive' stance and unlikely to ever become a working policy.
In the meantime, gird your loins and bide your time. . .things could get nasty.

1 comment:

Quentin said...

Bob,

Nice post....sad thing is that things ARE going to get worst. Week after week of job layoffs, companies closing ( or moving overseas ) and mounting debt on all fronts is simply a recipe for disaster. 2009 is going to be a financial bloodbath.