Monday, August 29, 2011

Painful Problems Aren't Anticipated

After under preparing for the big snowstorm in December 2010, Mayor Bloomberg over prepared for Hurricane Irene, which left New York City with pretty minor damage. This pattern is rather typical, because the cost/benefit ratio for over hyping a disaster clearly favors over-reacting after under reacting. Bad events are usually really damaging only when we totally do not see them coming.

Back in 1999, every risk management department had allocated considerable resources to the Y2K problem: that old software with two digit dates would implode at the end of the year. Many scaremongers conjured up plausible hypothetical, generalized, and scared the crap out of everyone. It turned out to be a non-event, and probably would not have been a problem even if there was no preparation.

In 2009, with financial crisis fresh in people's minds, everyone was worried about immanent commercial real estate crisis, which via the necessary refinancings, suggested several large defaults. The logic seemed impecable, but these haven't happened, as there are many ways to modify contracts to eliminate the dead-weight costs of a true crisis, and I predict this sector will work around these problems without any serious crisis.

In contrast, consider the housing crisis of 2008-9. I was at an NBER meeting in May of 2008, just before everything hit the fan, and remember a very well received talk by Markus Brunnermeier that the market had, at that time, overreacted. Virtually all the esteemed audience found the presentation convincing (including me!). The logic was as follows. Global stock markets had fallend by $8Trillion, though it appeared housing seemed to have only extinguished $500B in value. Brad DeLong, with hindsight, even makes a similar argument for a different narrative, but the logic is the same: no one understood the extent of the mortgage problem even after it was identified. The extent of the decline in underwriting, the legislative and regulatory reaction that lowered borrower's willingness to pay, was totally unappreciated. The base idea is that most experts didn't understand the crisis as it was happening, which is why things were as bad as they were. The things that hurt us are those things expert conventional wisdom does not see coming.

I would put default by the PIGS, a double-dip US recession, and muni defaults, in the category of something scary that many people are considering. A big jump in inflation or US interest rates, is something that I think most people would find rather surprising, and so would probably be much more damaging.


DKenny said...

I disagree. Absolutely everyone I know is totally confident that rates can only go up from here. Look at the massive amount of money that has moved into floating rate funds.

I think a far less anticipated event is a long period of low rates and low growth, ala Japan. A total meltdown of the Eurozone is also not anywhere near anticipated.

D said...

What 99% of people, intelligent market people, don't grasp is that the global financial system functions because of us treasury origination. why? collateral/reserve value. the number one way to disrupt the entire financial system again is to not give the market the treasuries it demands.

borrowing costs are not low because the fed "sets" them low, but because the market demands that much treasury debt relative to the supply!


so while everyone believes austerity and balanced budgets are the cat's meow they are, perversely, sealing their own fate.

B. A. said...

it makes sense to over hype a dysaster particularly if you are representing somebody else's interests, not your own. to keep your job, you have to manage that somebody else's impression of your job performance. the evaluation of your performance can be down to a couple of rules of thumb or benchmarking. being extra prepared is often seen as responsible behavior without wondering how much it all costs. if 1 million was to be wasted slowly over time by being extra cautious, the manager would still keep the job. but if the same 1 million is lost in one go, the cause of the loss will be seen to be the obvious lack of caution, and the natural thing to do is to fire the manager.

I see something similar all the time. people prefer to run long vega/ long gamma positions, because being long vol is somehow seen as responsible behavior during these tough times (implicitly assuming that the price you pay for it is always "reasonable", which is not true). the perception of risk of the people that decide how much you should be paid is more important than actual risk. at least in this part of finance, some kind of risk premium still seems to exist after all, but is paid for job security.

Dave Pinsen said...

You're right that the December 2010 blizzard fiasco caused Bloomberg to go overboard in the run-up to Hurricane Irene, but the blizzard problems weren't due to a lack of preparation; they were the result of a deliberate work slowdown by the sanitation department.

Regarding Y2K, I remember a presentation in 1999 by one an economist employed by a major fund company who made essentially the same point. He said he wasn't worried about Y2K because everyone was talking about it, and, besides, the switch to the Euro went smoothly and that involved similar challenges. "Be afraid of what you don't hear about", was his advice.

Anonymous said...

"The base idea is that most experts didn't understand the crisis as it was happening, which is why things were as bad as they were. The things that hurt us are those things expert conventional wisdom does not see coming.

That sure sounds like your nemesis, Nassim Taleb.