When Countries Go to Zero

I just had coffee with Mohamed El-Erian, who pointed out to me that he didn’t actually push the PPIP plan, as I said he did. He just said that the government needed a plan to deal with toxic assets, and that some plans made a lot more sense than others.

On the subject of PPIP, though, I did ask El-Erian about how much value there is in clipping tails. If the government promises to absorb all losses beyond the first 15 cents on the dollar, how much does that raise the amount of money you’re willing to pay for any given asset? I was trying, in effect, to come at a value for the FDIC guarantee in the PPIP plan, but I didn’t get very far.

The answer, you see, is basically “it depends”. Every asset has a different probability distribution, and if you think that there’s a good chance the asset is actually worth 90, the tail-clipping at 85 is much more valuable than if you think the asset in reality is more likely to be worth 110. In short, it’s a long and laborious process of looking at every asset individually determining a probability distribution, and doing some math on it. How many good credit analysts are out there and capable of doing that kind of analysis? I think it’s not nearly enough, but El-Erian is a bit more bullish on that front: he thinks that if you create the right incentives, people will start to work this stuff out.

We also talked a bit about the probabilities of a big secular shift into a whole new world of class warfare or even real warfare. El-Erian asked me what I thought the probability of that was, and I pulled a number out of thin air: 20% to 25%. After all, it’s simply a truism to say that historically speaking, long periods of peace and prosperity end with war and destruction. And the rise of global markets and economies since 1945 has certainly been a long period of time, which seems in many ways to be coming to an end.

El-Erian’s response was to say that probabilities that high aren’t remotely priced in to the market, which I think is undoubtedly true. People are happy talking about big-picture geopolitical risks, but they tend not to invest on that basis; instead, they habitually revert to thinking about “bottoms” and the like. Old emerging-market hands like El-Erian and myself are probably more prone to thinking about entire countries going to zero than most investors are — but I suspect that more and more people are going to be thinking along such lines over the coming months.

Comments

[waf76:]

if everyone is going to be thinking along those terms then we'll be at zero real fast so i have to disagree

Apr 27 04:47 PM

[Warm_Paw:]

The American public invests with no clear knowledge of what is occurring.
Trends are bullish right now with no reason for this being so.
My opinion is that the benign bank earnings occurred as a by product of changes to accounting rules suspending mark to market accounting.
Does the public realize if these 19 banks were to rid themselves of their toxic assets right now, it's more likely they'd all be destroyed.
BAC has equity of 177 billion dollars. Their liabilities are almost a trillion dollars greater than that number.(As of Dec 2008.)
Of course the Homer Simpsons are out there dumping their hard earned money back into Wall St.
Institutional investors won't be coming in until the Fed explains in detail, where the banks are in relation to what they hold in toxic assets and what the plan is to revalue these assets to a more correct valuation.
The Banks themselves don't even know what the true valuations are. The mortgages have to come due to see who defaults.
Beware the pundits on CNBC who race along in manic babble, talking over one another like some midnight shopping channel. They interrupt anyone who doesn't pump up the market.
The people coming on with bearish views are suppressed.
Pay attention to the bearish views. That's the real news.

Apr 27 05:13 PM

[Larry House:]

Thanks, Felix. Too many are getting too comfortable too fast. There are some big "tails" out there. Thanks for the dose of reality. I would rather be overly cautious now than overly upset (and poorer) later.

Apr 27 05:31 PM

[Jasper M:]

Warm_Paw, excellent observations.

I seem to remember reading somewhere that possibilities that are perceived as low probability, but extremely good Or bad, are processed by a different part of the brain than more common, moderate outcomes (amygdala, I think). This leads to them being either over or under emphasized, depending of mood. Thus we ignore extreme dangers until we can't, and then those who survive obcess about them, long after they have passed.

Apr 27 07:59 PM

[Hmm?!:]

Historically there has been a tendency to address the more probable but less devastating risks.

Therefore the very unlikely eventually devastate, often with no contingency plan.
- Titanic: the odds on hitting an iceberg in the open seas (fog or not)
- Bin Laden: the desert monkey had 2 pathetic WTC attempts before success
- New Orleans: The levee breaks, many are still there, and all their school buses are parked in the flood plain
- AIG both a bank and his backer would have to fail first. How many times can that happen at once.

Apr 27 09:32 PM

[Alok Swain:]

Jasper M, you comments to Warm_Paw were even better. :-)

You discuss a very important point - about the brain ignoring low probability risks early on and then when they happen (the low probabilty event occurs) it obsesses over it, ignoring that they are low probability and hence to recur (conjointed probability) also is low.

Its a shortcoming of human psychology, I guess.

On Apr 27 07:59 PM Jasper M wrote:

> Warm_Paw, excellent observations.
>
> I seem to remember reading somewhere that possibilities that are
> perceived as low probability, but extremely good Or bad, are processed
> by a different part of the brain than more common, moderate outcomes
> (amygdala, I think). This leads to them being either over or under
> emphasized, depending of mood. Thus we ignore extreme dangers until
> we can't, and then those who survive obcess about them, long after
> they have passed.

Apr 27 10:22 PM

[nym:]

So, Felix, where is your gold stored? Are you sure it's safe?

Apr 28 12:49 AM

[Jasper M:]

Alok Swain
Don't think of it as a shortcoming. Along with every other human trait common enough to have a name, it would not exist if it had not been selected for, thus it would seem arguable that it is a net benefit (at least to humans "in the wild state")

Apr 28 03:34 AM

[Jasper M:]

That was a little thin, so I will expound -
Humans have better memory than processing power. Maybe the particular problem of rare events (good or bad) is sufficiently difficult for our neuronal architecture that analysis is just not the most effective way of dealing with them (from an evolutionary standpoint). Instead, irrational (that is, not in proportion to actual risk) fixation on relevant memories turned out to be a more efficient option.
To give a personal example, in my impressionable youth, I made my first fortune buying long bonds (back when dinosaurs roamed the Earth . . . ). I made another investing in equities. The analytical part of my head tells me those games are no longer the optimum choice. But the lizard part of my head remembers the notable successes, unprecedented in my then short life, and I Just CAN'T let it Go. I Know that I should be concentrating on currencies, and commodities, but to this day, I react to video tickers the way some youngsters react to MTV.

Apr 28 03:55 AM

[John Lounsbury:]

Jasper M - - -

You wrote: "But the lizard part of my head remembers the notable successes,..."

I would call this the prejudice of success. Just as insanity is defined as repeating the same process again and again, but expecting a different result, obliviousness could be defined as doing the same process again and again and expecting the same result.

Just because something has not happened in a long time does not mean the probability of reoccurrence is low. For example, the longer the time since a major quake along the San Andreas fault, the greater the probability of a new major quake becomes. Similarly, the longer the world goes without a major economic upheaval, the greater the opportunity for extreme imbalances to build and the more probable a new upheaval becomes.

You may wait a long time for the improbable, so maintaining a position to profit from it may not be a viable strategy. However, not staying in a position to protect against being devastated by the improbable is unwise.

Apr 28 10:53 AM

[morph366:]

Agree with the comments from John Lounsbury and would extend his reasoning to suggest that there's a high likelihood that there's more aftershocks to come as part of a major economic upheval

The article talks about entire countries going to zero which is not such an outlier as it might seem. One thing is pretty certain which is that Moody's would only declare a negative outlook after the event.

Apr 28 11:09 AM

[kelm:]

Good article. The world has been so focused on the financial crisis that most other world events and trends are getting ignored. Many, like a North Korean missile launch are because we've been there before and by the way they still can't get it to work past the first stage. Other issues though like Pakistan are also getting lost and that is troubling. If there is a state headed for zero that is it. I will be surprised if it is not in full scale civil war by year end.

We have also not seen civil disturbances in this country, only a massive accumulation of weapons and ammunition and a lot of polemics on the web. I can't help think there is a point where sparks start flying.

Apr 28 11:10 AM

[Rob Viglione:]

Every portfolio should be picking up insurance of some kind to guard against black swan events. It's amazing how quickly fear is subsiding in this stock rally!

Now is the time to buy insurance and guard against that low-probabilty, but devastating event.

Apr 28 11:59 AM

[Lilguy:]

I realize Felix picked a number out of thin air (20-25% probability of "a new world of class warfare"), but maybe the air was too thin and he was hallucinating. That's a horribly high probability, especially without reference to a timeframe (say, the next 5, 10,25 years).

What is remarkable, however, is that from the period of the falling of the Berlin Wall and Desert Storm/Shield (ca. early 1990s) and a decade of comparative world peace, the probabilities of class and world warfare have mushroomed since 9/11.

On the class divide, clearly the current economic crisis is highlighting the growing divide between the rich and poor as well as the deterioration of the middle class in the US. This was evident even in the "good times" of the mid-decade as real median HH incomes stagnated or eroded. Now, as the USG under two administrations, asks the underclass to bailout the overclass, the stress is expanding rapidly. While I don't think there is a 20-25% probability that this stress will result in class warfare (I mean battles in the streets--real warfare), the likelihood that the government will be thrown out via elections (a Republican return to power in Congress!!) is growing substantially.

On the world warfare front, I view the continuing deterioration of the security situation in Pakistan as a major mid-term threat to US security. Takeover of nuclear-equipped Pakistan by the Taliban would threaten the region immediately, and specifically US interests in eliminating terrorist havens in Afghanistan and the NWFP of Pakistan. Having to carry out attacks on terrorist strongholds in a Taliban-ruled Pakistan would massively increase the risk that terrorists would counter in the United States, possibly with nuclear devices.

Apr 28 12:32 PM

[Sober Realist:]

The financial sector debt of our economy is currently $17.2 trillion and going vertical on the charts. That's 151% of national income. Back in 1957, the financial sector debt was only 5% of the economy's national income. It has now zoomed to 140% of today's economy - a debt ratio growth rate 28 times faster than general economic growth.
The government will ultimately not be able to keep most of these banks propped up. A day of reckoning is fast approaching that will send another major shock wave through the system.

Apr 28 10:39 PM

[Dusty:]

The investing population is Sigma Two and Sigma Three on the high end. This group is mostly highly educated and intellectual. Sigma Plus Two and Three total about 15% of the entire population.

If you want to look at the probabilities of war and other violence, look at Sigma Plus One and Sigma Minus One, Two and Three. That group is the working class and the anti-intellectuals. It totals about 85% of the population. That 85% is busy arming itself to the teeth. Its basic values are the words and ideas of the American Constitution as that document was originally written.

I hope that you intellectuals fix the big problems before the temperature of the rest of the population reaches the boiling point. I think the pot is already too hot to touch.

------------Dusty.

Apr 29 04:21 AM

[Hmm?!:]

In all of this I see a very strong bias in the media as the biggest cause of Black Swans!

I am sure I will get hard for saying this but its true! Media bias has tainted the Democratic party. Not the Democratic supporters just the leaders and their morals! The mainstream media misses on both sides but nothing as blatant as the devastating examples below.

If anyone can give more significantly destructive events where failures were IGNORED by the media I will gladly change my tune

- Bill Clinton cuts military spendings to its lowest level since the day of Pearl Harbor, after two attacks on US embassies in Africa (officially US soil), the COLE, a US military base in Saudi Arabia and two previous attempts on the world trade center. I liked his "just get the leader concept" but a lot of innocent people died in the desert monkeys 3rd WTC attempt. Then Clinton pardoned Marc Rich right off the FBIs ten most wanted list. Rich went on to fund Sadam Hussein, being a central figure in the UN "OIL for food" scandal.
If the media is unbiased....how is Clinton the expert speaker on National Security at the DNC???? The only one who questioned the choice was Clinton himself??

Barney Franks stopped oversight of Fannie and Freddie in congress in 2003. There is no more significant event in this meltdown. Serious flags had already been raised but oversight was stopped by Barney who swore the taxpyer would never pay for a bailout "Invest, and you are on your own, there is no guarantee, there is no explicit guarantee, there is no implicit guarantee, there is no wink-and-nod guarantee.....people, in my judgment, exaggerate a threat of safety and soundness..........I think we see entities that are fundamentally sound financially"

If the media is unbiased how is this moron still the house speaker? He basically stopped congress from saving America the enitre financial meltdown! The biggest 5 years of bad mortgages never would have happened!
www.taxfoundation.org/...

On Apr 28 12:32 PM Lilguy wrote:

> I realize Felix picked a number out of thin air (20-25% probability
> of "a new world of class warfare"), but maybe the air was too thin
> and he was hallucinating. That's a horribly high probability, especially
> without reference to a timeframe (say, the next 5, 10,25 years).
>
>
> What is remarkable, however, is that from the period of the falling
> of the Berlin Wall and Desert Storm/Shield (ca. early 1990s) and
> a decade of comparative world peace, the probabilities of class and
> world warfare have mushroomed since 9/11.
>
> On the class divide, clearly the current economic crisis is highlighting
> the growing divide between the rich and poor as well as the deterioration
> of the middle class in the US. This was evident even in the "good
> times" of the mid-decade as real median HH incomes stagnated or eroded.
> Now, as the USG under two administrations, asks the underclass to
> bailout the overclass, the stress is expanding rapidly. While I don't
> think there is a 20-25% probability that this stress will result
> in class warfare (I mean battles in the streets--real warfare), the
> likelihood that the government will be thrown out via elections (a
> Republican return to power in Congress!!) is growing substantially.
>
>
> On the world warfare front, I view the continuing deterioration of
> the security situation in Pakistan as a major mid-term threat to
> US security. Takeover of nuclear-equipped Pakistan by the Taliban
> would threaten the region immediately, and specifically US interests
> in eliminating terrorist havens in Afghanistan and the NWFP of Pakistan.
> Having to carry out attacks on terrorist strongholds in a Taliban-ruled
> Pakistan would massively increase the risk that terrorists would
> counter in the United States, possibly with nuclear devices.

Apr 30 02:20 AM