...tails, you lose.

Oscar Wilde famously defined a cynic as someone who knows the price of everything and the value of nothing.  The wit appeals to us intuitively as we think of an old family photograph, which may have enormous sentimental value to us, but for which there is no market and therefore no price.  But let’s turn for a while to the world of financial assets, where sentimentality doesn’t, or at least shouldn’t, play a part.  When it comes to financial assets, price and value are synonymous.  The cynic in Wilde’s definition is a contradiction in terms.  If you know a financial asset’s value, you know its price, and vice versa.  Financial assets are intangible; they have no intrinsic use.  A financial asset isn’t a gallon of milk you can drink, a car you can drive, or a house you can live in.  Financial assets always and only are worth what the next person will pay for them.  The financial markets are in crisis today because the next person does not know what to pay for many of the financial assets traded in those markets.  The reason for this comes down to the difficulty, perhaps even the impossibility, of accurately assessing tail risk.

The graph above is a bell curve.  When a teacher grades on a curve, the curve in question is a bell curve.  In a class of 30 students, most scores will be in a fairly tight cluster.  Only a few, perhaps none, will score on the very high or the very low end.  Those ends are called the tails of the curve.  Over a wide number of data sets, most scores will be within 95% of the average score, and practically all scores will be within 99% of the average.   .  People who evaluate risks for a living use the same concept. Gathering relevant historical information, they calculate the probability of potential future outcomes.  Plotting the results of a school test is easy; the outcomes are finite and circumscribed. But virtually anything and everything can affect the value of a financial asset.  A risk manager may be concerned that Godzilla will rise up out of the ocean to ravage Tokyo, and, in the ensuing confusion, knock the bottom out of the market for securitized subprime mortgages.  The historical data indicate, however, that the probability of that event is less than 5%, putting it way out on the tail of the curve.  The risk manager—or more likely, the risk manager’s model—discounts it.  But suppose Godzilla does ravage Tokyo.  Now the probability is 100% and financial market participants find themselves in a predicament no one has prepared them for or warned them against.

The most recent manifestation of tail risk in the financial markets has popped up in the $300+ billion realm of auction-rate securities. Like the asset-backed commercial paper market that blew up last fall, the auction-rate securities market matches lenders who want short-term exposure with borrowers of long-term debt.  Many debtors who participate in the auction-rate markets are tax-exempt organizations or governmental units who have needs for long-term funding for capital projects, such as school or hospital buildings.  To avoid high fixed rates of interest, these entities issue bonds that are auctioned weekly at prevailing short-term interest rates. The auctioneers are the large banks or brokerages who underwrite the debt.  The sellers and buyers are money-market investors who want the safest, shortest and most liquid investments.  In the past, a shortage of buyers was rare, and when it did happen, the large bank or brokerage bought the paper, essentially acting like a market maker on the stock exchange to preserve the smooth functioning of the market.  But, the willingness of investors to buy or banks to provide a backstop was never guaranteed.
In recent days, sellers have greatly exceeded buyers in security auctions.  Sponsoring banks have been unwilling to act in the normal buyers’ stead.  When the auctions fail, the sellers must hold onto the bonds and the interest rate resets to a contractual level, which can be startling.  A few days ago, the weekly rate on a $100 million Port Authority of New York bond reset at 20% when an auction run by Goldman Sachs failed.

The Port Authority of New York is not going out of existence anytime soon, unless Godzilla transfers his attention from Tokyo to Manhattan.  Why did both buyers and banks shun the credit?  For the last 20 years or so, many municipal bonds have been insured by specialized companies who transferred their triple-A ratings to the bonds.  Since almost no municipal bonds ever default, this was a no-brainer business, the equivalent of selling life insurance to the immortal gods.  But then the insurers got greedy.  They began insuring more and more exotic types of securitized loan deals including subprime mortgage pools.  In the process, they killed the goose who laid the golden egg.  Most of these insurers are now losing their triple-A ratings, causing the municipal bonds they insured to lose theirs as well.  Many of the investors who participate in the auctions, such as tax-exempt money market mutual funds, require at least a double-A rating on the bonds they buy.  That explains the buyers’ strike.  As for the banks and brokerages, their problem is capital.  They have suffered well over $100 billion of losses tied to subprime mortgages, and they have had to retain other risky assets on their balance sheets that they would prefer to sell.  They have no wish to add significant additional assets onto an already strained capital base, even when those assets are in no actual danger of default.

The trail leads back to the tail.  The rocket scientists who calibrated the risk in subprime mortgage pools should have known that home values could not appreciate forever.  But could even the brightest of them have imagined that falling home values would create a meltdown in subprime mortgages leading to a devaluation of municipal bond insurers’ credit ratings, which in turn would cause the auction-rate securities market to seize up? Frankly, I don’t think they could have.  I think that risk was too far out on the tail to have been considered.

The crisis now playing itself out in the auction-rate securities market is a perfect example of the law of unintended consequences.  A group called the Financial Stability Forum, composed of international central bankers, recently published an interim report of recommendations or lessons learned from recent market events.  The group blames “a wave of financial innovation [that] created instruments and risk exposure so complex that risk management systems at a broad range of financial institutions, including many of the largest global banks, failed to control them effectively.”  They suggest, as a remedy, that both bankers and regulators “sharpen firms’ focus on tail risks.”

This is whistling in the wind.  The introduction of Godzilla into this commentary was not, as some readers may suppose, simply an ill-advised grasp at humor.  The point is that financial markets are at risk of anything, even pre-historic monsters, and no person or computer program can identify or guard against all of them.  The specific excesses and failures of judgment that led to the subprime mess won’t be repeated but others will be.  Different tail risks will emerge in future crises and they will be just as unpredictable as those we are seeing today.

In closing, it seems appropriate to note another tail risk in the making.  Ben Bernanke and the Federal Reserve received harsh but deserved criticism for failing to understand the magnitude of the subprime problem.  The Fed sat on its hands through the summer when it should have eased credit conditions proactively.  Now the Fed has caught up.  The dramatic reduction in the fed funds target in January to 3% leaves no doubt that the Fed gets it.  Chairman Bernanke in testimony to Congress today indicated that the Fed stands ready to reduce rates further.  “More-expensive and less-available credit seems likely to continue to be a source of restraint on economic growth,” Bernanke said. ``The outlook for the economy has worsened in recent months, and the downside risks to growth have increased.''

True, but credit is constrained not because short-term rates are too high, but because lenders are afraid to lend.  They don’t know the value of the assets they are lending against.  This is a problem that only time will solve.  Continued reductions in the federal funds target rate at this stage will have a diminishing impact on easing credit conditions.  In fact, they would be counter-productive if, as is likely, they ignite fears of rising inflation thereby driving long-term rates higher.  That would cause 30-year fixed rate mortgages to become more expensive, since they are priced off long-term bond rates.  Lower short-term rates would, however, make adjustable rate mortgages cheaper and more attractive. And that’s what opened the door to the whole subprime mess in the first place.