Ah, it was the Gaussian Copula Function!

Mispriced risk.  The global economic contagion was created by mispricing (read, underestimating) risk.  And apparently this is all a Canadian-educated Chinese mathematician's fault (way to externalize blame!)

So, for me the question is how do governments create policy regimes that encourage proper risk-management?  Obviously, powerful governments have a credible commitment problem since the costs of letting a financial institution dissolve in the face of risk bets gone bad are untenable.  But, as the parable of the Gaussian Copula Function tells us, there is little incentive for financial institutions to moderate or to be cautious.  So, our outcome seems doomed to be Pareto sub-optimal.

Even more concerning is industry and governments proclivity toward over-compensation.  When this financial mess bottoms out and we recommence our dogged climb toward ever-increasing prosperity, there will probably be a heck of a lot of regulation concerning the ways in which CMOs and credit default swaps can be created, rated, bought, and sold.  But, the underlying cause of financial blow up was not crazy mortgage-backed derivatives per se, rather risk mis-management stemmed from a deeply human tendency to discount "outliers" and treat events that occur under a certain threshold of probability as practically impossible.  And, until risk calculations take correlation seriously, financial firms in their legal obligation to produce the greatest returns for shareholders will continue to find ways to delude themselves and their clients into believing that you can make lots of money without taking on any risk.

Financial Contagion?

Iceland is near bankruptcy. Credit crisis hits Canada. Belgium, France, Luxembourg intervening to save bank after bank. The Euro falls to 14 month low as credit crisis spreads throughout Europe. Asian equity markets continue their deep slide.

$700 billion bailout. 50 basis point emergency global coordinated rate cut. Banking deposit guarantees. Governments taking equity stakes in banks (yes, including here in the US). 

Is there any further action that can stem the spread? Can the government do anything? Is this too little too late? Is a global recession inevitable? 

Shock and Awe

Reading the news feeds, one can't help but wonder if governments know what the heck they're doing.  New three-point plans, rate cuts, and proposals are exploding onto the scene like the finale in a fireworks display, often to no avail at stemming the depressing tail-spin of global equity markets.  Now, we have a whole lot of smart people working on a whole lot of stop gap solutions, and a very capable Bernanke using his knowledge of the Great Depression to try to make sure monetary policy doesn't make things worse.

Still, it seems through all the noise, the policy makers are missing the core problem - you can cut interest rates and provide increased government funds for short-term lending all you want, but banks still are simply not lending to one another.  Robert Pozen of MSF Investments has an opinion piece in the Wall Street Journal today calling for governments to guarantee short-term interbank lending.  This, in turn, will provide the time and space for the Economic Stabilization Act to generate more liquidity through the absorption of toxic debt.

It's clear from the increased international cooperation that governments understand and are willing to act (to varying extents) in concert to avoid the worst of the worst scenarios of deep and protracted global depression.  But, willingness to act is not enough.  Let's hope that global leaders are willing to cut through the noise and the panic to enact the correct combination of stop-gap and systemic measures to limit the damages and strengthen global credit and equity markets for the long term.

Risky Business

Continuing the incredulous unraveling of the financial markets, AIG has become the latest recipient of US Fed and Treasury orchestrated and US tax-payer funded bailout (see here - NY Times free account needed - and here).  Adding to mass hysteria is knowledge that a prominent money market fund dipped below a $1 NAV yesterday (it sounds mundane, but basically realizes risk in the traditionally most riskless and liquid asset class available).

It's hard for most to conceptualize just how recent events on Wall Street will effect the global financial environment, mostly because the financial instruments that got us into this mess by failing to accurately assess risk are so hard to understand (see here for a basis primer on derivatives).  The proliferation of esoteric credit derivatives on the global financial market has made a lot of people a lot of money, but it's also contributed to increased opacity of information and a decrease in the ability of governments to regulate.  And now, the chickens are coming home to roost.

As Alex mentioned in his previous post, the events of the past few weeks (and really the past six months) beg the question of what appropriate regulation looks like and how to get there.  In an interconnected financial world, how much space are we willing to give to free market machinations?  When do you think the government, governments, or institutions should step in, if at all?  How will the effects of a systemic under-estimation of risk change investor behavior going forward (especially large investors like oil-rich countries and sovereign wealth funds)?