The Cost of Uncertainty

Economists often make the distinction between risk and uncertainty. When they do, most people think they are splitting hairs just for their own personal amusement. This kind of thing gives rise to my favorite definition of economics: "Common sense made difficult".

However, what we are seeing on display in the equity markets is a classic example of the distinction. Risk is normally defined as the likelihood of a negative outcome upon which a probability can be assigned. Uncertainty on the other hand exists when outcomes are out there to which no probability can be reasonably assigned.

Since no one is certain how pervasive and deep the default rate will be on the so-called subprime mortgages that kept the housing boom going long after the actual demand was satisfied in many areas, the securities which contain these risky mortgages cannot be priced. When a security cannot be priced, it cannot be bought or sold and it certainly cannot be used for collateral to access more capital.

What you see happening in the markets is the effect of this uncertainty. As people who own these securities want their money freed up to avoid further losses, in many cases no price is available to sell them and therefore there are few if any buyers. These instruments were sold under the expectation that the default rate was relatively known and the return and cost were built into the price (that was risk). Those risks were often hedged with other instruments which generally would have transferred the risk of a normal default pattern to those who were willing to accept a heightened prospect of returns for the assumption of the risk.

As paralysis sets in due to an inability to sell, hedge funds, some banks which offer hedge fund investments and many mortgage companies that are supposed to stand behind the instrumets are unable to perform. To the extent that these instruments were pledged as collateral for other loans, banks have been calling those loans or demanding injections of other equity like cash to bring the collateral value up to where it should be with respect the amount of the loan outstanding.

Since firms have invested the loan money, often in stocks and other instruments, they go into wave after wave of selling or unwinding those investments to pay up collateral values or allow troubled securities to be sold. When you hear that the FED is injecting liquidity from time to time, it means the government is stepping in to purchase some of these securities that otherwise would be frozen in uncertainty.

The panic spreads when the common investor sells their equity holdings trying to avoid loss of value. As stock prices fall to prices well below their actual value, others step in to purchase these bargain stocks. This creates a price increase for the stock. But many investment advisors are telling clients to do what the hedge funds are doing, namely "selling into" any strength in the market to get as much cash as possible. This selling into strength causes stocks to plunge just about every afternoon when morning optimism/bargain hunting has put a gain back into the market. So the cycle of fear and panic continues and will continue until uncertainty becomes risk and these assets can be priced again.

When people's 401k and stock investments fall in value, they begin to curtail discretionary spending in the current period even though their retirement funds may be decades away from actually being drawn upon. In a word, they feel less wealthy and that feeling results in cautious buying of everything from cars to refrigerators even in the current period.

That is the worry that some have now, that this relatively confined problem that should be wacking the day lights out of those that caused it (and it is) is spreading and driving expectations for consumers and others in the business community far removed from mortgage investments into a decidedly negative posture. People's attitudes alone, regardless of the fundamentals, can cause trillions in losses. Lets hope uncertainty becomes risk again in a hurry. You will know when that happens; the day the stock market is up 400 points or so all the way to the closing bell.