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.

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About Eric Falkenstein 136 Articles

Eric Falkenstein is an economist who specializes in quantitative issues in finance: risk management, long/short equity investing, default modeling, etc.

Eric received his Ph.D. in Economics from Northwestern University , 1994 and his B.A. in Economics from Washington University in St. Louis, 1987

He is the author of the 2009 book Finding Alpha.

Visit: Eric Falkenstein's Website

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