Why Ambiguity Aversion is Rational

The SEC gave a Wells notice to S&P for their dealings with a 2007 AAA rated CDO that subsequently went into junk status. The smoking gun is that while the deal was done with an assumed collateral issue that would be investment grade, by early 2007 the market was already tanking, and the issuer had subprime collateral. An email documents S&P was aware of this.

This was a mistake, one that was probably made many times previously but they got away with it because AAA securities tend to have multiple levels of security, belts and suspenders. Securitization become very complicated, with many different tranches and waterfalls, rules about replacing assets and prioritization that took required a lot of specialization (see Gary Gorton’s work here). Alas, any explicit, complicated process invites its circumvention, and issuers and borrowers eventually figured out the mortgage-CDO game. Those screaming warnings while it was happening were ignored (Stan Liebowitz), those who said these effects were innocuous, even morally righteous, were rewarded (eg, Richard Syron, Alicia Munnell). When this house of cards collapsed, everyone points to those with the deepest pockets, though no one seems to be going after Jamie Gorelick.

This was probably the last big mortgage deal to go through as if things were business as usual. As Bernanke noted, the mortgage market shut down in mid 2007 because issuers could not get the ratings needed. Market players make mistakes, but at least they stopped their idiocy 4 years ago, unlike our government, which even today issues mortgages with 3.5% down though private lenders are back to demanding 20% down.

This case highlights the importance of ambiguity aversion, as opposed to risk aversion. If a bad outcome were to result from a prospect about which an agent had, with the benefit of hindsight, made a mistake, he looks not just unlucky, but incompetent or malicious. In experiments, a lottery ticket is worth a lot less after the drawing for most people even if they don’t know what the true number is, and seemingly the seller does not either. People shy away from processes about which they think they have insufficient, as opposed to probabilistic, information, even if framed identically (eg, both with a 50% chance). This is ambiguity aversion.

A bad outcome resulting from a pure risky prospect, on the other hand, cannot be attributed to poor judgment. All possible information about the risky prospect was known, and a failure is simply bad luck. The key is, ex post, can you look like a sucker or just unlucky? Investment managers can live with bad luck, but their reputation is essential and they can’t be seen a fool.

This aversion to ‘incomplete information’ games is related to, but different from, classical risk aversion, and probably explains why lenders are now so afraid to lend: if they make a mistake now, it won’t be merely a bad investment, but a crime. This is known as ‘operational risk.’

AAA ratings on securities that subsequently suffered generated big losses to investors, the people who ultimately should be monitoring the credit agencies. Their incentives are already aligned. The rating agencies themselves have suffered credibility shocks for this, and so now we have DBRS and Kroll jumping into the previously unpenetrable field. Jumping onto the battlefield and court-marshalling the wounded is a poor tactic for improving morale or future performance, rather, it will just encourage all sorts of tentative, butt-covering behavior that precludes the dynamism a growing economy needs.

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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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