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GLOBAL PERSPECTIVE S A Hard Day’s Knight: The Global Financial Market Confronts Uncertainty, Not Just Risk (and the Difference is Important) October 2007 Richard H. Clarida Global Strategic Advisor PIMCO “A variety of asset-backed securities have led to disruption around the world.” Bank of England, September 4, 2007 “Markets for a wide range of securities have de facto disappeared.” Financial Times, September 20, 2007 1 ”Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.” John Maynard Keynes It is a truism to observe that financial markets clear at asset prices that balance the demand for reward against the supply of risk that is on offer at any point in time. Textbook models — even the most sophisticated, Nobel prize winning ones — typically begin with the assumption that there is a known underlying distribution from which asset returns are drawn. Given a fixed- and known-return distribution, investors can price options, identify relative values on yield curves, and decide on optimal hedge ratios for currencies. Of course, in practice the art of investing comes down to making informed judgments about distributions of returns that are not ‘known’ in advance. Indeed, getting the ex ante distribution of returns right is often the most important element of successful ‘risk’ manage- ment in actual financial markets, where the distribution of returns is an equilibrium outcome, not a preordained physical constant. However, under certain circumstances, it is crucially important to distinguish between the risk of undertaking an investment and the possibility of substantial uncertainty regarding the range of possible distributions of investment outcomes that an investor may confront. This distinction is important because financial markets may function very differently in a world of uncertainty than in a world of risk, in GLOBAL PERSPECTIVE S which market participants believe they are The global financial system right now is going making informed decisions about the distribu- through a serious bout of Knightian uncertain- tion of returns on the investments they make. ty, which may have significant consequences for investing and global financial markets for Nearly a century ago, the economist Frank some time to come.4 The proximate cause of Knight (191) made exactly this point. He this “hard day’s Knight” was the more or less argued that financial markets might operate simultaneous realization by millions of global very differently in a period of uncertainty than they function during periods in which there investors that their underlying assumption is broad agreement among investors on the about the distribution of returns on a wide distribution of possible investment outcomes. “variety of asset-backed securities” was 5 In the words of a recent paper on ‘Knightian’ fundamentally flawed. The realization was uncertainty, Rigotti and Shannon (005)3 write: more or less simultaneous because it was triggered by a common, instantly reported and “If risk were the only relevant feature of random- disseminated event: the July 10th announce- ness, well-organized financial institutions should be ment of imminent downgrade, and a revised able to price and market [financial] contracts that methodology for assigning new ratings, by only depend on risky phenomena. Uncertainty, some rating agencies of hundreds of asset- however, creates frictions that these institutions backed securities (ABS), specifically those may not be able to accommodate. …An event is backed by portfolios of subprime mortgages. uncertain or ambiguous if it has unknown probabil- The consequences of these downgrades spread ity. Uncertainty and risk are distinct characteristics far beyond subprime mortgage pools to asset- of random environments, and they can also affect backed securities secured by portfolios of other individuals’ behavior very differently… assets — corporate bonds, bank loans, automo- “Since uncertainty, as distinct from risk, can exert bile loans, and credit cards. a significant influence on individual behavior, it should also be a significant determinant of equilib- Single-A Spreads rium outcomes [in financial markets]. For example, 800 700 Knight claims that risk is insurable through Credit Cards – A 600 HEL – A exchange while uncertainty is not. [Knightian] CLO – A 500 uncertainty should arguably lead to two notable ABS CDO – A Option Arm – A 400 departures from standard risk-sharing behavior in 300 [financial markets].When uncertainty is 200 prevalent, some [financial] markets might 100 break down, resulting in equilibrium with no 0 trade. Moreover, indeterminacy may also arise [and 1/4/2007 3/4/2007 5/4/2007 7/4/2007 9/4/2007 Source: PIMCO this] can generate excess price volatility.” Figure 1 This contagion occurred, at least in part, holds it for that one year, one of two things because these different asset-backed securities will happen. The investor is either paid back in were structured and rated by the agencies full, or the borrower defaults and the investor using a similar methodology. When the receives a lower — usually much lower — agencies downgraded hundreds of subprime recovery value. The recovery value will asset-backed securities in July, investors in all- depend upon the value of collateral, if any, and asset-backed securities using this methodology the value of collateral will, in part, depend on realized they were in fact investing in an how many other borrowers have defaulted uncertain market in the sense of Frank Knight, and thus dumped collateral on the market. not just a riskier market (though it certainly Ex ante, when an investor buys the bond, the is also a riskier market than investors were price he is willing to pay, and his expected counting on July 9th). That is, investors began to return absent default, must compensate him realize this summer they didn’t know what they for that event of default – where recovery is didn’t know and this realization fundamentally much lower and much more uncertain - as changed the ways in which the global finan- well as any additional premium required cial markets clear and price discovery occurs. for taking on that risk. Thus, an investor in As predicted by the economics of Knightian a spread product must have a view of the uncertainty, many financial markets, in effect, probability distribution of default, in order to failed to function and price discovery was decide whether to buy a bond with default risk substantially impaired in those markets that instead of a government bond of comparable did trade.6 maturity which is backed by the full faith of the issuing government. In the remainder of this paper, I lay out my argument, and then distill what I think this all There are two ways to do this. The investor means for the global investment outlook over can do his own fundamental research on the the next several months. individual credit and the macroeconomic out- look. He needs to take a stand on the macro Risk or Uncertainty in outlook as well as the individual credit — its Spread Product cash flow, balance sheet, payment history An investor who buys a corporate bond, a — because the likelihood of default may be mortgage, or a sovereign issue knows that affected by both. For example, a homeowner there is some likelihood he will not be paid with a given credit history as of January 1st is back in full. As a consequence, the investor’s more likely to default by December 31st if he expected return must compensate for that becomes unemployed during the year, and he chance of default. If our investor buys one is more likely to become unemployed if the corporate bond that matures in one year and economy goes into recession during that year. 3 GLOBAL PERSPECTIVE S This is the way PIMCO invests. Our global agencies can offer their ratings as a free service credit team does its own fundamental analysis to investors because the agencies charge a fee of individual credits — be they sovereigns, to those credits that desire or require a rating corporates, or mortgages — and (this is where to place their paper. Many investors decide I come in) the global macro team does its own that, to gain access to credit exposure, and to macroeconomic analysis — be it G10, emerg- the higher average returns credit exposure can ing markets, or U.S. We then combine our offer compared to government bonds, they fundamental analysis of individual credits will invest based on the credit rating, often in (and portfolios comprised of those credits) a portfolio of credits that have similar ratings. with our macro view to assess the richness or Take 100 A-rated credits; combine them into a cheapness of these securities. Richness and portfolio, and that is one efficient way to invest cheapness, in turn, reflect our view of the in A-rated credits. A portfolio consisting of 100 probability distributions of default and recov- A-rated credits is an A-rated portfolio, but it ery compared with those that are reflected avoids the all–or –nothing (technically, all–or- in the market price. We buy (or overweight) recovery value) aspect of buying a single bond. credits that are cheap (i.e., those we think But, you may ask, how does a single rating — have lower default probabilities and/or greater be it A, AAA, or BBB — convey information recovery values than those reflected in the about the probability distribution of default market price) and short (or underweight) that investors need to assess when deciding credits that aren’t (i.e., those we think have whether to invest in a security or portfolio of higher default probabilities or lower recovery similarly rated securities. After all, distribu- values than reflected in the market price). Of tions are complicated beasts — they have course, this approach is expensive and, as means, variances, skews, and tails that can be they warn on Mythbusters — young Mathew skinny or, more often, fat.

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