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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 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 G l o b a l 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 (1921) made exactly this point.2 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 (2005)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 .” 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.

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This is the way PIMCO invests. Our global agencies can offer their ratings as a free service credit team does its own 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 (or underweight) that investors need to assess when deciding credits that aren’t (i.e., those we think have whether to invest in a 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. And did I mention and Russell Clarida’s favorite TV show — it kurtosis, fourth moments, and transition prob- is something that most people should not be abilities? How does an investor turn a single “trying at home.” rating index — say, AA — into the information But there is an alternative, and historically it about the probability distribution of defaults has served many investors well. The alterna- that he needs to make an investment decision? tive is to outsource credit evaluation to a rating The answer is track record. The rating agencies agency. The rating agencies have large staffs, have a track record and investors can and do do serious fundamental analysis, and distill take the historical track record of defaults for the results of this research into a single index, a credits with a given rating into account to make rating. Better yet, investors can outsource credit their assessment of the probability distribution evaluation to the rating agency for free! Rating

 of default for credits with that rating. For similar ratings. For example, this track record example, Figure 2 illustrates the distribution suggests the probability that a Baa-rated of actual defaults on corporate bonds rated by security will default in year three is about 1%, Moody’s for the period 1983 to 2004. and the probability that a Baa-rated security will be upgraded to an A rating in year three Distribution of Defaults is about 3.9%. Corporates Rating Category Year 1 Year 2 Year 3 Year 4 Year 5 Year 6 Year 7 Year 8 Year 9 Year 10 Aaa 0.00% 0.00% 0.00% 0.11% 0.35% 0.49% 0.63% 0.79% 0.79% 0.79% ABS Tranche Securities and the Aa 0.00% 0.00% 0.03% 0.14% 0.20% 0.24% 0.27% 0.32% 0.37% 0.48%

A 0.03% 0.10% 0.25% 0.38% 0.50% 0.65% 0.84% 1.07% 1.30% 1.48% Ratings That Make Them Possible

Baa 0.21% 0.58% 1.00% 1.64% 2.27% 2.95% 3.57% 4.08% 4.50% 5.01%

Ba 1.21% 3.68% 6.46% 9.25% 11.70% 14.12% 16.18% 18.24% 20.10% 21.65% Although the U.K. and U.S. are the global B 5.60% 12.85% 19.77% 25.89% 31.47% 36.46% 41.38% 45.34% 48.76% 51.63% centers for financial innovation, the asset- Caa-C 22.15% 36.36% 48.29% 57.07% 63.36% 68.78% 72.90% 77.92% 81.93% 84.94% Investment backed spread products they make possible Grade 0.10% 0.28% 0.51% 0.83% 1.12% 1.41% 1.71% 1.98% 2.22% 2.47% Speculative are distributed and held around the world. Grade 5.52% 11.41% 16.94% 21.75% 25.88% 29.47% 32.69% 35.44% 37.76% 39.61% All 2.33% 4.77% 7.00% 8.92% 10.49% 11.80% 12.91% 13.83% 14.57% 15.18% While the products differ in some important Source: Moody’s Investor Service respects, they share some key similarities.7 Figure 2 The portfolios are divided into different tranches, with the riskiest tranches taking the Figure 3 shows the distribution of ratings first loss, receiving the lowest credit rating, transitions for U.S. corporate bonds over and offering the highest yield; and with the the same 21-year period. least risky tranche taking the last loss, receiv- ing the highest credit rating, and offering Distribution of Ratings Transitions the lowest yield. The methodology requires Corporates To From Aaa Aa A Baa Ba B Caa-C D WR the agencies to take a stand not so much on Aaa 85.7% 8.3% 1.7% 0.0% 0.1% 0.0% 0.0% 0.0% 4.3%

Aa 0.9% 85.0% 9.0% 0.4% 0.1% 0.0% 0.0% 0.0% 4.6% the value of individual credits, but instead A 0.0% 1.5% 87.4% 6.1% 0.6% 0.2% 0.0% 0.0% 4.1% to focus on the correlation of defaults among Baa 0.0% 0.1% 3.9% 85.0% 4.7% 0.9% 0.3% 0.2% 4.8% many credits with similar attributes. If the Ba 0.0% 0.1% 0.4% 4.8% 75.1% 9.0% 0.7% 1.1% 8.8%

B 0.0% 0.0% 0.2% 0.5% 5.2% 73.0% 5.6% 6.8% 8.6% realized correlation of defaults is lower than Caa-C 0.0% 0.0% 0.0% 0.1% 0.3% 3.5% 35.9% 53.3% 7.0% the rater expected, investors in the more senior

Source: Moody’s Investor Service tranches would likely be paid back in full, Figure 3 even if defaults occur and the holders of lower- rated tranches take losses. However, if the These are distributions of default probabilities realized correlation of defaults is higher than and ratings transitions that investors have the rater expected, some more senior tranches, come to expect when they buy corporate notwithstanding their higher initial rating, bonds or portfolios of corporate bonds with will default. In this way, a portfolio comprised

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of individual securities with BBB default risk A, and even BBB corporate bonds in which we have can be packaged to offer senior tranches (those decades of experience investing.” that are senior and take the later or last loss) This is a world of Knightian uncertainty, which receive an A or even AAA rating. not just risk, and the global ABS market is It is my opinion that hundreds of billions of exhibiting all the symptoms of a serious bout: dollars of asset-backed securities were pur- markets are essentially frozen, bid-ask spreads chased in recent years because investors thought are wide and ‘indicative’ and many investor and were encouraged to believe that their ratings portfolios are concentrated in corners, as in offered similar (if not identical) default distribu- “I don’t want any ABS.” Note this is differ- tions to those which had for decades been associated ent from a portfolio selection that is long ABS with individual corporate bonds. Since the mass based on the notion that ABS are cheap, or downgrade on July 10, investors have short ABS based on the expectation that ABS concluded they were mistaken, and this are going to get cheaper. Standard textbook rational shift in sentiment has rocked the models that ignore uncertainty predict that financial markets. It has placed us in a if risk goes up, portfolio composition should Knightian world in which investors don’t change, but should generally not go to zero! In a know what they don’t know. What they do know world of Knightian uncertainty, the best thing to do is that the model upon which they originally can be to leave the market! This is not something you learn in Finance 101 where Knightian uncer- based their purchases of these securities has tainty is assumed away. turned out to be the wrong model. Investment Implications At the 30,000 foot level (which is where I, as a macroeconomist, view such things and often, A world of Knightian uncertainty suggests as I am now, write about them) there is nothing several investment implications. First, as Paul conceptually wrong with this approach to McCulley said presciently back in July, these creating asset-backed securities. A tranche that markets will not clear when they are ‘fair’, is very senior in the is less they will clear when they are ‘cheap’. A real likely to default than the first loss piece and issue with the global ABS meltdown is that its spread and yield should reflect this. The fundamental valuation of these securities is question now is: how much less likely to default? exceedingly complex. There is value opportu- In other words, what is the distribution of nities today in our Frank Knight marketplace, default probabilities for these various and but you have to work (hard) to ascertain it. sundry securities? The markets after July 11 First, those firms, such as PIMCO, that have are saying, collectively, “We don’t know, but we do the expertise and resources can and will find think we know they are not the same as the AAA-, value opportunities in this market, precisely

 because a lot of the players who were in the episode of Knightian uncertainty will eventu- market on July 10th have left. Second, as Bill ally pass. While many of these ABS structures Gross highlighted in his Investment Outlook in are novel and have short track records today, September (which was the inspiration for the current conditions will provide a track record present article), the realization that complex for future stress testing of ABS tranches. In the ABS structures comprised of weak credits future, portfolio managers will likely look back that were sold as A-rated aren’t the same as at 2007 as yet another ‘six sigma event’ and will traditional A ratings for individual corporates simulate their exposure to see how it would will have a long lasting effect on investors. do in a 2007 credit episode.8 This, in turn, will The ABS market will not disappear, but going enable them to better calibrate risk and reward forward it will likely trade with an appropri- for their exposures so that today’s 2007 bout ately healthy risk premium that was all too of Knightian uncertainty becomes a crucial in- absent in recent years. This is not a bad thing; put to the next episode’s (perhaps in 2011?) risk indeed it is efficient relative to the alternative of management exercise. capital being excessively allocated to borrow- ers that are unable to repay loans. Third, this

1 Quoting Marco Annunziata, chief analyst at Unicredit. 2 Knight, F. (1921). Risk, Uncertainty, and Profit. Houghton Mifflin Company. For an illuminating discussion of Knightian uncertainty as it relates to finance, see Peter Bernstein’s Against the Gods, especially Section Four. 3 Rigotti, L. & Shannon, C. (2005). Uncertainty and Risk in Financial Markets. Econometrica. 4 This paper has benefited from a stimulating discussion I had with Chris Dialynas, PIMCO Managing Director and Portfolio Manager, during our recent Strategy Week. 5 A case that has been made for some time by Bill Gross, most recently in: Gross, B. (September 2007). Where’s Waldo? Investment Outlook. See also, Gross, B. (July 2007). Looking for Contagion in All the Wrong Places. Investment Outlook, and Gross, B. (December 2006). Reality Check. Investment Outlook. 6 With significant implications for the survival of what Paul McCulley has called ‘the shadow banking system.’ The point being that these opaque ABS structures were held, in part, by special purpose vehicles and conduits that financed the positions by rolling commercial paper. As the world plunged into Knightian uncertainty this summer, the entire business model of the shadow banking system has come under significant stress. This, in turn, has resulted in contagion to the LIBOR market where spreads over policy rates have widened because of the need/desire on the part of banks to hoard cash in anticipation of the collateral of the shadow banking system being returned to bank balance sheets. See Teton Reflections. (August 2007). Global Central Bank Focus. 7 For a useful introduction to the wonderful, if uncertain world of structured credit, see Meade, R. (May 2007). Demystifying the Structured Credit Jargon and Identifying the Opportunities. European Credit Perspectives. 8 As the saying goes, “On Wall Street, there is a 100-year flood every four years.”

 Past performance is no guarantee of future results. Investing in the is subject to certain risks including interest-rate, issuer, credit, and inflation risk. Investing in government securities do not guarantee an investment and it will fluctuate in value. The value of some mortgage-related or asset-backed securities (ABS) may be particularly sensitive to changes in the prevailing interest rates. A change in interest rates can affect the pace of payments on the underlying loans, which in turn, affects total return on the securities. Similar to mortgage-related securities risks, some ABS (in home equity transactions) carry interest-rate risk and prepayment risk. When interest rates decline and many home equity loan borrowers refinance and prepay their existing fixed-rate loan, ABS backed by these loans will likely mature earlier than expected. In falling rate environments, prepayments result in lower total returns for investors on the ABS. Investors investing in ABS are also exposed to the following risks: credit risk, default risk, structure risk due to early amortization or early payout. The value of such securities may fluctuate in response to the market’s perception of the creditworthiness of the issuers. Additionally, there is no assurance that private guarantors or insurers will meet their obligations. Diversification does not ensure against loss. This article contains the current opinions of the author but not necessarily those of Pacific Investment Management Company LLC. Such opinions are subject to change without notice. This article has been distributed for educational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this article may be reproduced in any form, or referred to in any other publication, without express written permission of Pacific Investment Management Company LLC, 840 Newport Center Drive, Newport Beach, CA 92660. ©2007, PIMCO.

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