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October 20, 2008

Weird analogy

Tyler Cowen uses the following odd analogy to describe the recently ended environment of extra risk taking:

Greater risk-taking was driven by investor hubris and collective delusion. Banks and other financial institutions bet against the possibility of bad times and in the short run those bets paid off handsomely. But in the long run they were disastrous.

For a simple analogy, imagine betting against a sports underdog every year. You may win consistently for a while but eventually you will lose all your money when the odds turn against you. In essence, banks were betting against extreme volatility, which sooner or later does arrive.

Because the track takes its vig off of every winning bet, one would expect that any betting strategy would turn against you. Long shots just as well as sure thinks could bankrupt you. There is some statistical evidence that long shots have been systematically over bet upon, but I doubt most of those strategies are trade-able nor are they persistent phenomena. If you bet money over and over again and you'll lost it.

Cowen could well be correct that firms and investors took risk for which they were uncompensated. That would be tough to prove. How would you distinguish the following investors:
1) An investor who had a disastrous bit of bad luck but thought the models were true. That is he was taking on less risk due to diversification and his position as a senior creditor
2) An investor in the same thing and who was betting the the risk of disaster was low. That is, he thought the models were false but that the ways in which they were not true were unimportant the the possibility of disaster low.
3) A third investor in that same asset who thought that the possibility of disaster was moderate but that the payment was adequate for that risk of disaster.

Of the three, only the third could reasonably be described as an excess risk taking. My guess is that categories one and two contain most of the investors in the problematic assets.

Posted by OneEyedMan at October 20, 2008 7:32 AM

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