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Pandora’s Risk: Uncertainty at the Core of Finance resources

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6 Safety in Numbers Many credit markets behave as if they are inferring from only a few dozen years of relevant observations and frac- tional evidence of default. Their beliefs are modeled most plausibly as highly dispersed distributions, where the consensus might be wildly wrong. The uncertainty calls for much larger contingent reserves on top-rated credits than standard regulatory calculations recommend. Modern bond markets are highly sensitive to perceived default risk. Credit spreads are normally mea sured in basis points (bps), which are one- hundredth of percentage points. While default might not trigger com- plete loss, the residual or salvage value of a defaulted claim is oft en less than half the nominal value. Ideally the market wants a 1 or 2 bps accuracy in its estimates of default risk per annum. Th ere is no way to achieve that degree of accuracy for the debtors we care most about. Knowledge is always rooted in directly relevant observa- tion, and we don’t have nearly enough. So analysts branch into indirectly relevant or possibly relevant observation and draw on their imaginations. Th ey are lucky to obtain one- in- one- hundred part accuracy. Th nancial risk analysis. Yet it receives is problem is fundamental to fi scant attention. To redress the balance, let’s start with a real- life example. Real-Life Ignorance Th e coun- e Soviet bloc imploded around 1990, give or take a few years. Th tries that emerged from the wreckage were a motley crew. Some had strong

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