Risk

| Mon Dec. 8, 2008 7:33 PM EST

RISK....Brad DeLong says that, ultimately, the global stock of capital fluctuates based on five factors: (1) savings and investment, (2) good and bad news out in the real world, (3) the default discount, (4) the liquidity discount, and (5) the risk discount. The first two haven't changed recently. The third has produced about $2 trillion in mortgage losses and $4 trillion in followon recession-based losses. The fourth, thanks to heroic efforts from central banks, has had a positive impact of about $3 trillion. So in Brad's estimate, the first four factors have produced a net loss of about $3 trillion worldwide. However, total actual losses worldwide during the economic crisis of the past year have come to about $20 trillion so far:

Thus we have an impulse — a $2 trillion increase in the default discount from the problems in the mortgage market — but the thing deserving attention is the extraordinary financial accelerator that amplified $2 trillion in actual on-the-ground losses in terms of mortgage payments that will not be made into an extra $17 trillion of lost value because global investors now want to hold less risky portfolios than they wanted two years ago.

....Our models predict that in normal times, with the ability to diversify portfolios that exists today, the risk discount on assets like corporate equities should be around 1% per year. It is more like 5% per year in normal times — and more like 10% per year today. And our models for why the risk discount has taken such a huge upward leap in the past year and a half are little better than simple handwaving and just-so stories. Our current financial crisis remains largely a mystery: a $2 trillion impulse in lost value of securitized mortgages has set in motion a financial accelerator that we do not understand at any deep level but that has led to ten times the total losses in financial wealth of the impulse.

.... $2 trillion shocks to global wealth [] happen every several years, every time there is a recession or a big rise in the prices of natural resources. But financial distress of the magnitude we see today happens once a century. Since the Bank of England developed its lender of last resort doctrine in the 1830s, we have only had two episodes this bad: the Great Depression and today.

If I had to guess, I'd say the financial accelerator was so outsized this time around because of the size and scope of the uncertainty it generated. During an oil shock, say, or a dotcom bust or a Latin American default, investors have at least some idea of which investments are going to be hardest hit and — more importantly — which ones aren't. But this time around, because of the size of the initial losses and their fundamental opacity, every investment has become suspect. After all, until the global derivative chains are somehow unwound, virtually every bank, hedge fund, and corporation with any serious exposure to modern financial instruments is — maybe, possibly — bankrupt. A housing bust wouldn't normally affect IBM very hard, for example, but what if it turns out that IBM has a bunch of CDS counterparty exposure to mortgage losses somewhere on its books? They probably don't, but how sure are you of that? Multiply that uncertainty by every company in the world, and you get $17 trillion in losses.

Eventually, I guess, the housing market will bottom, the toxic waste sloshing around the financial system will once again have a reasonable range of values, and the question of who has exposure to the losses will start to get narrowed down. Until then, the risk premium will probably stay sky high.

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