Friday, September 7, 2007

A problem of information uncertainty -

Investment banks need to restore investor confidence by making a concerted effort to reveal the full extent of any losses arising from the credit market turmoil, Josef Ackermann, chief executive of Deutsche Bank, has urged.

What has been a major issue with the credit crisis has been the uncertainty of the problem. How big is it and where is it held? This may fall into the definition of Knightian uncertainty.

There are subtle differences in definition, but risk is usually defined as probabilities that are measurable. If we know the structure of a CDO, we should be able to determine its risk through some form of scenario analysis and stress testing. This may provide some insight on the level of potential loses. However, the real uncertainty with this crisis is not knowing who is holding the sub-prime paper. This is uncertainty that is not measurable and is what the market is reacting to. You cannot discuss the risk because you do not know whether a given institution has the problem.

This is not a matter of trust but an issue of information. The faster this information is put in the hands of investors, the better off the market will be. Of course, this process will identify winners and losers and this is exactly what the losers (large sub-prime holders) do not want to have happen. What is curious is why more institutions have not declared their holdings in CDO’s and sub-prime loans beyond what may be required. There may be a place for government to help eliminate this externality.

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