Will the price of risk be too high or too low?

From the comments at MR:

…we had all better hope that there will be some stupid groups in the
future, because if not, then our society will be poorer due to a
societywide excessively high price of risk. an excessively high price
of risk isn’t as spectacularly catastrophic as the excessively low
price of risk of the last 10 years, but compounded over time it can do
just as much damage…

I hold a few beliefs:

1. For a while the price of risk had been too low.

2. Currently the price of risk is too high.

3. In response to the crisis, we will regulate to prevent the particular previous manifestations of #1.  The bad news is this will be an overreaction; the good news is that because of #2 the regulatory overreaction won’t matter for some while.

4. We do not know how to regulate to prevent other, future, hitherto unexperienced manifestations of an excessively low price of risk.

5. Maybe #4 is wrong, but beware of any huff-and-puff polemic discussion that is not at least considering these points.

Comments

Tyler, can you speak to what you mean by "the price of risk?" I think you're using "risk" in a sense that's unfamiliar to me -- I'd say risk is the probability of losing one's investment, then risk itself is the price... Please clarify? Thanks.

He's talking about risk premiums (the rate of interest required for an investment - risk free rate). Tyler says those rates were too low.

Was the problem that risk premiums were too low or that there was significant systemic risk? Or both? Has anyone come up with good ideas on how to mitigate systemic risk?

Lending was so cheap because of the way banks calculate the risk from each loan. The Basel I and II agreements say banks must keep 8% of risk-weighted assets on hand. There are all sorts of problems with this, but the main one is that it forces most banks to use the same techniques to measure risk.

When you use these econometric techniques, risk is underpriced in the boom, and overpriced in the downturn. Thus, banks are forced to keep more capital in the downturn when there is more "risk", even though cash may be harder to come by.

If we are gonna use risk weighted assets as the basis for bank capital requirements, there has to be a simple way to make this countercyclical. Perhaps this involves taking a 5 year moving average of the risk or somehting...

And in the time of overreaction is exactly the wrong time to subsidize further overreaction.

Tyler,
All previous comments make clear that we are having problems to understand what you mean by the price of risk. First, you talk about risk as if you were talking about tomatos (each unit is a perfect substitute of any other unit) but we all know that risk is an aggregate of different types of risks and even worse that each individual type of risk does not consist of units that are perfect substitutes. You should clarify at least what are the relevant types of risks, and if you include systemic or systematic risk as a type of risk, please tell us exactly what you mean by it. Second, you about talk about the price being low and high as if you had a clear criterion to determine it, but we all know that at most what we have are time series of asset prices and interest rates that we can relate to time series of other prices. Please try to be more specific about what you mean by low and high prices of risk and how you measure them. Third, despite the two problems I've just mentioned, I believe that what you're trying to say in #4 is right but this is because you add the adverb "excessively". I believe that ex ante people cannot agree on the meaning of adjectives as excessive, unsound, systemic, etc., and therefore they cannot be used to determine policy. Fourth, your last point is right, but you have been ignoring it in your previous posts because you have relied heavily on those adjectives.

Well in your opinion the price of risk is too high currently

but until SYSTEMIC risk is drastically reduced then there is still a chance that many assets go to zero.

As long as politicians protect the hucksters, we will have plenty of risk. If the politicians hadn't protected Fannie and Freddie from more regulation, we wouldn't be in the situation we are today.

The price of risk is a standard term in quant finance, where many simple models assume the expected return of any asset equals the riskfree rate ( ie treasuries) plus the price of risk times some estimate of the risk of the asset. This is an oversimplification, and most people do treat the price of risk as different for different types of risk, but you get the idea. You can see the change in the price of risk in the ted spread, emerging market debt spreads, junk bond spreads etc, most of which were at extreme lows before the crisis. It is generally measured by market indices like the above -- I agree with the commenters above that a diversity of risk models helps but in the end there is a market clearing price.

Brad DeLong has posted a lot on this.

Current A-grade bond short-term yield: 5.4% (from Vanguard's fund for that category)
Current inflation rate (lower bound using corrupt methodology): 5%
Current real interest rate on short-term A-grade bonds: 0.4%
Claim: "Risk is overpriced right now."
Silas's reaction: HAHAHAHAHAHAHAHAHA! *rolling over*

This discussion seems silly to me until

(1) somebody defines the price of risk, and
(2) based on that definition, shows us a graph of the price of risk over time.

Then will might have a basis for discussion.

Are we talking about risk premiums? In what context?? Either way, to say that "4. We do not know how to regulate to prevent other, future, hitherto unexperienced manifestations of an excessively low price of risk" is, i believe, looking at the problem the wrong way. When the fed came in and "sponsored" fmae and fmac it pushed risk premium on mortgages to unnaturally low rates, making market equilibrium occur with the pooled risk lower then compatible with the overall underlying assets. It´s like getting a crack addicted bum on the street who´s asking for a loan. Then you define a risk premium for loaning him money. Then warren buffet says "I know this bum, it´s for a good cause, and i´ll sponsor him if he defaults". All of the sudden people are willing to lend to this guy at rates well below the inherent risk of the loan. Why? Nobody cares if the crackhead goes bust, so long as Warren is there to pay. So then Mr. Crackhead gets an AAA rating. You then have abnormal market returns sponsored by Mr. Buffet. Add leverage and matters get considerably worse. Now Warren Buffet has inadvertently created a mini crackhead credit bubble, and ultimately will have to pay the bill. Nevertheless, this bubble will stop growing once people start to doubt Mr. Buffet´s capabilities of sponsoring every loan. Now what would happen if there were (virtually) no limit to his resources, i.e., Mr. Buffet could, say, print money?

The problem of added regulation as a method of control is, therefore, that it is merely palliative. It would do the costly job imperfectly trying to correct the evils of the fundamental problem - government intervention in the market.

Another article by Brad DeLong in the same vein:


The Fed and the Treasury are walking down a road that ends with making the price of risk in financial markets, along with the price of liquidity, an administered price.

We do have some indirect evidence from asset prices that 'the price of risk' moves with business cycles. See, for example all the current asset pricing models with habits in the preferences. Empirically, the 'price of risk' increases in recessions, and drops during booms simply from the statistical properties of asset returns.

There is no really compelling structural model of the finding, though.

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