When countries go to zero

April 27, 2009

I just had coffee with Mohamed El-Erian, who pointed out to me that he didn’t actually push the PPIP plan, as I said he did. He just said that the government needed a plan to deal with toxic assets, and that some plans made a lot more sense than others.

On the subject of PPIP, though, I did ask El-Erian about how much value there is in clipping tails. If the government promises to absorb all losses beyond the first 15 cents on the dollar, how much does that raise the amount of money you’re willing to pay for any given asset? I was trying, in effect, to come at a value for the FDIC guarantee in the PPIP plan, but I didn’t get very far.

The answer, you see, is basically “it depends”. Every asset has a different probability distribution, and if you think that there’s a good chance the asset is actually worth 90, the tail-clipping at 85 is much more valuable than if you think the asset in reality is more likely to be worth 110. In short, it’s a long and laborious process of looking at every asset individually determining a probability distribution, and doing some math on it. How many good credit analysts are out there and capable of doing that kind of analysis? I think it’s not nearly enough, but El-Erian is a bit more bullish on that front: he thinks that if you create the right incentives, people will start to work this stuff out.

We also talked a bit about the probabilities of a big secular shift into a whole new world of class warfare or even real warfare. El-Erian asked me what I thought the probability of that was, and I pulled a number out of thin air: 20% to 25%. After all, it’s simply a truism to say that historically speaking, long periods of peace and prosperity end with war and destruction. And the rise of global markets and economies since 1945 has certainly been a long period of time, which seems in many ways to be coming to an end.

El-Erian’s response was to say that probabilities that high aren’t remotely priced in to the market, which I think is undoubtedly true. People are happy talking about big-picture geopolitical risks, but they tend not to invest on that basis; instead, they habitually revert to thinking about “bottoms” and the like. Old emerging-market hands like El-Erian and myself are probably more prone to thinking about entire countries going to zero than most investors are — but I suspect that more and more people are going to be thinking along such lines over the coming months.


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