Michael Foody

There are many lessons to learn from the credit crisis and its causes are complex and varied. That said, one thing that I think we can take away from the credit crisis is the danger of viewing risk manipulation as risk mitigation. What I mean is that, in many cases, it is easier to manipulate the nature of risk than to actually decrease risk. Suppose you’re dealing with a chaotic or poorly understood system, we’ll use roulette for this example, what is the proper strategy? The correct answer is that there isn’t one. With some odd exceptions the house edge remains the same regardless of what decisions the player makes. Having said that, it is possible to manipulate the risk. If you were to bet one dollar on one number your odds of winning would be one out in 38, but it pays out at 35 to one. Your chances of a bad outcome (losing your dollar) are very high when you only bet on a single number. You can correct this betting on more numbers if you bet on 32 numbers, you would only lose about ten percent of the time instead of around 97% of the time. But, is the betting on 32 numbers less risky than betting on one? Not really, because in the first example you will probably only lose a dollar, while in the second example when you do lose you will lose 32 dollars. In short you have decreased the likelihood of a bad outcome but increased the magnitude of the bad outcome. This is very similar to what happened with the credit markets. People bet a huge amount of money against an unlikely event (the simultaneous devaluation of many property values). It took a while for the loss to come up, but when it happened the results were catastrophic.

How is the above situation like nuclear proliferation? Nations with nuclear weapons are very unlikely to attack one another. In fact it has never happened that two nations with nuclear weapons have went to war with one another (directly). The fact that both the United States and the former Soviet Union both had substantial nuclear arsenals is a big part of why the two nations never went to war with each other. But the deterrent effect of nuclear weapons is directly tied to the extreme severity of the consequences. And just like in the case of the credit marks it is an easy mistake to pay insufficient attention to unlikely but catastrophic outcomes when weighing them against likely but less serious costs.