Economists distinguish between “Risk” and “Uncertainty”: the former can be priced by financial markets while the latter cannot. The distinction between the two was made by the famous economist Frank H. Knight in his seminal book, Risk, Uncertainty, and Profit (1921). In brief, “Risk is present when future events occur with measurable probability” while “Uncertainty is present when the likelihood of future events is indefinite or incalculable”.  
 

This distinction between risk and uncertainty helps to explain the recent market panic and turmoil. Today, the FT cites a market economist at Lehman who said: “We are in a minefield. No one knows where the mines are planted and we are just trying to stumble through it”. A few days ago another market participant put it this way: “It is not the corpses at the surface that are scary; it is the unknown corpses below the surface that may pop up unexpectedly”.
 

Unknown minefield; unexpected corpses: this is “uncertainty” rather than “risk”. Risk can be measured and priced because it depends on know distributions of events to which investors can assign probabilities. Uncertainty cannot be priced by markets because it relates to “fat tail” distributions and extreme events that cannot be easily predicted or measured. A few days ago the CFO of Goldman Sachs justified the massive – 30% plus  - losses of the two Goldman Sachs hedge funds by arguing that these were unpredictable “25 standard deviation events” that should occur only once in a million years. The same thing was said by the LTCM “masters of the universe” when their highly leveraged hedge fund went belly up in 1998.
 

Too bad that these fat tail events do occur more often than once in a million years: the real estate bubble and bust and S&L crisis of the late 1980s; the boom and bust of the tech stocks in 2000-2001; the 1987 stock market crash; the 1998 LTCM debacle; the variety of asset bubbles that ended up into busts from Japan (1980s) to East Asia (1997-98).
 

Indeed, for many reasons the current market panic has to do with unpriceable uncertainty rather than measurable risk.
 

First, we have no idea of what the subprime and other mortgage losses will be: $50 billion, $100 billion, $200 billion? They could be as large as $500 billion if the US enters in a recession and we have a systemic banking and financial crisis. The uncertainty about these losses depends on the fact that we have no idea of how deep and protracted the housing recession will be and how much will home prices will fall. If home prices were to fall – as my research suggests as likely – more than 10% in the next year or so, the subprime carnage will massively expand to near prime mortgages and prime mortgages. There is already plenty of evidence that the delinquencies are not limited to subprime mortgages as a number of near prime and prime lenders are now bankrupt or in trouble (AHM, Countrywide just to cite two examples). The worse the housing recession will be the worse these now uncertain losses.
 

Second, we have no idea of where the mines and the corpses are. Every day the turmoil is popping out in unexpected institutions and places: by now hedge funds, banks and asset managers in US, France, Germany, UK, Asia, Australia have gone belly up. And every day a different financial market gets into a liquidity crunch and credit crunch: first subprime; then near prime, prime, CDOs, CLOs, LBOs, ABCPs, corporate credit spreads, overnite interbank loans, money market funds, mutual funds. Every day we get a different surprise that adds to the market’s uncertainty and investors’ nervousness.

This increased financial uncertainty is in part due to the increased opacity and lack of transparency in financial markets.

As pointed out by Gillian Tett in a January FT article the opacity of financial markets vastly increased in the last few years thanks to the rise in credit derivatives:

However, the fastest area of growth last year was in "structured finance" instruments, such as securitised products or derivatives.

The proliferation of such products, as I have often noted before, carries many benefits for the financial system (most notably that they disperse risk across a much wider pool of investors). But this trend also carries at least one downside; it is adding to the opacity of the financial world.

For although many corners of the structured credit universe are becoming more transparent, almost as soon as one chink of light emerges, another shadowy wave of activity emerges that is far more opaque.

Take collateralised debt obligations. Several investment banks and data groups have started to publish regular data about rated CDO issuance. That is a welcome step, given how much impact CDO issuance is having on the credit world. But such data is only available to the banks' clients and contacts. And even these "public" (or, more accurately, semi-public) figures reveal just part of the tale. For banks are apparently also arranging billions of dollars of private CDOs too. Such activity is never included in, say, the Dealogic data on overall DCM issuance.

Such opacity is, of course, not new. And it undoubtedly serves many people well. Hedge funds, for example, thrive in the shadows. So do investment banks, and - arguably - parts of the media (after all, if every detail of financial activity was freely available on the internet, who would buy newspapers?).

But, even with these caveats,I still find it extraordinary just how little public debate occurs about the continued (large) pockets of opacity in the financial world. More notable still is the apparent lack of research examining whether this world is becoming more, or less, transparent to regulators, let alone "citizen investors" or politicians.

But that, of course, is precisely the conditions in which opacity can flourish - and, barring any large financial crisis, will continue to do so this year.

But it is not just credit derivatives that create market opacity. This increased lack of transparency in financial markets is much broader: thousands of hedge funds that not only are unregulated but whose activities are opaque and not measured by any supervisor; shift of the corporate system from a public to a private one via LBOs and private equity transactions; increased size of unregulated over-the-counter trading in derivative instruments rather than on regulated exchanges; development of complex financial instruments whose correct pricing and rating is increasingly difficult; mis-rating of these new instruments by credit rating agencies saddled with severe conflict of interest as a large part of their revenues come from rating these new structured finance instruments; a laissez faire attitude among US supervisors and regulators that allowed reckless lending to foster.
 

Here are two examples of how uncertainty and opacity has vastly increased in financial markets.

First, you take a bunch of shaky and risky subprime mortgages and repackage them into residential mortgage backed securities (RMBS); then you repackage these RMBS in different (equity, mezzanine, senior) tranches of cash CDOs that receive a misleading investment grade rating by the credit rating agencies; then you create synthetic CDOs out of the same underlying RMBS; then you create CDOs of CDOs (or squared CDOs) out of these CDOs; and then you create CDOs of CDOs of CDOs (or cubed CDOs) out of the same murky securities; then you stuff some of these RMBS and CDO tranches into SIV (structured investment vehicles) or into ABCP (Asset Backed Commercial Paper) or into money market funds. Then no wonder that eventually people panic and run - as they did yesterday – on an apparently “safe” money market fund such as Sentinel. That “toxic waste” of unpriceable and uncertain junk and zombie corpses is now emerging in the most unlikely places in the financial markets.
 

Second example: today any wealthy individual can take $1 million and go to a prime broker and leverage this amount three times; then the resulting $4 million ($1 equity and $3 debt) can be invested in a fund of funds that will in turn leverage these $4 millions three or four times and invest them in a hedge fund; then the hedge fund will take these funds and leverage them three or four times and buy some very junior tranche of a CDO that is itself levered nine or ten times. At the end of this credit chain, the initial $1 million of equity becomes a $100 million investment out of which $99 million is debt (leverage) and only $1 million is equity. So we got an overall leverage ratio of 100 to 1. Then, even a small 1% fall in the price of the final investment (CDO) wipes out the initial capital and creates a chain of margin calls that unravel this debt house of cards. This unraveling of a Minskian Ponzi credit scheme is exactly what is happening right now in financial markets.
 

So combine an opaque and unregulated global financial system where moderate levels of leverage by individual investors pile up into leverage ratios of 100 plus; and add to this toxic mix investments in the most uncertain, obscure, misrated, mispriced, complex, esoteric credit derivatives (CDOs of CDOs of CDOs and the entire other alphabet of credit instruments) that no investor can properly price; then you have created a financial monster  that eventually leads to uncertainty, panic, market seizure, liquidity crunch, credit crunch, systemic risk and economic hard landing. The last two asset and credit bubbles in the US – the S&L real estate bubble and bust of the late 1980s and the tech stock bubble of the late 1990s – ended up in painful recessions. The latest credit and asset bubble was much bigger: housing, mortgages, credit, private equity and LBOs, credit derivatives, corporate re-leveraging. So, the current bust and de-leveraging of the financial system is likely to lead to another painful economic hard landing.