Tuesday, December 02, 2014

The Oil-Drenched Black Swan, Part 3: Multiple Risks, Multiple Unknowns

It is these unforeseeable and uncontrollable consequences that are poised to wreak havoc on the global financial system.

Here's the thing about risk: it bursts out of whatever is deemed "safe." It wasn't accidental that the Global Financial Meltdown originated in home mortgages; it was the perceived safety of the mortgage market that attracted all the speculative debt and leverage.

The authorities (those few who weren't bribed to look the other way) were caught off-guard by this explosion of risk in a presumably "safe" market, but this was entirely predictable: this is the nature of systemic risk.

Since 2009, central state/bank authorities have backstopped the private banking sector and the sovereign debt market with everything they've got. The Federal Reserve alone threw something on the order of $23 trillion in guarantees, loans and backstops at the private banking sector, and the other central banks have thrown trillions of yuan, yen and euros to shore up the banking sector and sovereign debt.

They did this because they identified the banking sector and sovereign debt as the sources of systemic risk. Now that they've effectively shored up these two risk-laden sectors with the full weight of the central state and bank, they presume the systemic risk has been eradicated.

They could not be more wrong. As I often note, risk cannot be disappeared, it can only be masked or transferred. The systemic risk will not manifest in the heavily protected banking sector or the sovereign debt market--risk will break out of sectors that are considered 'safe"--like oil.

Yesterday, I described how The Financialization of Oil has followed much the same path as the financialization of home mortgages in the 2000s: a "safe" sector has been piled high with highly profitable and highly risky debt and leverage.

Once the narrow base of collateral shrinks (as it has in oil), the inverted pyramid of debt and leverage collapses, distributing losses that then trigger defaults as the dominoes fall.

What are the risks that result from the drop in oil prices? We can identify four right off the top:

1. Financial market turmoil. Right now, the extent of the losses created by oil's sharp decline have yet to become visible. Everyone holding the losses is scrambling to hide them and sell positions to limit the losses. The full consequences of losses and defaults will only become public in the weeks and months ahead.

Those who think the losses are confined to the oil patch and lenders are mistaken. How many hedge funds and pension/mutual funds own oil stocks or oil-related bonds, loans and instruments?

2. Currency market turmoil. Venezuela is the leading candidate for currency collapse resulting from the drop in oil prices. Russia's currency (ruble) is already in a free-fall, and though some may blame Western sanctions, the real driver is the collapse in oil revenues.

3. Geopolitical conflicts. History suggests that declining oil revenues tend to spark geopolitical conflicts as those losing revenue seek scapegoats in other oil exporters who refuse to cut production to support higher prices.

There are a host of other reasons for geopolitical conflicts to arise out of oil's price decline. Stronger rivals may seek to exploit the weakened state of oil-exporting competitors. Oil exporters might seek to trim supply by disrupting rivals' production via fomenting domestic unrest. The temptation to invade and conquer rises in parallel with desperation.

4. The unknown unknowns and the rising odds of miscalculation. As I noted in The Oil-Drenched Black Swan, Part 1, the The Smith Uncertainty Principle expresses the multiple ways risk can manifest:

"Every sustained action has more than one consequence. Some consequences will appear positive for a time before revealing their destructive nature. Some will be foreseeable, some will not. Some will be controllable, some will not. Those that are unforeseen and uncontrollable will trigger waves of other unforeseen and uncontrollable consequences."

The highlighted passage echoes the impact of Black Swans and Donald Rumsfeld's famous encapsulation of the risks implicit in the unknown:
"Reports that say that something hasn't happened are always interesting to me, because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns -- the ones we don't know we don't know. And if one looks throughout the history of our country and other free countries, it is the latter category that tend to be the difficult ones."
Psychoanalytic philosopher Slavoj Žižek noted that there is a fourth categorythe unknown known: what we know that we intentionally refuse to acknowledge that we know.

I think this is an ontological (intrinsic) source of risk: we know our activities and choices are piling up risk, but we refuse to acknowledge this because we do not want to deal with the consequences of all that risk accumulating.

This is the root of Chuck Prince's famous line about dancing (i.e. pursuing reckless financial speculations) as long as the music is playing ("As long as the music is playing, you've got to get up and dance."): everyone engaged in speculation knows the risks are piling up, but to avoid having to exit the game, they deny knowledge of the risks that are visibly piling up.

Then when the house of cards predictably collapses, they can plead ignorance.

The Power of Black Swans lie in the unanticipated consequences of the unknown unknowns. Some of the consequences of lower oil prices are known, but some are unknown. It is these unforeseeable and uncontrollable consequences that are poised to wreak havoc on the global financial system. 

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