Distress Testing

The Economist put out a piece on the psychology of trading in stressed environments, such as those facing floor traders.

The piece brings to the fore the idea that, in deciding between a low-probability major loss and a high-probability minor loss, the stressed conditions encouraged participants to roll the dice with the major loss.

This theory -- which culminates in traders taking profits too soon and being unwilling to realize losses while they're still manageable -- is consistent with the "loss-aversion winning over utility theory" pieces that stock-trading-psychologist-guru Phil Pearlman writes (see here and here for example).

The nuts and bolts: if a trader has a 100% probability of winning 1 unit, versus a 60% probability of winning 2 units, the theory suggests that the trader often chooses the former option, against the principle of utility theory (since 60% x 2 units = 1.2 units, which is greater than 1).

The alternative is, however, much more troubling especially as it relates to pension funds and government intervention implementation: the willingness to roll the dice and risk a major problem, rather than suffer a sure, minor blow now. On the government level, this "theory" may manifest in an unwillingness to cut rates or even to draw down on the credit line available from the IMF. The United States was a front-runner in cutting rates in early H2, 2007, but some even criticize the U.S for cutting too slowly, too late, with the downturn having begun in 2006. A more rash action may have qualmed fears sooner, and nipped the problem -- now massive -- in the bud.

This trend remains "watchworthy" as companies like Ford reap the rewards of raising capital sooner rather than later and the Japanese banks continue to resist their governments attempt to inject capital, despite their relatively massive exposure to the stock market. Post the G20 meeting, it will be interesting to see how the Balkan (and particularly Baltic) countries differ in their approach towards relying on the IMF.

While it may be acceptable for smaller hedge funds to play ball on the downside, it's incrementally detrimental if systemic-risk-issue-companies, and governments themselves, don't carefully avert losses on the downside.

UPDATE April 22 (Bloomberg): Fitch says Japanese banks may need, yet avoid, public funds

Japan’s biggest banks may need to accept funds from the government as bad debts increase and investors demand higher capital ratios, according to Fitch
Ratings Ltd.

“Capital pressures are growing,” David Marshall , a managing director at Fitch in Hong Kong, said in a Bloomberg Television interview today. Capital weakness and loan losses “might even pressure some of the bigger Japanese banks eventually to have to turn to the government,” he added. “That’s something they’ll resist as long as they can to avoid that stigma.”

UPDATE April 23: Despite wider-than-estimated fourth-quarter loss -- as bad loans spiraled and the global financial crisis cut the value of its investments -- Japan’s second-largest bank Mizuho Financial Group Inc. did not announce any plans to raise money.