Coming back from vacation, the world seems lost. You don't need to be an actuary to grasp that the recent decision to lift the U.S. debt ceiling is first class trickery and completely inadequate.
What the Chinese rating agency Dagong already concluded back in November 2010, is only now (August 5, 2011) reluctantly and partly followed by S&P:
U.S. AAA status = Dead.
It's interesting to see which countries Dagong rates lower than the three famous rating Agencies in the U.S. (download complete Dragon report).
Meanwhile Dagong downgraded the U.S. again to an ordinary A-status on august 2, 2011.
The arguments for country degrades (as the U.S.) are as much clear as simple: if lifting debt ceilings is not at the same time combined with serious debt reduction measures (spending cuts), you go DOWN!
The outlook on the U.S. is still negative.
Outlook
Let's take look at what happened during 2011 and what 2012 will bring..
This chart instantaneously makes clear what's happening:
Jan 2011 - half May 2011
Although the whole world can figure out that the original debt ceiling of $14.294 trillion will be reached within a few months, no measures or actions are taken by the U.S. Treasury to prevent a debt default,.
May 16, 2011 - August 1, 2011
Treasury Secretary Timothy Geithner informs Congress he will start tapping into federal pension funds on Monday to free up borrowing capacity as the nation hits the $14.294 trillion legal limit on its debt.
By these and (possible) other optical actions the actual debt is kept artificially stable, slightly above the first ceiling. Of course the factual debt will (non reporting or visible) continue to keep growing.
August 1&2, 2011
The U.S. House of Representatives and the U.S. Senate pass the Budget Control Act on Aug 2, 2011.The debt ceiling is immediately raised by $400 billion, to $14.694 trillion.
A second debt ceiling increase allows the current new ceiling to grow by an additional $500 billion, to $15.194 trillion, so that government can pay its bills until the end of February 2012. However, Congress has the authority to reject this second increase.
August 5, 2011 - March 2012
TresuryDirect reports show the debt catch-up effects on August 5, 2011.
Already $271 billion of the $400 billion debt ceiling lift turns out to be 'consumed'. Another $129 billion is left.
As my two year old son can calculate: If no measures will be effective, around mid September 2011 a new ceiling crisis and media lift-show shall start.
After agreeing in September to the second ceiling of $15.194 trillion the muppet debt show will start again in March 2012, when the second ceiling will break.
The party is over
I'm not a pessimistic person by nature, but the U.S. is running out of possible solutions.
We'll have to build a society on new ethical financial principles.
If real measures stay out and claims on other countries or banks (as was the case with the sub prime debacle) are limited, the U.S. will unfortunately default in the end.
This U.S. default will take along most western countries.
It will result in a worldwide financial meltdown.
They only way out that seems left is:
Inflation
Let's hope for the best or a miracle. God bless America!
In July 2011 holidays - instead of blogs - are ahead...
Just chew this month on the next actuary no-brainer:
The smartest actuary in the world
The Pope, a well seasoned actuary and a student nurse are flying on an airplane. The captain comes back and says that he has some bad news and some really bad news. The bad news is that the plane is going to crash! As he puts on a parachute and jumps out he says that the really bad news is that there are only 2 more parachutes.
The actuary says: “I am the smartest man in the world. I've just calculated my life expectancy to be more than fifteen years. Excuse me...” With that he puts on a parachute and jumps out.
The Pope says: “Well, my child, I would love to live, but I believe that my time is up. Please take the other parachute and save yourself.”
The student nurse says: “Not to worry Holy Father. Right now the smartest man in the world is trying to find the rip-cord on my back pack!”
We all are more than familiar with the definition of Risk:
Risk = Probability × Impact= P×I
This way of measuring risk is a nice, simple, explainable and intuitive way of ordering risks in board or bath rooms, but unfortunately quite useless.
To demonstrate the limits of this kind of typical Risk definition, let's take a look at the next story:
The Risk of bicycling
You decided to start a 3 year math study at City University in London. From your brand new apartment in Southall, it's a 12.5 mile drive to the University at Southhampton Street. As a passionate cyclist you consider the risk of cycling through London for the next three years.
Based on your googled " DFT's Reported Road Casualties 2009" research (resulting in a cycling death rate of 36 per billion vehicle miles), you first conclude that the probability of getting killed in a cycle accident during your three year study is relatively low : 0.1% (≈ 3[years] × 365[days] × 25[miles] × (36 [Killed] ÷ 109[vehicle miles]).
Subjective probability
After this factfinding you start to realize it's YOU getting on the bike and it's YOUR 0.1% risk of DYINGin the next three years of your study....
Hmmmm...this comes closer; it makes things a little different, doesn't it?
Its looks like 'subjective probability' - on reflection - is perhaps somewhat different from 'objective probability'.
While your left and right brain are still in a dormant paradoxical state of confusion, your left (logical) brain already starts to cope with the needs of the right (emotional) half that wants you on that bike at all costs!
Russian Roulette
Now your left brain tells you not to get emotional, after all it is 'only' an additional 0.1% risk. Already your left brain starts searching for reference material to legitimate the decision you're about to take.
Aha!.... Let's compare it with 'Russian Roulette', your left brain suggests. Instead of 6 chambers we have thousand chambers with one bullet. Heeee, that makes sense, you talk to yourself.
With such a 1000 chambers Russian gun against my head I would pull the trigger without hesitating.... Or wouldn't I?..... No.., to be completely honest, 'I wouldn't risk it', my right brain tells me.
Hé... my left brain now tells me my right brain is inconsistent: It wants me on the bike but not to take part in a equal 'death probability game' of Russian roulette. Why not?
In Control
My left half concludes it must be the 'feeling' of my right side that makes me feel I'm 'in control' on my bike, but not in case of Russian Roulette. That makes sense, tells my left brain me. Of course! Problem solved! My right and left brain finally agree: It's only a small risk and it's I who can control the outcome of a healthy drive. Besides, this way the health benefits of cycling massively outweigh the risks as well, my right brain convinces me superfluous.
A final check by my right brain tells me: If I can't trust myself, who can I?
This rhetorical question is the smashing argument in stepping on the bike and to enjoy a wonderful ride through London City.
As ever...,
Aftermathematics
After returning from my accidentless bike trip, I enjoy a drink with a colleague of mine, the famous actuary Will Strike [who doesn't know him? ;-)].
After telling him my 'bike decision story' he friendly criticizes me for my non-professional approach in this private decision problem. Will tells me that I should not only have analyzed the probability (P), but also the Impact (I) of my decision. Remember the equation: Risk=P×I?
Yes of course, Will is right. How could I forget? ..., the probability of getting a deathly accident was only 0.1%.
Yet, 'when' a car hits you full, the probability of meeting St. Petrus at heaven's gate is 100% and the Impact (I) is maximal (I=1; you're dead ...)
Summarized:
Risk[death on bike;25 miles/day; 3 years] =
Probability × Impact = 0.1% × 1=0.1%
From this outcome it's clear that, even though the Impact is maximal (1=100%) , on a '0% to 100% Risk scale' this 3 year 'London-Bike Risk Project' seems negligible and by no means a risk that would urge my full attention.
I'm finally relieved... it always makes a case stronger to have a taken decision verified by another method. In this case the Risk=P×I method confirmed my decision taken on basis of my left-right brain discussion. Pff....
Afteraftermath
The next morning, after my subconscious brain washed the 'bike dishes' of the day before, I wake up with new insights. Suddenly I realize I tried to take my biking decision on the wrong variable: Probability, instead of Impact.
Actually, in both cases and without realizing, I took my decision finally on basis of the Impact and the possible 'Preventional Control' (not damage control !!!) I could exert before and during my bike trip.
I had to conclude that in cases of high Impact (I>0.9), nor my left-right brain chat, nor the 'Risk=PxI' formula lead to a sound decision, because both are too much based on probability instead of Impact. In other words:
In case of high Impact, probability is irrelevant
In case of high Impact, only control counts
From now on this 'bike conclusion' will be engraved in my memory and I will apply it in my professional work as well.
P.S. for disbelievers, the tough ones!
If you're convinced you would take the risk of firing the 1000 chamber Russian gun against your head, you probably valuate the fun of the bicycle trip higher than probability of the loss of your life or good health.
In this case, suppose someone would offer you an amount of money if you would take part in a 1000 chamber Russian roulette instead of a bicycle tour. At which amount would you settle?
Let's assume you would settle at € 10.000.000 (I wouldn't settle for less). In this case you really value your bicycle trip!!!!
As we've seen in banking business as well : extreme low probabilities and high impact situations are tricky! That's why stress tests focus on impact and not on probability.
The different faces of Risk
Another issue when looking at risk is that risk is always conditional.
'The' probability of death or 'the' mortality rate doesn't exist. Mortality depends on a number of variables, such as age (the run down state of your DNA quality), the DNA-quality you where born with and lifestyle. Secondly mortality also depends on a number of uncertain events in your life.
To demonstrate this 'Chameleon property' of probability, lets take a look at the probability of a meteor hitting good old earth.
The initial probability of an asteroid devastating the earth within a 10 year time frame is around 0.1%. A typical case of low probability and high impact. Once we've become aware of a spotted meteor in our direction, the probability suddenly changes from a general probability in a time frame to a asteroid specific probability during his actual passage of the earth.
In case of the asteroid '2011 MD' that will pass the earth at a minimal distance of 11000 km on June 27, 2011, this specific probability turns out 0.11% (remember the Russian Gun...).
With a diameter of around 8 meter, this asteroid is no big threat to our civilization.
Here's a short impression what's coming flying in on us within the next decades (Source: Nasa; asteroid>50 meter or minimum distance< 100,000km):
Apart from some 'big asteroids' in the next decade, this picture puts our minds at rest. Yet we should keep in mind that most asteroids are discovered only a few weeks before a possibe collaps...
In their document they analyze the case of the film Armageddon, where an asteroid of the size of Texas is on a direct collision course with the earth and Harry Stamper (alias Bruce Willis) saves the world by blowing it up.
Trying to fill in the Risk=P×I model in this Armageddon case is useless.
In this case, Risk is defined as:
Risk = [Probability of Impact] × [Impact of asteroid striking the earth]
Fanton and Neil conclude:
We cannot get the Probability number.
The probability number is a mix up. In general it makes no sense and it's too difficult for a risk manager to give the unconditional probability of every ‘risk’ irrespective of relevant controls, triggers and mitigants.
We cannot get the Impact number.
Impact (on what?) can't be unconditional defined without considering also the possible mitigating events.
Risk score is meaningless.
Even if we could get round the two problems above, what exactly does the resulting number mean?
It does not tell us what we really need to know.
What we really need to know is the probability, given our current state of knowledge, that there will be massive loss of life.
Instead of the Risk=P×I model, Fanton and Neil propose (Measuring risks) the use of causal models (risk maps) in which a risk is characterised by a set of uncertain events.
Each of these events has a set of outcomes and the ‘uncertainty’ associated with a risk is not a separate notion (as assumed in the classic approach).
Every event (and hence every object associated with risk) has uncertainty that is characterised by the event’s probability distribution.
Examples:
The Initial risk of meteor strike
The probability of loss of life (meaning at least 80% of the world population) is about 77%:
In terms of the difference that Bruce Willis and his crew could make there are two scenarios: (1) the meteor is blown up and (2) where it is not.
Reading off the values for the probability of “loss of life” being false we find that we jump from 8.5% (meteor not blown up) to 82% (meteor blown up). This near tenfold increase in the probability of saving the world clearly explains why it merited an attempt.
Lessons learned
Use (Bayesian) Risk Maps rather than the Probability Impact Model or Risk Heat Maps, if you want to take decisions on facts instead of your intuition.
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What the Chinese rating agency Dagong already concluded back in November 2010, is only now (August 5, 2011) reluctantly and partly followed by S&P:
The party is over 
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