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"Such conditionality gives rise to a material uncertainty related to events or conditions, which may cast significant doubt on the group's ability to continue as a going concern," Paragon said.

Scaling back

Paragon's comments came as it reported record profits of £91m for the year to the end of September, up nearly 10% on the previous year.

The havoc on Wall Street following the collapse of the subprime-mortgage market boils down to a simple truth: for years, lots of very smart people took lots of very foolish risks, betting borrowed billions on dubious mortgage derivatives, and eventually the odds caught up with them. But behind that simple truth is a more surprising one: the financial whizzes made bad decisions in part because that’s what they were paid to do.

Not literally, of course. The way that hedge-fund managers and investment-bank C.E.O.s get paid is supposed to make them perform better for the investors they serve. Hedge-fund managers, for instance, typically are paid “2 and 20”: they get two per cent of total assets as a management fee, and they keep twenty per cent of their investment gains (above some agreed-upon benchmark). Letting hedge-fund managers keep a chunk of their winnings gives them an incentive to do well for their clients: in theory, they get rich only if their clients do.

As the man who oversees about $20 billion of fixed-income investments at American Century Investments, we revisited with Keegan as part of today’s The Game column on the recurring foibles of Wall Street.

Deal Journal: You were right back in April. You called it all. Why does Wall Street keep messing up?

Jim Keegan: It’s too profitable to stop. It’s too profitable at the individual level, so the individuals interests are not necessarily aligned with the company’s interest. Pay me now and you pay for it later.

There is no clawback. Employees can walk away with hundreds and tens of millions of dollars. And someone else will hire them to do it again.

Ten years ago I stepped out of international business and into the think-tank community with a primary goal of getting reality on the table. I had seen more corruption, more money laundering, more financial crime than any one person should see in a lifetime, and I resolved to say what I wanted to say about this overarching reality. Why wasn’t reality already on the table? What is it about this subject matter that is so mysterious or so frightening that we hesitate to go there? Basically is it that we can’t see it or don’t want to see it?

"In crude terms, the Bank is basically providing additional cheap finance to the banks to meet any short term requirements they might face," he said.

"An increase in the reserve requirement is in affect an increase in lending to banks at the base lending rate of 5.75%.

"It represents a significant increase in the liquidity of the banking system ¿ and relieves pressure on the banks to borrow at the higher penalty rate of 6.75%."

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.

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.

Consider the evidence uncovered by Paul Oyer, a Stanford Business School economist, in his recent paper, "The Making of an Investment Banker: Macroeconomic Shocks, Career Choice and Lifetime Income" (National Bureau of Economic Research Working Paper 12059, February 2006). Dr. Oyer tracked the careers of Stanford Business School graduates in the classes of 1960 to 1997.

He found that the performance of the stock market in the two years the students were in business school played a major role in whether they took an investment banking job upon graduating and, because such jobs pay extremely well, upon the average salary of the class. That is no surprise. The startling thing about the data was his finding that the relative income differences among classes remained, even as much as 20 years later.