Sunday, April 25, 2010

Risk Has Left the Building

The financial collapse of AIG wasn’t an accident. The conditions were just right for individuals of every walk of life to make a killing on the way the financial system reacted to the real estate boom. The basic mistake was the misallocation of resources. The world didn’t need all of this new housing, but it was very profitable to build and finance. The increased property values implied that the banks couldn’t lose on any loan. The tax base increased proportionally and government expanded (exploded). It was only "short bus" math to figure out that over 30 years, a person earning $35,000 per year was not going to have the resources to pay off, a 30 year, one million dollar mortgage.

All of a sudden it stopped, the bubble burst. AIG and several hedge funds collapsed. The side bets (derivatives/insurance/credit-default swaps) covering those exposed to loss came to the surface. These hedge funds were writing insurance on everything including the kitchen sink.

Risk had been removed from the business model. It’s hard to lose money if you place the right side bets (that’s without even including Fannie and Freddie in this mess). Too much “insurance coverage” had been written. The insurance premiums were collected and went into someone’s pocket. The estimated 40 to 80 trillion of derivatives written to insure against financial loss will never be paid.

For example, Greek bonds have a substantial risk, but buy insurance and your worries are gone. If you are the Greek government, buy the insurance (you can’t lose). If you work for the Greek government, why buy the bonds? Just buy the insurance and when Greece goes belly up, retire to the good life. Greece will make that glaringly apparent when they collapse (after receiving their bail out money).

The real fault with this "insurance" is that you don’t have to have a relationship to the asset being insured. There is nothing to stop you from insuring your neighbor’s home and then burning it down. Plus if the neighborhood has "a gut feeling about that house," there’s going to be several policies written on that home. Then when the expected happens, (it burns to the ground) everyone gets rich. It’s as if, AIG was the insurer for anyone placing a bet on that house. Geithner and Bernanke saved the day; everyone got paid on that one.


Three questions arise. Were the insurance rates too low for the coverage written? Should the contracts have been allowed to be written in the first place? Shouldn’t you have to prove your vested interest in the insured, in order to purchase the product?

The Panic of 1907 led to legislation that made this sort of "insurance" illegal; the bucket shops which sold it, were banned in 1909. And then 91 years later, Congress rolled that law back. We were smarter now and knew what we were doing. Just as a our person making $35,000 a year can't pay off that million dollar loan, the 50 trillion dollars in risk arbitrage can't be paid either. The risk in the market is real, the "insurance" isn't. And, as in all fairy tales, everyone lives happily ever after.

7 comments:

Rob in NS said...

Jim

Read your post and as always appreciated your insights. I find it odd that there are no comments. I wonder if it is because it looks like a shoe is going to drop over in Greece and everyone is holding their collective breath. Could it be that everyone is running for the hills. I'm still amazed that people in power can keep plugging the holes in the dyke. Sooner or later this game has to end and it won't be pretty. We are waiting for politicians to get us out of this mess but they were voted into office on platform of bread and circuses for everyone. I read somewhere the other day that the greatest weakness of a democracy is that once the masses realize that they can vote themselves a raise thru entitlements the endgame has begun. So many in our society live a life of delusion and the person making 35K with million dollar mortgage is just the poster child for a great many others who wish to go nameless.

Jim in San Marcos said...

Hi Rob

You're right, the lack of comments, kind of made me take a second look at what I wrote. Maybe it was the picture of Ben and Tim. It didn't quite fit, but I threw it in for humor.

They've rated Greece's bonds as junk which is a start. It doesn't help the country much. It's ripe for a dictatorship.

I have read similar thoughts on Democracy and the masses voting themselves entitlements. It has some truth to it, but I think that the way you destroy Democracy is when you destroy the savings of the middle class. The poor cannot afford idealistic political views.

The taxes the rich and the middle class pay are to protect their wealth from confiscation by the poor. Our Democracy went through its greatest challenge during the Great Depression. The middle class had been trashed.

The thing not realized this time around, is that we borrowed an awful lot of this money from foreigners. They are going to feel a lot more pain than we do.

I think we are rapidly approaching reality and I don't think it will be as bad as I have projected it to be. A pessimist is never disappointed, only pleasantly surprised.

Thank you for making a noise in the forest, I know that I am not alone. Take care.

Anonymous said...

Good article. Perhaps people have some other things on their mind and choose not to focus on insurance.
One idea would be to have a "Financial Open forum" post and see what everyone's thinking about.

Anonymous said...

Jim,

I don't have a problem with a company that wants to sell insurance on anything as long as that company is not insured with my tax dollars. I still have no idea as to why AIG was bailed out. Did they have some sort of tacit agreement with the US beforehand?

Risk I don't see ever leaving the building...it goes somewhere. If an insuance company want's to take on that risk, let them. Again that goes with the caveat that no one should step in and save them if they insured something they shouldn't have.

I have no stocks, I don't know enough to invest. It is my opinion that most people are like me and should not have been in the market to begin with.

frakrak said...

Jim I wonder why risk has left the building? There’s nothing new under the sun, when it comes to making a buck, it has all been done before (reference to your last paragraph)! Just repeal, pair back the safety on legislation, dust off the book of tricks, and act two begins, same c@#p different century!

It’s like someone hitting the “reset” button, every couple of decades, or musical chairs (the ones not seated comfortably when the music stops get a stint overseas fighting a war, or something similar), by the way I am hoping I get to keep sitting on my “assets” for a little longer!!

Having what would amount to a financially challenged understanding of this, are you saying without assessing risk properly (?) in the underwriting of some of these deals, who would?

How would an underwriter assess risk with some of the deals? Especially when they involve billions? And when a lot of underwriting happened right at the top of the curve? You would have to put some of these immense losses down to some very bad luck, something totally out of left field, for example a housing bubble imploding etc! Not that your housing market looked anything like imploding at the time right!
cheers

Jim in San Marcos said...

Hi Anon 1:20

I agree. In this case, AIG wrote a whole bunch of policies on home loans and they ran out of money to pay claims. As long as the markets were going up this was added profit.

I too wonder why they were bailed out. I can see bailing out a life insurance company, but not the local race track.

Jim in San Marcos said...

Hi Frakrak

When I was saying that risk had left the building, I meant that the interest rates being charged for risky bonds was not figured into the actual interest rate. Greece's junk bonds were trading at 6% not 20%. Investors were buying insurance to cover the difference between the real spread. If we get rid of the insurance options, interest rates would reflect the true quality of the underlying debt. Crap is still crap, but you wouldn't be able to make money on the very obvious side bets.

What I am suggesting, if the swaps and other forms of insurance were eliminated, interest rates might reflect the true risk.

As you suggest when reality hits the fan, it will get messy

Take care.