Monday, September 29, 2008

House Republicans and Identifying Risk

So the bail-out bill failed to pass the house, mostly because of the objections of house Republicans who just can't stomach getting government that involved in business. This concept does have its merits in theory. The invisible hand of the market and not being a commie and all, but a lot of very smart people seem to think that unless there is some sort of help provided by somebody, that we are headed for depression, not recession.

Everyone in congress appears to agree that something needs to be done, but the house Republicans seem to like this idea of a government backed insurance program for holders of mortgages and mortgage backed securities (MBS).

I absolutely hate it when people just shoot down the ideas of other people without having a good suggestion themselves, but what I'm about to do is shoot down the ideas of other people without having a good suggestion myself.

I was reading the Economist from last week and came across this sentence in an already horribly out of date article:
It is a measure of the scale of the crisis that, by the evening of September 17th, all eyes were on Morgan Stanley, and no longer on AIG, which only 24 hours before had thrust Lehman out of the limelight. After its share price slumped by 24% that day, and fearing a total evaporation of confidence, Morgan attempted to sell itself. Its boss, John Mack, reportedly held talks with several possible partners, including Wachovia, a commercial bank, and Citic of China.

Did you see it? There at the end, they snuck it in. Wachovia was being courted to buy the teetering Morgan Stanley. Sound familiar? It should because Wachovia just got scooped up by Citigroup. And not just out of the goodness of their hearts either. The Fed stepped in and is guaranteeing all losses from the Wachovia takeover for Citigroup above $42 billion. Now $42 with nine zeroes after it is a lot, but the other side of that is infinitely large and that's the part for which the US Government, already $11 with 12 zeroes in the whole before this mess even started, is on the hook.

My point here is this. A week ago Morgan Stanley was trying to get bought by a large commercial bank that seven days later was so worthless and pestilence ridden that it had to be married off to Citigroup with an infinitely large dowry from Uncle Sam.

What does this have to do with house Republicans and their insurance plan? This is the environment in which they want to establish a healthy and balanced insurance market overnight which involves the need to somehow price the premiums that must be paid in order to correctly balance the risk associated with the insured asset.

The whole point of this entire catastrophe is that the financial sector couldn't properly identify risk if it came up behind them with a rubber glove and a wry smile, which I think is exactly what's been going on recently.

Without the ability to determine how risky something is, its impossible to have a successful insurance market around it. People make a ton of money calculating risk for insurance. Remember the physical you had to go through before you got life insurance? You think they like carrying your urine around in a cup? NO! They are going through a lot of effort to calculate your risk of shuffling off this mortal coil.

There is no mechanism right not to determine how much of the risk of the currently held MBS has been worked out and how much is still to come. That is why they are completely worthless and why everyone that holds them has to value them as such so their balance sheets have been soaring recently the same way that bricks do.

The insurance plan that the house Republicans want may very well be a good idea for a long term safety net, but it won't do anything in the near term for allowing banks to lend money again.

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