Tuesday, November 25, 2008

Of Hubris and Moral Hazard.

Suppose you lived in a nice neighborhood. Suppose further that anyone, friend or foe, could buy fire insurance on your house. Suppose even further that they did buy it, and that there was no limit to how much they could buy -- even up to multiples of the value of the home -- as long as someone was willing to sell them a policy. In fact, you even bought a little fire insurance on your neighbor's houses.

And let's suppose you and your neighbors are in the fire insurance business. Why would you sell so much insurance? Well, for one thing, your neighbors didn't really talk much about who was buying policies from them, and neither did you. But you all were pretty sure you were fireproof, being experts in the business. So you kept selling policies and collecting those big premiums.

Then say over the spring and the summer a half a dozen houses in your neighborhood did burn down. Wouldn't you have to wonder what caused all those fires, one after another, in the same neighborhood? How are you going to pay all those claims?

Crazy, isn't it? It would never happen! The insurance industry is regulated; the bright guys in the suits at City Hall would never allow such a thing.

Well, it is crazy, and it's not regulated, and it has happened. The "homes" in question are broker dealers and big banks; the insurance policies are CDS contracts, and it's anyone's guess who bought all the protection. But the "insurance companies" -- the sellers of protection -- are also among the ones whose homes are on fire, so it's a downward spiral for them, and with each fire they are less adequately capitalized to pay the claims.

That's why the taxpayers being called on to bail them out.

Talk about a perfect storm.


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