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Sep 23, 2008

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James Tauber

Also see the speech Ron Paul made back in 2003: http://blog.mises.org/archives/008572.asp

Jarett

Ron only got half the story right. While socialistic policies were the root cause of this problem, it is actually a lack of regulation that has caused the current catastrophe in the US.

The losses that banks and other lending institutions would incur due to their subprime exposure represented a relatively small amount in the large scheme of financial assets (I haven't seen anything indicating that defaults have raised beyond 2% of all outstanding mortgages. Sure, companies that focused on one type of business may have had such losses that they would go bankrupt (and this occurred in mid 2007 with all the subprime borrowers like Countrywide), but that's not enough to destabilize an entire financial economy.

What has blown this mess out of proportion is the use of leverage in credit default swaps to 'insure' against potential losses. Essentially companies that did not have the assets to back potential losses were able to write protection policies against them. This in turn allowed the original institutions (with the money to cover off these losses) to turn around and deploy that now-freed up capital in other ways. These (unregulated, private) contracts are what are causing trillion dollar institutions to fail. See Ben Stein's recent article on the subject to get a layman's description:

http://finance.yahoo.com/expert/article/yourlife/109609;_ylt=Au5e5DgcFyLxsplbl_uZSdBAt9IF

I am for libertarian principles in general, but believe in the couching of such principles is necessary when the greater public good will be interfered with. Financial institutions that are relied upon for the normal functioning of society need to be and are regulated for a reason. When the government doesn't stay on top of what they're doing, greed has the chance to override reason (aka risk management) and cause harm to the greater good.

Proper leveraging controls (possibly even the mandate of no leverage) would have avoided nearly everything we've seen since the beginning of 2008. The original bad seeds were all but wiped out in 2007, but the de-winding of the leveraged positions is what's causing all this current turmoil. Buffet was spot on when he termed derivatives as financial WMD.

Graham Glass

Hi Jarett,

Thanks for your comment, it was very informative. I read the article you linked to and noticed one paragraph in particular:

"Because these giant financial companies never dreamed that the subprime mortgage securities could fall as far as they did, they did not enter a potential liability for these CDS policies anywhere near their true liability - which again, is virtually bottomless. They do not have a countervailing asset to pay off the liability."

I wonder if the reason that the companies did not imagine that the house prices would fall as far as they did was because of the government assurances in the first place? In other words, did they view the situation as far less risky because of government intervention?

Regardless, I do believe that some form of regulation needs to be in place. The best kind is probably simply transparency, since then companies, advisors and customers can calculate real risk instead of just guessing. Pension funds for example would tend to be risk adverse and could have steered clear of risky transactions.

Thanks again for your comment, it was very instructive!

Cheers,
Graham

Jarett

Hi Graham,

Good point - I think it may have been partially due to implicit government insurance, but also due to the 'AAA' ratings that supposedly objective credit agencies magically bestowed on a collection of junk bond-like asssets. Perhaps the biggest tragedy here is that S&P, Moody's, etc. have had no repurcussions for being so farcically (possibly criminally?) wrong with their assessment, which contravened basic financial portfolio theory.

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