Wednesday, September 17, 2008

Risky Business

. Wednesday, September 17, 2008

Continuing the incredulous unraveling of the financial markets, AIG has become the latest recipient of US Fed and Treasury orchestrated and US tax-payer funded bailout (see here - NY Times free account needed - and here).  Adding to mass hysteria is knowledge that a prominent money market fund dipped below a $1 NAV yesterday (it sounds mundane, but basically realizes risk in the traditionally most riskless and liquid asset class available).

It's hard for most to conceptualize just how recent events on Wall Street will effect the global financial environment, mostly because the financial instruments that got us into this mess by failing to accurately assess risk are so hard to understand (see here for a basis primer on derivatives).  The proliferation of esoteric credit derivatives on the global financial market has made a lot of people a lot of money, but it's also contributed to increased opacity of information and a decrease in the ability of governments to regulate.  And now, the chickens are coming home to roost.

As Alex mentioned in his previous post, the events of the past few weeks (and really the past six months) beg the question of what appropriate regulation looks like and how to get there.  In an interconnected financial world, how much space are we willing to give to free market machinations?  When do you think the government, governments, or institutions should step in, if at all?  How will the effects of a systemic under-estimation of risk change investor behavior going forward (especially large investors like oil-rich countries and sovereign wealth funds)?


Kindred Winecoff said...

Questions related to your questions:

1. if this crisis has occurred largely because ratings agencies and investment banks mis-judged risk, then what sort of government control or regulation would have averted the problem? In other words, does anybody trust the government to judge riskiness better than markets?

2. If it's true that AIG's trouble isn't insolvency, but rather liquidity, then it's possible that the Fed will make a substantial amount of money on this deal. If that happens, is it good or bad in the long run?

3. Derivatives are truly tricky. But the whole point of derivatives is to hedge against risk; not to increase it. now it's true that CDOs of packaged subprime loans did a poor job of that, but haven't most of the rest of derivatives done their job? if so, then maybe we shouldn't throw the baby out with the bathwater? moving forward, it would seem that derivatives can still have an important and valuable role in financial markets.

Risky Business
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