Archive for the ‘Systemic Risk’ category

Should we be concentrating regulatory attention on Systemic Risk?

January 1, 2013

Think of it somewhat like the town that just suffered a very bad winter season with huge snowfalls that they were unprepared for clogging up everything for weeks on end. They spend the spring fixing up and deciding what to do. Their conclusion is to have all town employees carry snowshovels at all times and to keep snow plow trucks patrolling the streets all day and all night through the entire summer. Sometime in early fall, they decide that was a waste of time and sell all the shovels and trucks by the end of the fall.

RISKVIEWS does not think that our situation will include any systemic risks that we will anticipate. We will not repeat the exact same mistakes. Systemic risk oversight will in the end be a fixed Maginot Line defense.

What we need is

  1. to figure out how to distinguish between creation of wealth by new innovation and by extraction from past innovation so that we can encourage the former and discourage the later. The former widely distributes increases in wealth while the latter concentrates it.  The former creates growth while the latter captures the benefits of future growth now – which means that we will not have them later.
  2. to understand leverage better. Look at the Minsky Financial Instability Model myself. Often, we are not honest with ourselves on the extent of debt. RISKVIEWS favors full disclosure over regulations. For example, firms should disclose the amount of debt that is implicit in derivative positions. And disclose the counterparties for that debt.
  3. to figure out how we are going to find the next big thing that will employ all of the people who are now permanently, structurally unemployed. We can keep hoping for something that increases wealth, something that merely decreases wealth less than the current situation or something that decreases wealth but employs people.
  4. to orient research into how to operate an economy in the long term with much less or no growth. Most of our economic expectations are built off of a constantly growing economy. With population about to start falling, we will necessarily experience much less growth. We don’t collectively even have any idea of what the shift to large retired populations will do to our economies.

The regulators need to focus on whatever is within their purview that gets in the way to accomplishing those things.

For the town above, that means storing the snow shovels to the winter and looking at the problems of the summer heat. They still need to keep an eye out for the next winter. But that does not mean it needs to be a primary focus NOW.

A Very Slow Emerging Systemic Risk – The Retirement Drain

August 12, 2012

This Systemic Risk is caused by the Central Banks. It is a pure and direct conflict between the “Real economy” and the “Financial System”. The Central Bankers have been taking actions to shore up the Financial System, i.e. the Banks, without any regard for this particular Systemic Risk. Perhaps they do not notice. This risk has never hit before.  But it is showing up almost daily in the press.  And it is massive.  It effects a generation of people.  And it is likely to be the most pressing worldwide financial issue of the next 30 years.

This is the Retirement Drain issue.  It is the opposite of a bubble.  It will be a constant drip, drip, drip of the assets of the retirees being liquidated to fund their living and medical expenses.  Looking backwards, it is quite possible that financial commentators will eventually decide that the two bubbles of the last decade or so are a direct consequence of the extra savings in the run up to the Retirement Drain.  Too much money that out ran the capacity of the world economy to invest productively.

But the current central bank actions are and will continue top have a very serious impact on this cycle.  The central banks have been doing all that they can to depress interest rates.  They may get what they want from that action, but they are making the Retirement Drain much worse.  The low interest rates are a transfer of wealth from the savers to the spenders in society.  From the old to the young in general.  At some point, the old will spend down their assets.  The selling of financial and real assets over the next 30 years will be putting immense pressure on prices for both over that whole time.  Just as the working lifetime of this generation of retirees has featured a general upward swing in the world economy, the retirement phase will see a massive disinvestment and the concurrent drop in world economic activity.

And the current low interest rates are making it more and more likely that the accumulated savings of the folks who did put aside money will be insufficient.  So folks will eventually sell all of their assets and then finally need to be supported by their children and grandchildren’s generations.

The problem is fundamentally demographic.  The failure of this generation to produce enough children to support them in their retirement results in the situation that the retirees will be supported by fewer and fewer working folks.  Just as a major portion of the boom of the last 50 years was actually a demographic phenomenon.

Almost all of the major economies of the world will be facing this problem sooner or later.  That is what makes it Systemic.

Let’s hope that we do not willfully deny the problem.

Systemic Risk Metrics for Insurers

July 2, 2011

The US and Global banking regulators have been tasked with regulating systemic risk.  One area where they admit that they are unprepared is with the insurance sector.  In the recent Global Financial Crisis, several insurance companies played a pivotal role, specifically AIG and the US Financial Guarantee insurers.  Most insurers do not consider their activities that helped to build up the bubble and precipitate the crisis to be insurance activities and therefore persist in saying to regulators that insurance is not a systemically important sector.  However, the political facts are that AIG and the Financial Guarantors are/were insurers and the idea of leaving insurance completely out of the efforts to prevent a future systemic crisis is simply not a possible.

Last week, the American Academy of Actuaries provided a letter to the US Financial Stability Council titled, “Metrics to Enable FSOC to Monitor Insurance Industry Systemic Risk”.  That letter provides a good starting point for discussion of the issues involved in bringing the insurance sector into the discussion. For example, the letter provides the following list of ways that an insurer might have systemically significant risks:

  1. Risk assumption services provided to the insurance companies through reinsurers, foreign and domestic (e.g. mortality risk in excess of a company’s risk management limit).
  2. Risk assumption services provided by the non-insurance financial services companies to the insurance industry, (e.g. hedging of financial risk, catastrophe bonds).
  3. The interconnectedness of the insurance industry when part of a financial services group.
  4. The interconnectedness of a U.S. insurance company that is owned by a foreign financial services company.
  5. The insurance industry as a lender to the US economy (e.g. through its purchase of corporate bonds).
  6. The interconnectedness of risk assumption services external to the insurance industry when part of a financial services group.

Riskviews cautions the participants in this discussion to realize that it is most likely that the next systemic crisis will take a different form than the past crises.  So setting up measures and regulatory structures that will prevent a recurrence of past crises is no guarantee of preventing a future crisis.

This letter, with its emphasis on setting down broad principles for Systemic Risk in the insurance industry is a good step in the right direction.  Much broad based discussion is needed to take this further to produce a truly dynamic, principles based monitoring and regulating structure that will be imaginative and flexible enough to actually be of future good, not just short term political cover.

Systemic Risk, Financial Reform, and Moving Forward from the Financial Crisis

April 22, 2011

A second series of essays from the actuarial profession about the financial crisis.  Download them  HERE.

A Tale of Two Density Functions
By Dick Joss

The Systemic Risk of Risk Capital (Or the "No Matter What" Premise)
By C. Frytos &I.Chatzivasiloglou

Actuaries and Assumptions
By Jonathan Jacobs

Managing Financial Crises, Today and Beyond
By Vivek Gupta

What Did We Learn from the Financial Crisis?
By Shibashish Mukherjee

Financial Reform: A Legitimate Function of Government
By John Wiesner

The Economy and Self-Organized Criticality
By Matt Wilson

Systemic Risk Arising from a Financial System that Required Growth in a World with Limited Oil Supply
By Gail Tverberg

Managing Systemic Risk in Retirement Systems
By Minaz Lalani

Worry About Your Own Systemic Risk Exposures
By Dave Ingram

Systemic Risk as Negative Externality
By Rick Gorvette

Who Dares Oppose a Boom?
By David Merkel

Risk Management and the Board of Directors–Suggestions for Reform
By Richard Leblanc

Victory at All Costs
By Tim Cardinal and Jin Li

The Financial Crisis: Why Won't We Use the F(raud) Word?
By Louise Francis

PerfectSunrise–A Warning Before the Perfect Storm
By Max Rudolph

Strengthening Systemic Risk Regulation
By Alfred Weller

It's Securitization Stupid
By Paul Conlin

I Want You to Feel Your Pain
By Krzysztof Ostaszewski

Federal Reform Bill and the Insurance Industry
By David Sherwood

The Year in Risk – 2010

January 3, 2011

It is very difficult to strike the right note looking backwards and talking about risk and risk management.  The natural tendency is to talk about the right and wrong “picks”.  The risks that you decided not to hedge or reinsure that did not develop losses and the ones that you did offload that did show losses.

But if we did that, we would be falling into exactly the same trap that makes it almost impossible to keep support for risk management over time.  Risk Management will fail if it becomes all about making the right risk “picks”.

There are other important and useful topics that we can address.  One of those is the changing risk environment over the year. In addition, we can try to assess the prevailing views of the risk environment throughout the year.


VIX is an interesting indicator of the prevailing market view of risk throughout the year.  VIX is in indicator of the price of insurance against market volatility.  The price goes up when the market believes that future volatility will be higher or alternately when the market is simply highly uncertain about the future.

Uncertain is the word used most throughout the year to represent the economic situation.  But one insight that you can glean from looking at VIX over a longer time period is that volatility in 2010 was not historically high.

If you look at the world in terms of long term averages, a single regime view of the world, then you see 2010 as an above average year for volatility.  But if instead of a single regime world, you think of a multi regime world, then 2010 is not unusual for the higher volatility regimes.

So for stocks, the VIX indicates that 2010 was a year when market opinions were for a higher volatility risk environment.  Which is about the same as the opinion in half of the past 20 years.

That is what everyone believed.

Here is what happened:

Return
December 6.0%
November -0.4%
October 3.5%
September 8.7%
August -5.3%
July 6.8%
Jun -5.2%
May -8.3%
April 1.3%
March 5.8%
February 2.8%
January -3.8%
Average 1.0%
Std Dev 5.6%

That looks pretty volatile.  And comparing to the past several years, we see below that 2010 was just a little less actually volatile than 2008 and 2009.  So we are still in a regime of high volatility.

So we can conclude that 2010 was a year of both high expected and high actual volatility.

If an exercize like this is repeated each year for each important risk, eventually insights of the possibilities for both expectations and actual risk levels can be formed and strategies and tactics developed for different combinations.

The other thing that we should do when we look back at a year is to note how the year looked in the artificial universe of our risk model.

For example, when many folks looked back at 2008 stock market results in early 2009, many risk manager had to admit that their models told them that 2008 was a 1 in 250 to 1 in 500 year.  That did not quite seem right, especially since losses of that size had occurred two or three times in the past 125 years.

What many risk managers decided to do was to change the (usually unstated) assumption that things had permanently changed and that the long term experience with those large losses was not relevant. Once they did that, the risk models were recalibrated and 2008 became something like a 1 in 75 to 1 in 100 year event.

For the stock market, the 15.1% total return was not unusual and causes no concern for recalibration.

But there are many other risks, particularly when you look at general insurance risks, that had higher than expected claims.  Some were frequency driven and some were severity driven.  Here is a partial list:

  • Queensland flood
  • December snowstorms (Europe & US)
  • Earthquakes (Haiti, Chile, China, New Zealand)
  • Iceland Volcano

Munich Re estimates that 2010 will go down as the sixth worst year for amount of general insurance claims paid for disasters.

Each insurer and reinsurer can look at their losses and see, in the aggregate and for each peril separately, what their models would assign as likelihood for 2010.

The final topic for the year in risk is Systemic Risk.  2010 will go down as the year that we started to worry about Systemic Risk.  Regulators, both in the US and globally are working on their methods for inoculating the financial markets against systemic risk.  Firms around the globe are honing their arguments for why they do not pose a systemic threat so that they can avoid the extra regulation that will doubtless befall the firms that do.

Riskviews fervently hopes that those who do work on this are very open minded.  As Mark Twain once said,

History does not repeat itself, but it does rhyme.”

And for Systemic Risk, my hope is that the resources and necessary drag from additional regulation are applied, not to prevent an exact repeat of the recent events, while recognizing the possibility of rhyming as well as what I would think would be the most likely systemic issue – that financial innovation will bring us an entirely new way to bollocks up the system next time.

Happy New Year!

What is Too Big to Fail?

November 20, 2010

There seems to be various discussions going around about who needs to be considered Systemically important to qualify for “Special Attention” from regulators. Very large money managers are saying that they are not systemically important.

But it seems to me that there are quite a number of considerations. And everyone seems to be arguing solely from the part of that list that exempts them.

When thinking about money managers, I would think of the following:

  1. How is their liquidity managed? Can they really raise funds fast enough to satisfy a run on the bank?
  2. If they were to try to liquidate their funds, what would that do to the financial markets?
  3. How interconnected are they to other financial firms? Do regulators now have information about that?
  4. What about the future? (Isn’t that our concern, not the past or even the current situation?)
  • Could they shift their liquidity practices to become much more illiquid?
  • Their argument revolves around leverage, how much could they change their leverage under their current regulations? They can quickly leverage through derivatives as well as borrowing.
  • Could they become the center of new risky financial behavior that would endanger the financial sector?

That last point is a major concern of regulators regarding the Insurance industry. And they have history on their side. The insurance industry helped the financial sector to blow the mortgage business up to 4 or 5 times the underlying.

All you need to do that is a big balance sheet and a willingness to take one side of a trade without balancing it with the other side. And the money managers as well as the insurance companies both have exactly those characteristics.

Watch your Own Wallet

November 14, 2010

Polling the people who work at the New York banks that were at the center of the financial crisis, people were asked which of the following statements that they agreed with the most:

  1. We did it and we need to do something differently.
  2. They did it and they need to do something differently.
  3. Space Aliens did it and we hope that they do not do it again.

The poll results are in and the findings are:

  • No one answered that they agreed with 1.
  • The innocent all were able to answer that they agreed with 2.
  • Those who were directly involved in the problems that led to the crisis all answered 3.

So the conclusion that you should reach from this survey is that nothing will be different in the future.  The financial system will be run mostly the same as it had been run.

Your only protection is to WATCH YOUR OWN WALLET.  That is, pay attention yourselves to things that might turn into the next set of systemic risks.  Those things will all tend to be very large systematic risks.

So you need to use the emerging risks type process on the largest systematic risks.  You need to assess periodically whether your firm’s exposures to these risks might in a crash result in firm ending losses.  (Or you can prepare your application for a bailout – good luck on that).

Then you need to have a heart to heart discussion with your board.  Stories of the firms that did the worst in the crisis tell that their boards urged them to take more and more risk.

Risk managers need to know whether it is their board’s wishes to be dancing up until the band sinks below the water or to stop perhaps a few songs before and leave the ship ahead of the crash.

Forget you ever read this

August 30, 2010

I just read a great post that may be a key to understanding both the course of the economy and the public sentiment about government policies.

http://alephblog.com/2010/08/28/queasing-over-quantitative-easing-part-iii/

David Merkel suggests that people are unhappy with the unfairness of government policies.

I would go even further.  People have overwhelmingly come to the conclusion that they need to reduce their own debt.  Many, many people are enduring what they think of as hardship (by ceasing to spend money that they do not have) to bring down their personal debt level.  At the same time, they see the government adding to the public debt.  People are not stupid.  They think of the government debt as THEIR debt.  So they are economizing for naught if for every dollar of debt that they reduce, the government adds a dollar of debt.

Perhaps some day someone will discover a Pelzman effect like mechanism at work with regard to debt.  During the credit bubble that led up to the financial crisis, people where almost totally insensitive to the level of debt.  But now there is a high degree of sensitivity.  So if people feel that there is a right level of debt, then they will take actions to get to that level.  If the government works against that effort, then they will adjust their personal targets so that the aggregate of personal and public debt comes into line with their perceived optimal level of debt.  This may not be because they set a specific target, but because the rising level of public debt makes people uncomfortable and they express that discomfort in the way of looking for more security and less debt.

So maybe the extreme cutting of government spending that is happening in the UK is what is actually needed.  Because the government actions do not exist in some “all things being equal” economics textbook argument.  Government policy and the economy exist in and among the people of the world.

It is widely known that household consumption is a large fraction and major driver of the GDP in the US.  So if we want the GDP to grow, we need to do the things that will get households spending again.  Not in an all things being equal world, but in the real world with real people.

An interesting wrinkle to this is that the Keynesian ideas of using government spending to get out of the Great Depression did not work until the spending for WWII came along and the war spending did the trick.  Some economists have suggested that showed that a larger amount of government spending was needed than was tried prior to WWII.  But the ideas above – that the government spending will not be effective if the people want to save may have kept the earlier spending from working.  The spending for WWII may have worked though BECAUSE people thought of that spending as having its own merits.  WWII spending was necessary.

So perhaps government spending cannot go against the grain of public sentiment to overcome the Paradox of Thrift, unless the public believes that the spending is necessary.

And now to finally link this discussion to risk and risk management…

Perhaps Greenspan is right when he says that he did not know how to pop a bubble.  Maybe that is because he did not believe that he could have changed public opinion about the value of an asset class.  He could take actions that might temporarily hurt the value of an asset class, but it was quite possible that the public attitude would swing right back and keep inflating the bubble in spite of the actions of the Fed.

The same thing certainly has been true within firms.  When the risk manager finds him/her self at odds with the prevailing idea in a firm about a risk, he/she is more likely to lose their job than to change the prevailing opinion.

So in all three cases, in the general economy in severe recession, in an asset bubble and in a company overconfident about a particular risk. the only actions that can be effective will be actions that are not obviously going against the grain.  The actions will need to be designed so that they appear to go with the popular sentiment even when they are really intended to change the fundamentals with regard to that sentiment.

So, I now realize that I need to keep this secret.  So please forget you ever read this.

Risk Management: The Current Financial Crisis, Lessons Learned and Future Implications

August 8, 2010

The 2009 call for essays, “Risk Management: The Current Financial Crisis, Lessons Learned and Future Implications,” which was published in early 2009, contained 35 short essays . Over half of those essays were contributed by folks who were on the INARM email group.

The Joint Risk Management Section of the Society of Actuaries (SOA), the Casualty Actuarial Society (CAS), and the Canadian Institute of Actuaries (CIA) in collaboration with the SOA Investment Section, the International Network of Actuaries in Risk Management (“INARM”) and the Enterprise Risk Management Institute International (“ERM-II”), propose publishing a second series of essays as a follow-up to the first to address “Risk Management: Part Two – Systemic Risk, Financial Reform, and Moving Forward from the Financial Crisis.”

Systemic risk is the risk of the collapse of an entire financial system or market as opposed to risk associated with any one individual entity. Risk systems consist of social institutions, laws, processes and products designed to facilitate the transfer, sharing, distribution and mitigation/hedging of risks between various buyers and sellers. Examples of risk systems include insurance, banking, capital markets, exchanges, and government and private health and retirement programs. Historically, these risk systems are rarely analyzed in a manner that looks at the ability of the system to survive extreme risk events and still carry out their function – creating an ongoing market for the exchange of risk. The failure of a risk system may be due to asymmetric information, unbalanced incentives of its participants and/or the failure of trust amongst its participants. In reflecting on the events of the last two years, is it possible to effectively develop early warning indicators that trigger intervention in advance of a complete collapse of an entire financial system or market? Does it make sense to have a chief risk officer of, say, the United States of America, whose role it would be to manage/mitigate this risk?

We invite the submission of essays to address these questions, and to offer thought leadership on the ERM discipline and the essential elements needed to maintain risk transfer systems in times of unusual stresses and unlikely events.

This topic has been intentionally left broad to allow essays that address industry-specific issues or a wide range of issues across industries. Each essay should be no more than two pages (1,500 words or less) and should be submitted no later than Friday September 15, 2010. Depending on the response, we may limit the number of essays that are published. SOA/CAS resources will be utilized to publish and promote the resulting publication. Publication is planned for Fall of 2010. Submit your essay here .

Awards for worthy papers:

1st Place Prize – $500
2nd Place Prize – $250
3rd Place Prize – $100

Feel free to pass along any questions to Robert Wolf , FCAS, CERA, ASA, MAAA, Staff Partner- Joint Risk Management Section and Investment Section, who will be coordinating the publication.

Financial Reform & Risk Management – Financial Services Oversight Council

July 15, 2010

According to an AP summary of the negotiated consolidated Financial Reform act of 2010, there are 9 major provisions.  These posts will feature commentary on the Risk Management implications of each.

1. OVERSIGHT A 10-member Financial Services Oversight Council made up of the treasury secretary, Federal Reserve chairman, a presidential appointee with insurance expertise, heads of regulatory agencies and a new consumer protection bureau would monitor financial markets and watch for threats.

Does that make you feel safe?  An Oversight Council?  Not me.

Each of the 10 members will be busy protecting their turf.  Any action or proposed action that will damage “their” part of the financial services business more than the rest of the sector will be fought tooth and nail.

Or else, the group will be out to prove that they are really watching.  They will protect us from 10 of the next two financial crises.

More protection might seem like a good idea right now, but no one has any idea how disruptive it will be to the economy to have an committee of 10 fighting to be the one who drives the car of the economy.

And in addition, to date there has been no indication that any of these folks will protect us from the NEXT crisis.  Instead they will be watching out for a repeat of the last crisis.

The next crisis will come from whatever part of the world economy that they are not paying attention to.  Almost by definition.

So my advice is to watch out for yourself.  Do not rely on these folks.  Do your own homework.  Mind your own risks.

How to do that?  Start HERE.

Firms Can Treat Systemic Risk Same as Emerging

July 2, 2010

As one looks back at the recent history of the financial crisis, it can now be clearly seen that a large number of financial firms and a few regulators did identify the looming problems and took reasonable steps to avoid excessive losses. Almost all of the attention has been on the firms and regulators who missed the crisis until it was much too late.

Now, everyone is talking about how to avoid the next crisis and the focus seems to be on the regulators and the largest firms – in short, those who got it wrong just a few years ago.

“The unknown losses can potentially bring the system to a halt at a much lower amount of loss than known losses.”

But we should also be focusing on what everyone else could be doing to prevent their firms from experiencing excessive losses in future crises.

Planning to have no future crises is not a realistic way to proceed [see my earlier article: IERM, Risk governance, 16 September 2009, “Understanding the four seasons of risk management“). The broad idea of Basel II and Solvency II is sound. Firms would be forced to identify their risk exposures and compare that to their capacity to bear risk. That information would be available to five groups under the three pillars: management, boards, regulators, investors and counterparties. It is assumed that one or more of the five groups would notice upticks in risk and prevent the firms from taking on more risk than their capacity to bear that risk.

There have been many problems with the execution of those principles and Solvency II is just starting the discussion of exactly what information will be made available for investors and counterparties. But the broad idea of disclosure to all those groups is sound. The disclosure of potential systemic risks is absolutely necessary for firms to use as a basis for developing their own programmes for avoiding excessive losses in these situations.

Systemic risks

The way that the term “systemic risk” is used and misused, it seems clear that most people understand that systemic risk was a problem that led to the crisis, but beyond that there is little consensus, other than a conviction that we want much less of that in the future. The IMF provides a definition:

“the risk of disruption to the flow of financial services that is (i) caused by an impairment of all or parts of the financial system; and (ii) has the potential to have serious negative consequences for the real economy.”

Had the quote ended after 10 words, that would have been sufficient.

For the system to be disrupted, two things need to be true:

  1. there needs to be an exposure that everyone believes or suspects will turn into a loss of an amount that exceeds the capacity to bear losses of a large number of participants in the system and
  2. there needs to be either a high degree of interdependency in the system or else widespread exposure to the loss-making large exposure. The system may seize up because the losses are known and the institutions are known to be insolvent or more commonly, because the losses are unknown.

For the rest of this discussion go to InsuranceERM.com

Radical Collaboration

June 8, 2010

There are situations that require collaboration if they are going to be resolved in a manner that produces the largest combined benefit or the smallest combined loss.  This is not the “greatest good for the greatest number” objective of socialism – it is simple efficiency.  Collaborative results can be greater than competitive results.  It is the reason that a sports team where everyone is playing the same strategy does better than the team where each individual seeks to do their personal best regardless of what everyone else is doing.

There are also situations where the application of individual and separate and uncoordinated actions will result in a sub optimal conclusion and where the famous Invisible Hand points in the wrong direction.

You see, the reason why the Invisible Hand ever works is because by the creative destruction of wrong turns, the individual actions find a good way to proceed and eventually all resources are marshaled in following that optimal way of proceeding.  But for the Invisible Hand to be efficient, the destruction part of creative destruction needs to be small relative to the creative part.  For the Collaborative effort to be efficient, the collaboration needs to result in selection of an efficient approach without the need for destruction through a collaborative decision making process.  For the Collaborative effort to be necessary, the total cost of the risk management effort needs to exceed the amount that single firms could afford.

Remember the story of the Iliad. It is the story of armies that worked entirely on the Invisible Hand principle. Each warrior decided on his own what he would do, how and when he would fight.  It was the age of Heroes.

The stories of the success of Alexander and later the Roman armies was the success of an army that was collaborative.  The age of Heroes was over.   The efficiencies of the individual Heroes each finding their own best strategy and tactics was found to be inferior to the collaborative efforts of a group of soldiers who were all using the same strategy and tactics in coordination.

There are many situations in risk management were some sort of collaboration needs to be considered.

The Gulf Oil leak situation seems like it might be one of those.  BP is now admitting that it did not have the resources available or even the expertise to do what needs to be done.  And perhaps, this leak is a situation where the collective cost of their failure is much higher than society’s tolerance for this sort of loss.  But the frequency of this sort of problem has to date been so very low that having BP provide those capabilities may not have made economic sense.

However, there are hundreds of wells in the Gulf.  With clear hindsight, the cost of developing and maintaining the capacity to deal with this sort of emergency could have been borne jointly by all of the drillers in the Gulf.

There are many situations in risk management where collaboration would produce much better results than separate actions.  Mostly in cases where a common threat faces many where to overcome the threat would take more resources than any one could muster.

Remember the situation with LTCM?  No one bank could have helped LTCM alone, they would have gone down with LTCM.  But by the forced collaborative action, a large group of banks were able to keep the situation from generating large losses.  Now this action rankles many free marketeers, but it is exactly the sort of Radical Collaboration that I am talking about.  It did not involve any direct government funding.  It used the balance sheets of the group of banks to stabilize the situation and allow for an orderly disposition of LTCMs positions.  In the end, I beleive that it was reported that the banks did not end up taking a loss either.  (That was mostly an artifact of depressed market prices at the time of the rescue, I would guess.)

The exact same sort of thinking does NOT seem to have been tried with Lehman.  If Paulson could not find a single firm to rescue Lehman, he was not going to do anything.  But looking back and remembering LTCM, Paulson could have arranged an LTCM style rescue for Lehman.  In hindsight, that, even with government guarantees to sweeten the pot would have been better then the financial carnage that ensued.

Perhaps Paulson was one of the free marketeers that hated the LTCM “bailout”.  But in the end, he trampled the free market much worse than his predecessors did with LTCM when he bailed out AIG without even giving any thought to terms of the bailout.

Collaboration might have seemed radical to Paulson.  But it is sometimes needed for risk management.


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