Risky Bubbles

Today's question: Do we have a risk bubble that is yet to burst?

By RISK, I am not talking about the game of global domination, I am talking about the industry for pricing (ie. Moodies, S&P, bank underwriters), managing (real best practices in the work place), mitigating (carefully crafted disclosure statements written by attorneys), selling (by companies who engage in known risks), and buying (in some form or another, all of us) of exposure to the chance of financial loss.

By BUBBLE we can imagine a child's game of blowing bubbles; sometimes we get big bubbles, sometimes we get little bubbles, whatever. What I wonder is whether the value and pricing of risk isn't, at this moment in time, just as arbitrary as children experimenting with different soap brands and strings and maybe some fans and great big belts with suspenders.... all to make some bubbles. Less metaphorically, and more financially speaking, I think that we've come to think of bubbles as being baseless overvaluation; values that fluctuate drastically from some thing's "inherent" value.

PRICING of anything is by nature a proportional measure. A price of one thing can only truly be understood in terms of its value relative to other things. A dollar bill, for example, is nothing but a teaspoon whose volume capacity changes on the minute. If we don't measure every thing simultaneously, we are bound to get little bubbles of value. This, as I understand it, is a way to make money.

The PRICING OF RISK is a little bit different. I understand nothing about how risk is valued. I am privy only to small pieces of the market. By way of example, here is what I have observed: Underwriters will assign higher risk to a portfolio of mortgage loans made to sub-prime (low credit-scoring) borrowers. This type of lending is riskier than prime lending. So banks bundle these loans together into a security that is sold to investors, paying attorneys to draft disclosures that over-encompass the universe of potential risks and "pass the risk buck" on to the investors. Insurance is purchased on these securities to cover the investors in case the chance of risk materializes into default (I'm sure there are well written nuances to spell out what types of risk the insurance does and does not 'insure' against). Then these securities are sold again. And again. New Representations and Warranties are drafted at each sale juncture and new insurance is purchased. The real risks are (1) not understood; and (2) everyone feels immune from whatever the risk may be.

The Atomic Hot Potato
I imagine a game of hot potato played with, lets call it: a risk bubble. Such a strange translucent balloon made of a film full of air. Oh, and since we're talking about risks, lets say that our air is laced with airborne contagions. And with each pass of this risk bubble, more germ-laden air is added, more money goes in and then the now bigger bubble is sold and passed along to the next person. Silly analogy, I know. But everyone is betting on this thing not bursting in his own hands.

My Fear is that these bubbles have been made and are still (post-"crisis") out there. When they burst, they will infect us all. This myth that risk can be "passed along" does not serve any of us.

Risk exists and it can be mitigated:
(1) Management of Risk: good managers can guide operations in ways to minimize risks, good lenders can make available fair loans that people can actually afford; statutes and regulations can strengthen fiduciary responsibilities and hold company officers accountable for the avoidance of unnecessary risks.

(2) Ownership of Risk: each of the buyers along the route can tie into a fair and proportional share of said risk. Distribute risk proportionately rather than bundle it into an un-owned and dangerous mass.

Clearly there is a lot that I don't yet understand about all of this business. For example, I'd like to look more closely at the fine print in AIG insurance policies. I'd like to look at underwriter's pricing formulas. There is a lot to be learned. Still, I suspect that fancy formulas and language might not get around the fact that we are fundamentally wrong about the way we look at risk.

One final thought: Environmentalists talk about True Cost Economics, which , as I understand it is setting prices that account for all the costs associated with a product: the cost of it's disposal and any other associated pollutant clean-up.

Currently, risk seems to be priced based on some myth of what it costs to avoid it. Maybe we need to accept that it can't be avoided and include all the potential downstream costs into our calculation of sharing risk. And then, take it for what it is: a risk of investing. Flip a coin and our risk may pay off, if it doesn't we simply each must swallow our own proportional share of said risk.

Disclosure: these thoughts and opinions are based on incomplete knowledge and may even contain some flat out mis-information. I am just blowing hot air bubbles here.