Suppose somebody wants to make a bet with me that the San Francisco 49ers will win the next two Super Bowls. He gives me $100 today, and I have to give him $100 million in case he's right. The chances of this happening are very small, but just in case the impossible happens I want some backup. I buy insurance from my next-door neighbor. I offer to give him a nickel every week in return for his promise to cover my bet.
My neighbor sees that he has a good thing going -- getting money for nothing. After a while he takes on more and more bets until others follow in his footsteps. Soon, a market develops. In effect, people can bet on bets. Eventually, the total potential amount of money builds up into the billions and trillions of dollars.
Unexpectedly, the San Francisco 49ers win two Super Bowls in a row. My neighbor does not have $100 million on hand to cover my loss. The nickels I have been giving him have been wasted. I don't have $100 million either.
Suddenly everybody in the market is worried about people's ability to back up their bets. The Federal Reserve steps in and takes over the market. The free world is saved.
The FED did close the deal. The terms of this deal will likely be closely scrutinized. DeLong has already picked up on the interest rate. LIBOR plus 8.5%. Now there's a premium for default risk!
Much of the insurance that has been issued over the past decade or so was as a substitute for due diligence.
Municipal bonds are a simple example to follow. In order to sell the bonds, municipalities need to get them rated. This is expensive, so as a cheaper alternative they buy insurance instead. The insurance company thinks it is getting the premium for nothing, since such bonds seldom fail, and uses the income stream to invest in more risky areas.
The bond buyers are now not taking on the risk of the municipality, but of the insurance company. No one knows the risk of the bonds since their was no due diligence.
Extend this scheme into many other areas and you see the problem. If the insurance company folds, then the bond holders have to be made whole is some fashion. That's what the Fed is trying to avoid.
The free world is saved. Nicely sarcastic is my guess (which is not a bet).
Robert, yes, the rating agencies definitely played a role. Did they not admit to an inability to accurately measure risk in e.g. CDOs (even as that portion of their business became the most expansive)? Or at least that's my recollection from the Mason and Rosner paper and/or perhaps others.
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