To the Rescue: Black Swans and Moral Hazards

How many white swans must you see to prove that there is no such thing as a black swan?

That is a question put forward by one of my favorite financial authors Nassim Nicholas Taleb. It is even more interesting to learn that there are black swans, though most one us have never seen one.

Arguably, one such black swan is the current “mortgage crisis”. Some are calling this a credit crunch or an issue with illiquidity of assets. Most people, until recently didn’t expect such events to ever happen. If events like this were expected, few foresaw the magnitude of bank failures.

The thing about black swans is that they do show up occasionally. The other thing is that they are not entirely unexpected (at least by some). Black swans are why people buy insurance, and the relative rarity of such occurrences explains why insurance companies sell it.

I just saw the Senate on CSPAN pass the bailout rescue bill 74 to 25. This bill gives insurance claims to those that didn’t buy insurance in the first place. Oh, there is the raising of FDIC insurance to $250,000… and the banks have paid premiums to the FDIC, but that is more window dressing. As weird as it seems to me this bill appears to be a drastically amended bill involving, of all things, mental health coverage.

There are practical considerations for this bill and practical considerations against. The argument that sways my opinion against it is ideological. Simply put I this legislation crosses the line from regulating the market over to manipulating and attempting to manage the market. Secondly, it introduces a moral hazard. In this case it takes away (some of) the consequences of failure from banks and investors. In healthy markets failed ventures fail. There is a price for failure and that gives executives and business people pause and encourages prudence. If the congress takes away the consequences in full or part, doesn’t that just encourage more imprudent risk in the future?

Look, when Wall Street loses, often Main Street does too. Like it or dislike it, that’s the way it goes. But when the government puts $700 billion on the line… its our money on the line too. If all goes well the precedent is set. And if the economy goes south again, maybe 7 years from now, will there be another bigger bailout? How many times before the tax payers lose a big, big bet? This time, or the next, or the next?

Further, what if this bailout covers over structural flaws in the US (and global) financial industry? Perhaps these flaws should be allowed to continue to crack so that industry learns and adapts and emerges stronger.

My guess is that this bill will pass the House and become law in short order. My guess is that markets will like the passage and stock will bounce up perhaps 5-6%. I’m guessing markets open up 1-2% tomorrow morning (Thur, Oct 2). But I’m guessing that, long-term, this is merely a band-aid that covers up problems that will bite us in years to come.

My 2 pesos. Adios, amigos.

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