Tom Keene talking to Martin Freedson asked, "Can they regulate stupidity? Can they regulate away financial engineering?" This is the key question and probably the biggest reason for the last economic downfall of the United States and a lesson that has not been learned yet.

Financial engineering does not GDP make go up. Financial engineering is a tool to spread risk over and economy and it is such an unreliable science that those that do speculate into this are failing continually and causing trouble in the markets.

An underlying assumption, just short of law maybe, of financial economics is that you cannot get rid of risk, you can only spread it out over the economy. Spreading it out over the economy only switches risk from one central entity to more entities. When you have an increase in financial engineering tactics, you are defeating the spreading of the risk over the economy and this is what happened in the housing market and it has not been learned by the economy yet. In reality the entities ended up taking on more risk as a result of a poor performance by the ratings agencies.

Since financial engineering does not remove risk from the market, it cannot create GDP. Financial engineering should never have a positive influence on GDP as a result of the fact that it is not adding anything to the productive economy, it is just taking risk and spreading it wider over he economy and this is why the housing market is in shambles right now.

Taking the risk and spreading it wider over the market had the effect of making the larger banks feel that the risk is disapprearing or having less of an impact but specifically because the risk was in an illiquid object such as a house, the risk should have been felt larger. Further, the feeling that the risk was less, had the effect on the market of making a feeling that there was more economic profit in the housing industry. Therefore, more entities began to appear giving out riskier and shakier mortgages leading to more risk in the market and spreading to other industries.

The effects of the housing debacles has had effects economy wide and world wide. It has had effects in "munies", commodities, insurance, manufacturing, bond markets, stock markets...and so on across the world.

Lying with that little bomb, the trigger of the bomb was the ARM. The adjustable rate mortgage set the whole thing tumbling to the ground. As people could no longer afford the homes they were in, the banks began taking on illiquid assets causing them to become less liquid causing a seizing in the capital markets.

So here is an anecdote of what just happened. I am going to take a block and cut it up into 100 pieces...this 100 pieces of block represent risk in the market. Instead of one person taking on this 100 risk, 100 places are taking parts of the risk. Thinking that they have less risk, they buy more of these parts of risk...they buy 110 parts of risk...think about that now, do you have more or less risk then before. You clearly have more, more so on the market, you have 100 different entities owning part of something that is very illiquid. ..a block...no one own the block outright, just 100 different entities owning part of the block.

Who owns the block must be unwound from the package of blocks that each entity owns and that is the position that we were in and that is the position that we are coming out of. Since none of the entities knew what part of what they owned, they had to write off the entire ownership and hope that it turns out better then what they were writing off...they had to say, I do not own any of the 110 blocks anymore...I hope this is wrong but right now that is the way it seems.

When you consider this techically, consider that the original risk basket, the structured investment vehicle, has a normal spread of risk. If you divide that risk up, it is still a normal spread of risk. You not only are taking on less risk but you are also taking on less of an asset so the risk spread, if you take on 100 is actually the same as owning the entire original asset. More so because you are dividing up an asset, you are taking an espilon less of an asset as opposed to the risk you are taking and as opposed to the original risk you would have taken on had you just owned 100 percent of the original asset. You are actually in less of an ideal position then you were before.

Since the siv is not a mortgage, more companies bought the siv's and thus there was more money in the housing market allowing more people to get houses that were in increasingly more likely to default but because the blocks were being spread over the market, no one accounted for this and more risk was being put into the market even though it appeared that there was less risk in the market then there would be before. As those siv's became less and less liquid, the entities began to become less and less liquid thus seizing the capital markets.

Being that the larger entities are leverage out 33:1, the liquidity of these entities quickly dried up and lead to the current position. So what needs to happen is that the sivs need to be unwound and the markets need to deleverage for a while and that is what is happening. That is why we will be okay but we need to understand the moral hazard here in order to learn the lesson from the 2007 housing debacle. It bagan about 10 years ago though...that needs to be understood.

 

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