The Eggheads Blew It

It's quite clear that "down not so much" is the new "up" on the stock market. And "down not so much" hasn't happened in quite a while.

As of market close on Friday, the Dow was down over 40% since the market's peak last year, and the S&P was even worse. The housing market has put a broad swath of American's wealth underwater as home values plummet. And the credit markets, of course, are locked up tighter than Fort Knox. Clearly we're in a bit of a panic.

Getting into a credit and housing bubble was easy enough -- financial market bubbles seem to spring up at least once per decade. Getting into a market meltdown the likes of which we are in now, though, took some serious effort.

So how did it happen? In short, the financial eggheads thought that they could do the impossible.

But first ...
To get a background on what happened, let's revisit the concept of insurance. Insurers -- whether it's a health insurer like Aetna (NYSE: AET  ) , a property and casualty insurer like Berkshire Hathaway (NYSE: BRK-A  ) (NYSE: BRK-B  ) , or a reinsurer like XL Capital (NYSE: XL  ) -- are all selling the same basic product: risk management.

Think about it this way. You are concerned that you could get terribly sick and end up with a pile of hospital bills. So you buy health insurance that will pay out if you do end up in such a situation. In essence, you've just unloaded the financial risk of unexpected health problems.

For the risks that they take on, insurers are paid premiums by their customers. These premiums are determined by actuarial tables and how risky each insured appears. Insurers then estimate how much they'll have to pay out in benefits, and they hold on to cash so that they're ready to pay up when the estimated risks become reality.

Sometimes, insurers want to reduce the risk that they take on, so they'll "cede" some of the risk they've assumed to the second level of insurers -- the reinsurers.

Got all that?

Insuring the financial sector
Now we've just said that risk -- though you can't see it or touch it -- is bought and sold by insurance companies. Apparently, eggheads in the financial services business decided that risk would be the next big thing for them. After all, there is plenty of risk in the financial marketplace, and there are undoubtedly a lot of folks out there who would love to unload some of that risk.

And how right they were! The financial market went gaga over it, and "risk management" became a mantra on Wall Street.

You've no doubt heard about financial risk management even if you don't engage in it yourself. "Hedging" is one word that refers to it, and credit default swaps (CDS) are one of the major products out there used for risk management. The supposed smartest of the smart on Wall Street thought they had figured out a way to let financial companies sell off some of their risk so that they could take on more total volume of business and still sleep well at night. At the same time, a massive business in buying and selling financial risk was born.

Sounds good, so what in the bleep happened?
The beautiful thing about standard insurance is that they're working with largely independent risks. In other words, a national auto insurer can insure my Civic in Las Vegas and a Hummer in Denver knowing that if I get into an accident, it probably won't increase the risk of the Hummer getting in an accident.

The financial market doesn't work like that. The risks that the eggheads were buying and selling were highly correlated since the financial dealings, and -- more importantly -- the psychology of the financial market are all tightly tied together. So when Lehman Brothers went belly-up, that wasn't an independent event -- it rippled out and had effects on everyone from AIG (NYSE: AIG  ) and Morgan Stanley in the U.S. to ICICI Bank all the way over in India.

Back in August of 2007, fellow Fool Seth Jayson caught on to how much Wall Street misunderstood its own playground. He caught Goldman Sachs (NYSE: GS  ) CFO David Viniar saying: "We were seeing things that were 25-standard deviation moves, several days in a row." As the CFO of one of the key players in the financial market, it was distressing to see Viniar so badly misunderstand what he was saying. As Seth put it, we'd be "far more likely to see a real black swan fly out of Mr. Viniar's posterior than we (or he) are to see a single 25-sigma event."

In statistics-speak, it appears that Goldman's CFO was expecting the financial markets to be normally distributed when they're anything but.

And how the dominoes fall
Suddenly, you have a number of very distressing events coming to pass. Financial players who were buying risk suddenly have to assume huge losses that they hadn't expected could possibly come to pass. Those players that thought they were safe and sound because they were offloading risk are now scared stiff because they're realizing that they're still swimming in the stuff.

As a result, nobody trusts anybody else, and there isn't a banker in the world that wants to sneeze the wrong way, let alone part with any cash. So we're left with financial piping that's frozen solid and a global economy that's being held hostage by this financial standoff.

Defusing the problem
I'm no big fan of government intervention in general, but in a panic like we're having today, I see it as highly warranted. I think of the government efforts like a bomb team heading into a booby-trapped building to examine where the explosives are and defuse them as quickly as possible.

There's no guarantee that they won't fail and set off a big explosion, but if they do nothing, those bombs are guaranteed to go boom.

In the meantime, though, the plunging market is creating the type of environment where fortunes will be made. Stocks like Microsoft (Nasdaq: MSFT  ) -- which has little need for debt or capital raises -- have taken a beating with the rest of the market. As has Berkshire Hathaway, a company that holds more cash than I care to think about and that's run by probably the greatest investment mind to ever meet Mr. Market.

So go ahead, marvel at the spectacular collapse that's going on right now. But don't let it spook you from holding onto -- or better yet, buying -- the great companies out there that are selling at sweet discounts.

More Foolish panic coverage:

Microsoft and Berkshire Hathaway are Motley Fool Inside Value selections. Berkshire Hathaway is a Motley Fool Stock Advisor pick. The Fool owns shares of Berkshire Hathaway. Try any of our Foolish newsletters today, free for 30 days.

Fool contributor Matt Koppenheffer does not own shares of any of the companies mentioned, nor has he bought or sold any credit default swaps. The Fool’s disclosure policy ensures that Fool readers are not at risk.


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  • Report this Comment On October 13, 2008, at 5:26 PM, Gradientman wrote:

    Well, I think Seht Jasen got it right the first time -- the ego's blew it would be more accurate. Of course the risks are correlateed but I suspect that most quants would know that. The problem isn't creating insurance like products for financial risk it is pricing it correctly and rating it. This is just what we all pay Moodys for and they really performed.

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