Monday, October 27, 2008

Cutting debt into little bits

Comprehending what caused the recent credit-crunch/liquidity-crisis is much easier after reading Tom Cunningham's explanation:

But wait, there's a loose end, what about all the risky leftover pieces of investment? Who's going to buy those?

This is the clever part. Suppose you're offered the chance to flip a coin, where you'll get £100 if it's heads, but nothing if it's tails. On average you get £50, but it's risky. Now instead say you pool your winnings with 100 other people who are in the same situation and you all share the proceeds. Again you'll get £50 on average, but it's now a much surer prospect.

This is the trick to deal with the risky parts of the investments: if one firm can buy up a huge number of these separate risky investments then the risks start to cancel out, and as a whole it becomes a fairly safe investment.

It all makes sense. Sort of.

Cutting up debt

The thing investors really don't like is uncertainty. And what the financial engineers in the city have been trying to do is "smooth out" risk. Risk remains, but it is well managed *in theory*.

The logical conclusion would have been one enormous world investment, stitched together from all of the billions of separate individual investments. But the financial engineers stumbled before they could construct that one.

Cunningham's conclusion is that "no one has found any fundamental problem with the principle of sharing risk."

This raises the interesting possibility that once the smoke has cleared financiers might start doing it right.

[image from SqueakyMarmot]

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