A Word About Risk

Tuesday, September 22, 2009


Obama's warning to Wall Street last week:

"Hear my words: we will not go back to the days of reckless behavior and unchecked excess."

In response, I have to quote Barney Frank: "On what planet do you spend most of your time?"

Financial booms and busts have occurred since the beginning of finance itself. There is a never-ending cycle of risk mispricing that leads to the cyclical nature of our economy. Obama must be out of his mind to believe even for a second that ending these cycles is possible.

In times of prosperity, risk is finds itself cheap as economic participants forget about the bad times. The increased risk taking typically increases prosperity in the short-term reinforcing the risk-seeking behavior. Government officials are just as participatory in the increased risk taking as private individuals.

Eventually, the party ends. Some events turn the tide and the economy begins to melt. The pendulum of risk-seeking behavior swings to the other side: risk aversion. Often, a massive contraction in risk taking occurs and the risk averse are found where risk seekers used to be. The contraction likely mirrors the previous excess seen on the opposite side of the spectrum.

Over time curbs have been put in place through regulation to mute the excesses and control the contractions. Yet, regulation is seen as least needed at the top, when it is most needed. So, regulators are often victim to the same prosperity mentality as private firms and misprice risk as well.

The cycle will never end and any thought to counter is just silly.


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