Securitization Of Risk

T H E

S E C U R I T I Z A T I O N

O F

R I S K

You know that the best you can expect is to avoid the worst1 PURPOSE OF MARKETS IS TO EFFICIENTLY ALLOCATE CAPITAL If the purpose of markets is to efficiently allocate capital to the most productive activities in an economy, the primary and essential function of government is to “supply the institutions that create and sustain trust in financial promises.” “Good government is then the foundation of any…financial system” that promises a future return on invested capital in exchange for putting this capital at risk today. 2 Thus, financial markets’ tasks include: (1) efficiently reallocating capital and labor to projects that provide the technological innovation the economy requires for growth, and (2) maintaining the ongoing integrity of market transactions so that growth can continue over the long run. When financial markets accomplish these two tasks, risk is being managed appropriately: maturity, liquidity, market, credit, currency, technological obsolescence, and wider economic, ecologic, and political risks. Market risk consists of the danger of mispricing assets; credit risk covers the potential of financial promises not being honored; currency risk describes a mismatch between the value of liabilities’ and assets’ respective currencies; technological obsolescence describes the technological progress in achieving more output with less input of labor, capital, and time; larger economic, ecologic, and political risks refer to black swans, those highly improbable events such as global crisis, war, political upheaval, and ecological collapse that produce massive impacts on markets. Risks are often global, interlinked, emergent (the outcome cannot be fully predicted by antecedent causes) and must be addressed in a timely fashion. The quality of governmental regulations & enforcement may be the single most important forcing function for markets to assess risk and respond to new risks that emerge. Governmental regulations form the foundation on which the financial markets’ pyramid of promises rest. Governmental regulations and enforcement must be capable of rapidly adapting and evolving for changing market conditions. The recent collapse of the financial system suggests: (a) the financial system has massively failed to adequately manage systemic risk, and (b) government regulatory institutions have failed to provide the forcing function for markets to manage risk. Two regulatory changes: (1) to assure capital is allocated to productive activities, profits should be calculated based on economic value added rather than on self-referential accounting measures. Externalities and contingent liabilities matter and must be included in profits calculations to measure risk; (2) an automated means should be employed to call-out firms that are not managing risk before these firms collapse. 3

Italio Calvino, If on a Winter’s Night a Traveler (1979) in William Poundstone, Prisoner’s Dilemma (New York: Doubleday, 1992), 53. 1

2

Martin Wolf, Fixing Global Finance (Baltimore: The Johns Hopkins Press, 2008), 12, 16, 19.

3

See Market Assurance Early Warning System http://www.pdfcoke.com/doc/9790231/.

LYLE A. BRECHT 410.963.8680 DRAFT 1.1 CAPITAL MARKETS RESEARCH --- Sunday, September 13, 2009

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