Risk...More Than Just a Board Game

Ah, yes...I remember the good old days. When banks were banks, insurance companies were insurance companies, and Risk was a board game where you massed your multicolored armies to seize Irkutsk from your opponent with a lucky roll of the dice.

That's all gone now, especially the risk part.

You all know by now that I don't profess to understand high-level economics, other than as an example of herd psychology. But I do now understand that much of it involves the intelligent management of risk - Investorwords.com defines risk as "the quantifiable likelihood of loss or less-than-expected returns," while my trusty Websters New Collegiate Dictionary defines it as a noun as "possibility of loss or injury," and as a verb as "to expose to hazard or danger."

Risk is at the heart of our economic system. If you want rewards, you incur risks. You invest in a company at the risk that you will lose your money, but on the expectation that your money will in fact grow if that company takes off. There's nothing wrong with this...in general, if you do your homework and invest wisely, you can minimize the risk.

Unfortunately, recent events have shown that risk is a variable thing. You and I, as small investors, assume a great deal of risk; very large banks and brokerage houses assume very little.

When the investment brokerage house Bear Stearns threatened to go under last month, the Federal Reserve arranged a buyout of the company (at a fire-sale price) to J.P. Morgan Chase. So far, so good. After all, as Fed Chief Ben Bernanke told the Senate Banking Committee on April 3, "Given the exceptional pressures on the global economy and financial system, the damage caused by a default by Bear Stearns could have been severe and extremely difficult to contain." Hmmmm...

What risk did J.P. Morgan Chase incur by purchasing Bear Stearns? It depends on how you look at it. J. P. Morgan bought Bear Stearns with assistance from the Fed in the form of a loan backed by $30 billion of Bear Stearns assets, agreeing to absorb the first $1 billion of losses if the value of the assets declines. The government - meaning You and I, the American Taxpayer, is at risk for the remaining $29 billion.

I was listening to an interview on this topic on NPR one evening last week. Unfortunately, I was driving at the time and didn't write down exactly which government official was being interviewed on the Bear Stearns bailout, but I remember the question that really got my attention: the interviewer was trying to pin down the interviewee on the amount of risk the American Taxpayer was incurring as a result of this action. The interviewee flatly stated that there was little or no risk.

Let's look at this from the perspective of an inquisitive fellow in Northern Virginia with a large mortgage.

If there is little or no risk to you and I from the government's guaranteeing $29 billion of a $30 billion acquisition backed by $30 billion of Bear Stearns assets, why was J. P. Morgan Chase only willing to accept $1 billion of the entire $30 billion risk? What did they see that isn't quite obvious to me? Why is there little or no risk in accepting the $30 billion of assets that somehow weren't enough to save Bear Stearns in the first place? It sounds like it should be a sure thing.

It also sounds to me like you and I are being played for all-day suckers.

I don't know much about economics, but I know this: if I make a bad investment, and lose my shirt, the Fed isn't going to have a bunch of weekend meetings to figure out how to save me. My IRA took an $11,000 beating last quarter, and that was on the basis of the best advice of my financial advisor, whose sage advice is to "look at the long term...don't worry about short-term fluctuations." If I had the money of a J. P. Morgan Chase and the backing of a compliant Fed, that would sound a lot better than it does.

If I don't make payments on my house, the bank will have me living out of a shopping cart before you can say "leveraged buy-out." I don't see much chance of J. P. Morgan Chase rushing to my aid.

Risk was fun when I was trying to wrest Irkutsk from another player. It's much less fun when you're playing on a field where the rules can change from day to day, and you're too small to have someone worry about minimizing your risk.

Have a good day. More thoughts tomorrow.

Bilbo