Have a new blog post up on consolidating your personal finance accounts.
Have a new blog post up on the mymoneymanage.com on the first steps that are necessary for taking control of your personal finance.
Willem Buiter’s usual brilliant takedown on the CDS and why they are the spawn of the devil! One particular aspect is intriguing
When purchasing an insurance contract, the insured party is generally expected to have an insurable interest in the event against which he takes out insurance. This simply means that he cannot be better off if the insured against event occurs than if it does not occur. Determining what constitutes an insurable interest is often complicated in practice, but simple in principle: you have an insurable interest if, when (a) the future contingency you insure against occurs and (b) the insurance contract performs (something you cannot necessarily count on, without assistance from the tax payer, if you buy your CDS from AIG), you are not better off than you would be if the insured-against future contingency did not occur.
Clearly, CDS contracts don’t require an insurable interest to be present. Many other derivatives likewise don’t require an insurable interest to be present.
The key sentence is
Determining what constitutes an insurable interest is often complicated in practice, but simple in principle: you have an insurable interest if, when (a) the future contingency you insure against occurs and (b) the insurance contract performs (something you cannot necessarily count on, without assistance from the tax payer, if you buy your CDS from AIG), you are not better off than you would be if the insured-against future contingency did not occur.
Let us do a thought experiment. Assume that there is a Catering company Cooks For Free that provided catering for a major airline Wait Unlimited. This airline constitutes say 60% of their business. Their revenues from the airline are 60 million dollars and they make profits of 5 million from the airline.
Now they obviously have an insurable interest in the airline so they should be allowed to buy CDS contracts. Let’s say they buy 10 million of CDS contracts @ 200 basis points. That costs them 400,000/year and they can write it off as business expense.
Now there are multiple problems that leads to sub-optimal real world outcomes.
There is a moral hazard problem that if the airline gets into trouble Cooks for Free will not do their utmost to cut costs and try and save the airline.
There is an agency problem if the catering company is run by ‘professional managers’, in that they would be happy to take the 10 million and show an excess profit and not worry about future viability of the industry or business.
We run a business not to just hedge risks but to take on risks and create value that generates profits. That 400,000 paid to the insurer is better utilised in innovation t either in improving quality of meals or cutting waste and costs.
This scenario also holds for financial firms who manage money for their clients. Their job is to diversify by investing in various asset classes or by aggressively monitoring the operations of the entities to whom they have lent money.
The oldest lesson of economics is that there is no free lunch. We all have to work to earn a living by creating something of value. Diversifying risks which is in reality uncertainty is never a solution.
Steve Waldman riffing off on a statement by Arnold Kling that the key job of the financial system is to intermediate, to transform long term risky capital into short term liquid capital. As he rightly points out, there is no magical way to do this except through a misdirection of people and an implicit government guarantee of all capital.
This goes to the heart of the current financial crisis, that an intermediary could take on all sorts of risks funded via capital which they classified to their investors as risk-free.
Steve Waldman goes on to list a number of suggestions of what can be done in the future such as dis-intemediate, through equity arrangements rather than debt. But even equity arrangements need intermediaries and as long as people are not aware of the risks that they are undertaking or the intermediary obfuscates the risk.
A big reason for this is the bank depositors, house buyers, investors, insurance buyers have been innured to the fact that they are carrying any risk. Most people don’t expect to sell their cars or electonics at a higher price than what they bought it for. These are not seen as store of value, but rather consumption goods.
What a majority of people want it a store of value which will protect them against rising cost of consumption in future. The government should issue Inflation adjusted bonds and go on a campaign that this is the only reliable store of value. In every bank branch there should be signage just like there is on cigarette packets that there money is at risk with photographs of people made destitute by foolish investments. Everytime someone buys any asset which they buy simply because they think it will go up in value, governments should proactively start a Public service campaign which talks about how asset prices tend to fall after they have gone up. They do it for cigarettes, AIDS, STDs, flu epidemics, so why not for financial epidemics. It’s not bullet proof but atleast a counter-balance to the irational exuberance of people.
We all have a tendency to over-invest in insurance. We simply assume that somehow having someone else promise us a bail-out we can go ahead and stop worrying.
But as AIG’s 61.7 billion dollar loss and it’s reasons covered in NYT show, lots of people bought Credit Default Swaps from AIG assuming that if the companies or Securities defaulted they would be able to cover their ass. Now the only thing that is keeping these people afloat is the forbearance of the US Treasury.
A similar pattern also emerges if we look at individuals. Most buy too much insurance, starting from 3 year warranties on computers to buying insurance on car wind shields. We over-consume insurance by trying to shift the risk, but the real issue is uncertainty in aspects of our life.
A better approach instead of buying insurance would be to create emergency savings which you put aside at the beginning of the year and use it as and when the need arises. When your laptop crashes, when your mobile phone gets stolen or you just have a rough year.
The great thing about this approach is that unlike insurance premiums you can roll this over if there was no need in a particular year.
The Emergency Fund can be broken into the following proportions
- 30% in gold (mostly 10g coins as they are easy to carry)
- 30% in 3 month rolling FDs
- 20% in a Bank Current Account
- 10% in Blue Chip Stocks
- 10% in Cash in Hand
Roughly about 10% of the value of the electronics and household goods should be enough.
One of the areas that is critical in Money Management for consumers is for them to have knowledge on what kind of fees and other charges, that the banks are passing on to them.
Once a year, credit card issuers would be required to make available to users two secure electronic files. The first would be essentially a spreadsheet that listed all the ways in which a customer can be charged. For example, the spreadsheet might reveal that if a payment is received late, the customer is charged a fee and the interest rate is raised by 200 basis points. The disclosure would also reveal how much customers are charged for transactions in foreign currencies. The second file would be a list of all the actions the customer made in the past year that incurred a charge.
This is one of the areas that MoneyManage would leverage on to create value for it’s subscribers.