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Mike Rorty follows up on this post, discussing the ins and outs of the shadow banking system, with further ruminations on the topic Tuesday. He quotes Fischer Black saying:

I don’t see that the private market, in creating this wonderful array of derivatives, is creating any systemic risk. However, there is somebody around creating systemic risk: The government… Perhaps the biggest systemic risks that the government creates come from its debt guarantees...

And remarks:

I take a deep breath before saying this, but my man Fischer is wrong – AIGFP created systemic risk out of nothing by mispricing CDS contracts over a few year period. Systemic risk is the risk that effects us all, the risk we can’t diversify or innovate our investments away. It’s the risk that hits my boring index fund of stocks that I want to use to retire.

How do they do that? By underpricing CDS contracts – charge 2 or 15 bp on some accounts – they encourage people on the other end to take on more risk thinking they are insured, when they are not. This chains through the system to the point where it hits my boring index fund.

Perhaps I'm splitting hairs here, but it seems like the issue isn't so much who is creating systemic risk as who is accidentally increasing vulnerability to it. There is plenty of systemic risk out there at any given time. A housing price collapse in combination with an oil price spike would have generated a nasty recession, financial crisis or no, which probably would have affected all asset categories.

But firms are aware that these risks are out there and generally try to give themselves a cushion to survive them. But Mr Rorty is saying that AIG was selling default insurance on the highest rated securities—things that don't blow up unless the entire economy is blowing up—and pricing it pretty cheap, to boot. The problem, of course, is that when everything blows up—when the roll of the systemic risk die turns up an economy wide downturn—it's very difficult for any private actor to make good on its obligations. The collapse is the moment that AIG (NYSE:AIG) has to pay out to everyone, and it's also the moment AIG can't get its hands on enough funding.

It's a dubious proposition at any time that a private firm can credibly offer systemic risk insurance, but presumably if a private firm is going to offer it, it's going to cost a lot of money. Why? So that not everyone pays for it, and so that those that do are providing a lot of cash to fill up the insurer's rainy day fund. But AIG was offering it for a pittance.

And so AIG was selling insurance it couldn't afford to make good on, and people were buying it. And the people buying it were acting as though AIG could afford to make good on it. And so when collapse came, everyone was unprepared for the losses they sustained, and the pain grew very rapidly.

Does this mean that AIG was creating systemic risk? Maybe, in a sense. But another way of looking at this is that the systemic risk was always there, but both the buyer and seller of insurance on AAA securities wildly underestimated its scope.

This article originally appeared on The Economist.com

Source: Can We Insure Against Systemic Risk?