morph366

Can We Insure Against Systemic Risk?

"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."

The last sentence of your piece, I believe, poses two very different issues which are wrapped up in the word "scope"

1. The likelihood of systemic risk - it was perceived as much lower than it should have been - the so called Black Swan issue

2. The severity of the losses which would result sequentially from a default - again massively underestimated because of the highly inter-connected web of counter-parties to the CDS market and the implicit leverage involved in the underlying instruments.

The reason for the "wild underestimation" goes to the heart of Nicholas Taleb's critique of the maths involved in measuring the likelihood of extreme or systemic risk. Taleb (in the FT this week) described the mathematical framework for estimating VaR in such critical episodes as basically useless.

Would you still fly in a 747 if you were told that the maths and engineering behind their design was basically useless?
Me neither. But the financial establishment seem quite unfazed about carrying on with their flawed framework for extreme risk management.