The next financial crisis

James Surowiecki's article at the New Yorker is a great reminder why we won't know where the next financial crisis will come from.

Monoline insurers do a straightforward job: they insure securities—guaranteeing, for instance, that if a bond defaults they’ll cover the interest and the principal. ... Like everyone else in recent years, they wanted to cash in on the housing and lending boom. In order to expand, they started insuring the complex securities that Wall Street created by packaging mortgages, including subprime ones, for investors. ... —but it rested on a false assumption: that the insurers knew how risky these securities really were. the claims. They’re now on the hook for tens of billions of dollars in potential losses, and some esThey didn’t. Instead, they gravely underestimated how likely the loans were to go bad, which meant that they didn’t charge enough for the insurance they were offering, and didn’t put away enough to cover timates suggest that they’ll need more than a hundred billion to restore themselves to health.

Obviously, this is bad news for the insurers— ... but it’s also very dangerous for credit markets as a whole. This is because of a peculiar feature of bond insurance: insurers’ credit ratings get automatically applied to any bond they insure. ... As a result, any bond they insured, no matter how junky, became an AAA security, which meant access to more investors and a generally lower interest rate. The problem is that this process works in reverse, too. If the insurers lose their AAA ratings ... then the bonds they’ve insured will lose their ratings as well, which will leave investors holding billions upon billions in assets worth a lot less than they thought. That’s why so many people on Wall Street are pushing for a bailout for the insurers. It may be an abandonment of free-market principles, but no one has ever accused the Street of putting principle above profit.

... The situation illustrates a fundamental paradox of today’s financial system: it’s bigger than ever, but terrible decisions by just a few companies—not even very big companies, at that—can make the entire edifice totter.

In that sense, the potential collapse of monoline insurers looks like a classic example of what the sociologist Charles Perrow called a “normal accident.” In examining disasters like the Challenger explosion and the near-meltdown at Three Mile Island, Perrow argued that while the events were unforeseeable they were also, in some sense, inevitable, because of the complexity and the interconnectedness of the systems involved. When you have systems with lots of moving parts, he said, some of them are bound to fail. And if they are tightly linked to one another—as in our current financial system—then the failure of just a few parts cascades through the system. In essence, the more complicated and intertwined the system is, the smaller the margin of safety.