Risk and Aversion, Take 2

Following up on Robert’s post (he started later and finished earlier):

Dr. Black:

[T]he idea that all this came about simply because the banksters decided a bit of extra risk was good is an idea only a macro finance person could sanely entertain.

All right, I represent that remark in more ways than one. So let’s Tell the Truth, Shame the Devil, and make the case for Financial Intermediation—all while agreeing with him that Geithner’s statement is absurd.

(For my next trick, I’ll spin plates on poles and juggle cutlery while riding a unicycle. You might want to stay clear of the area for a while)

So let’s talk about weather derivatives, the driving habits of government employees, and Miss Spider’s Sunny Patch below the break.

It was 1993, I think, when Richard Sandor gave the closing presentation at the ISDA Conference in Washington, D.C. Sandor was enthusiastic; there was finally enough weather trend data that you could model damage expectations for an area and reasonably estimate, for instance, the likely exposure of an insurance company to hurricane or tornado damage.

We may not be able to do anything about the weather, but we can do something about managing the risk associated with it.

Sandor’s argument was, in short, That’s what we do. We manage risk.

Contrast that with the story of GEICO, the current crown jewel of Berkshire Hathaway. GEICO started as an insurance company dedicated to Government Employees. It started that way for a reason, and the reason has everything to do with risk. Because GEICO management looked at the data and realised what anyone who thinks about it for a second will already know: government employees are safer drivers than the rest of the population.

They are safer drivers because they are more risk-averse. They take a job with, as a rule, lower pay than they could get in the public market, but better security. They prefer stability. Short version: they are risk averse.

Therefore, they are safer drivers than the general populace (who don’t want to be stuck behind them when they are time-dependent).

SO when Brad DeLong says:

I think the private-sector players in financial markets right now are highly risk averse–hence assets are undervalued from the perspective of a society or a government that is less risk averse.

my immediate response is at best Inigo Montoya (“I do not think those words mean what you think they do”) and at worst a version of Nelson Algren’s amendment of Thackeray (“That’s Not the Way to Bet”).

Because risk management means managing risk, not just taking chances. Hitting on 17 in blackjack isn’t the way to get rich. Paying $50 for something that is worth $35 to you isn’t the way of getting rich.

And, worse, it isn’t the way to get capitalism working again.

Because sooner or later, the professionals have to take over again.

The kids were watching Miss Spider’s Sunny Patch this weekend, an episode where the young Dragonfly flies for the first time, accompanying a bunch of “Daredevil” dragonflies. They fly for a while and then the whole place gets covered in fog. The daredevils find a place to sit and wait. The youngster keeps chiding them: “C’mon, I thought you guys were Daredevils.”

The Daredevils explain, roughly, that they don’t fly without knowing where they are going.

Unlike, apparently, the U.S. Treasury.

Robert already dealt with the basic illiquidity of the market. So let’s talk about Price Discovery, but this is getting long even for me, so…