Thursday, March 05, 2009

Contagion Among Banks

To follow up on Musings, here's a really good post from TNT about banks and the tools Valdis Krebs, the author, used in analyzing how they got into trouble. Every endeavor known to man has a cost. Because of this fact, the question one must ask before doing the endeavor is, Do the benefits outweigh the costs? - RM

"This week's PBS Frontline show was fascinating. They discussed the financial meltdown and how it was exacerbated by the massive intra-connectivity of the banking system.

Frontline focused on the trade-offs between "moral hazard" -- punishing the bad guys for bad behavior, and "systemic risk" -- allowing the bad guys to fail and effect the rest of the interconnected system. The main contagion under discussion were the investments created by Bear Stearns, Lehman Brothers -- packaging up sub-prime and other mortgages into mortgage-backed securities which were then sold to other banks and investors."

Young Chuck, moved to Texas and bought a donkey from a farmer for $100.

The farmer agreed to deliver the donkey the next day. The next day he drove up and said, "Sorry son, but I have some bad news. The donkey died."

Chuck replied, "Well, then just give me my money back."

The farmer said, "Can't do that. I went and spent it already."

Chuck said, "Ok, then, just bring me the dead donkey."

The farmer asked, "What ya gonna do with him?"

Chuck said, "I'm going to raffle him off."

The farmer said, "You can't raffle off a dead donkey!"

Chuck said, "Sure I can. Watch me. I just won't tell anybody he's dead."

A month later, the farmer met up with Chuck and asked, "What happened with that dead donkey?"

Chuck said, "I raffled him off. I sold 500 tickets at two dollars a piece and made a profit of $898.00."

The farmer said, "Didn't anyone complain?"

Chuck said, "Just the guy who won. So I gave him his two dollars back."

Chuck now works for Morgan Stanley in their OTC Default Derivative Department.
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