Friday, October 10, 2008

Fractional Reserve Insurance


At 2:00 PM (ET), we will start to find out how deep the crater is, roughly.  More than 350 banks and investors basically insured against the Lehman Bothers failure well before it actually failed, and now they'll find out what their insurance is worth.  No one knows exactly how much is at stake because there's no central exchange or system for reporting trades.  It's that lack of transparency that has increased the reluctance of financial institutions to do business with each other.

The 350 banks and investors bet on Lehman Brothers failure.  Many of them also bet it wouldn't fail to cover themselves.  Then other banks and investors bet on their bets.  This went back-and-forth in what I'm calling "fractional reserve insurance" (the industry calls it "Credit Default Swaps").  This whole scheme would have worked fine if there were no problems.  But of course, there were problems.

The Lehman Brothers failure was the tip of the iceberg.  This is part of the systemic risk that has been freaking out the politicians.  Here's a good analogy:


Posted by email from Anthony Martin's Weblog (posterous)

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