"In mathematics or statistics, taking a risk based on calculated odds, is known as a bet. The amount you gain by doing so is called a payoff."

Very true and according to this description every decision you every take in your life is a bet of one form or another since every single decision entails risk. Driving your car to work is a bet that you won't get into an accident. There is no part of life that does not involve risk, however miniscule. And all those people in the real economy are also betting. When Intel makes a processor it is betting that its processor will be be bought at a good price by consumers, that its architecture will work etc. When a government decides to spend more on education it is betting that its expenditure will have a positive impact on student learning and it is betting on the importance of education. Social movements and social changes like feminism, gay marriage, nazism, communism can all be considered big bets that entailed enormous risk. In fact all progressive social change entails enormous risk and is therefore just a big bet. And since betting is the basis of probability and probability is the basis of science, all of our science is also a form of betting. In this case we are betting that a particular theory will be correct given evidence we have seen to date. In fact this is the exact Bayesian interpretation of plausible reasoning. All of our belief formulation is also a form of betting. So since all life is betting why is is so bad if you bet for money? And losing money is not the end of the world. On the other hand communism resulted in the deaths of 100 million people. So maybe progressive social change is the most dangerous form of gambling!

I did not finish my last post so . . .

I keep hearing discussion of moral hazard in insurance terms relating to the financial markets, but no-one mentions the biggest moral hazard, that bankers and executives are being paid to do deals -- period, regardless of overall quality. So if they sell a lot of overpriced debt, mis-rated, or push an M&A that is a loser for the companies involved, or a buyout that simply asset strips and then IPOs a company with long term problems they "make out like bandits." There is a moral hazard, doing lousy deals gets you paid, maybe more than if you did a good deal, and certainly its easier than finding a good deal to sell.

The moral hazard problem is compounded by structural changes in the investment banking and finance industry, in particular the end of partnership as a business model. Until about two decades ago the vast majority of financial firms were partnerships -- even Goldman Sachs. The bankers (or at least their bosses) were risking their own money, and indeed a deal in which the bank of finance house arranging it had little or none of its own partners funds at stake was regarded with suspicion. Today, the banks are at most risking shareholders funds, and often not even that. Even the big traded banks were institutions where bankers spent decades rising up the ladder, where as today they spend 1-4 years -- this means that when the "shit hit the fan" on a toxic deal, they were their to get canned; now the bankers have collected their bonuses and largely moved on.

To get an idea of how this has effected mortgages, recently I was talking to an old friend, a property lawyer. He is dealing with sub-prime litigation, where the big funds are suing the smaller aggregating funds for selling them suspect mortgages, or trying to cancel the mortgage. One cluster of mortgages he finds very interesting -- mortgages ostensibly written for owner occupiers, but in reality on rental properties -- million dollar beach houses, apartments, etc. The lenders are now arguing that they were 'had' because the property was a rental. The funny thing is the owner occupier covenants, which the lender wrote -- they say "Buyer will live in the property." This is very loose language -- "buyer will live" leaves open when, for how long, for what proportion of the time, etc. In essence, you could just intend live in the property for a few weeks at some point in the future and fulfill this, and thanks to the legal principle of contra proferentem, ambiguous terms are construed against the drafter, the borrower may be OK. However, this is an odd clause -- owner occupier clauses for decades have been more precise -- so why were the banks drafting such sloppy clauses; could it be that they wanted to make the loan to a landlord, but wanted to be able to sell it on as a prime-owner-occupier loan. Sure looks that way.

FINANCIAL SYSTEM IN JEOPARDY!

by Martin D. Weiss, Ph.D.

http://www.financialsense.com/editorials/weiss/2007/0813.html

The Gigantic, Poorly-Known, Highly Inflammable Market For DERIVATIVES …

[snip]

"In its latest survey, the Bank of International Settlements (BIS) calculates that the total "notional" value of all derivatives outstanding in the world is a mind-boggling $415 trillion.

That's over eight times the GDP of the entire world economy … twenty times the total value of all U.S. stocks … and fifty times all the Treasury debts of the United States Government."

[snip]

http://www.bitsofnews.com/content/view/5955/

The Insolvency Crisis: How we got here, and what to expect

Saturday, 11 August 2007 Written by Garrett Johnson

And Nouriel Roubini, naturally:

'[T]oday any wealthy individual can take $1 million and go to a prime broker and leverage this amount three times; then the resulting $4 million ($1 equity and $3 debt) can be invested in a fund of funds that will in turn leverage these $4 millions three or four times and invest them in a hedge fund; then the hedge fund will take these funds and leverage them three or four times and buy some very junior tranche of a CDO that is itself levered nine or ten times. At the end of this credit chain, the initial $1 million of equity becomes a $100 million investment out of which $99 million is debt (leverage) and only $1 million is equity. So we got an overall leverage ratio of 100 to 1. Then, even a small 1% fall in the price of the final investment (CDO) wipes out the initial capital and creates a chain of margin calls that unravel this debt house of cards. This unraveling of a Minskian Ponzi credit scheme is exactly what is happening right now in financial markets.

http://www.rgemonitor.com/blog/roubini/

And finally:

"Debt securitization is guerrilla warfare against a sound credit system. Unlike a credit-driven economy, a debt-propelled economy will inevitably reach a point where its ability to service the growing debt is exceeded, unless inflation stays ahead of interest charges, in which case the banking system will fail." - Henry C K Liu

(Emphasis added - cfs)