In the wake of MF Global’s collapse Russ Robert asks

And what “didn’t have to be this way?” That’s a question for the investors and creditors to answer for themselves. Why is it a question for the rest of us? Why do we want the government to protect naive or greedy investors from their own shortcomings? Let’s them learn a lesson for a change. Why won’t that work?

There are two ways to restrain imprudent leverage. The first just got imposed on Corzine. His creditors lost most or all of their money. They’ve learned a lesson. If they were overly optimistic about a bailout, they have adjusted their expectations somewhat for the next time. If they were just overly greedy or optimistic or naive they’ve had some prudence and sense knocked into them in a very expensive fashion. If we can avoid the temptation to bail out firms leverage will shrink as lenders learn its risks or at least lose their money. Both make it harder to keep leverage high in the future.

I need to work out the math on this to be sure my intuition is right but let me see if I can explain why I think that won’t work.

In this particular case we don’t know whether or not MF Global’s creditors lost most or all of their money. However, there is no particular reason why they had to.

Russ notes earlier in his piece that perhaps the equity partners in MF Global were hedged. However, one can hedge credit risk as well. The obvious instrument to do so is the Credit Default swap.

There is certainly some combination of loans to MF Global and Credit Default Swaps on Greek Bonds that leave the creditor with limited exposure. Of course, one could also purchase CDS on MF Global bonds themselves.

However, the first case could leave you with more upside open, including the possibility that an MF Global creditor makes money on an MF Global default that resulted from over exposure to Greece.

Generally speaking market participants can hedge away an arbitrary amount of idiosyncratic risk. That is, to say there is no amount of recklessness that is so reckless it does not make sense for anyone to back you.

However, in hedging away this risk they increase systemic risk in global financial system. This in turn drives up demand for assets with low exposure to systemic risk. Yet, the primary means for creating a “low systemic risk” asset is to push the risk into the tails of the distribution.

What you wind up with is a market in which everything is works for everyone, unless it doesn’t, in which case it goes wrong for everyone all at the same time.

My sense just pondering over it is that this is individually optimal for every single participant. I actually suspect it would be socially optimal as well if it were not for the fact that macro-economic effects caused the distribution of economic shocks to fall unevenly and to persist longer that they otherwise would.

Therefore everyone acting completely unrestrictedly in accordance with their own best interest will slowly construct a doomsday device in which everything goes absolutely swimmingly, until it doesn’t and then whole world bursts into flames.

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