fingers of instability

From John Mauldin December 7, 2007

the surprising conclusion that even the greatest of events have no special or exceptional causes … it has to do with the perpetually unstable organization of the critical state, which makes it always possible for the next grain to trigger an avalanche of any size.

Poor SO. He is going nuts. The sandpile is enormous, so there are fingers of instability of exceptional lengths all over the place, and for what ever reason, that trigger grain of sand just misses the critical point day in and day out. Or maybe not. It could be that that point is passed and we just don’t know it.

However, I love the image of a big sand pile with fingers of red instability laced throughout – not touching, just there, waiting…

“Endogenous Uncertainty” … the uncertainty coming from risks that we ourselves create – rather than risks coming from exogenous or outside events (the standard theory of risk management only considers risks that are outside events on which we have no participation in creating). It has to do with risks that we humans ourselves create through our actions, rather than coming from nature. The more the economy is globalized, the larger is human impact globally – the more frequently we will encounter such risks.

Graciela Chichilnisky of Columbia University and Ho-Mou Wu at the University of Taiwan

Yes, we are doing it to ourselves. What a concept.

I have always been amazed by the creativity of individuals and groups for good and evil – negative amortization is one of my all time favorites. Who comes up with something as toxic as that, and gets away with selling to millions as the answer to putting the American Dream within their grasp? Speaks volumes about the moral fabric of this country, but that’s a separate topic.

Since new instruments create new webs of obligations, financial innovation is the precipitating factor. The transmission of default from one trader to another and from one market to another transmits individual risk and magnifies it into collective risk. Default by one individual leads to a collective risk of widespread default.

I don’t pretend to understand the derivatives, securitization, credit default swaps and other schemes that have been created to spread risk and guarantee massive profits for all the Wall Street players. Too often we little people think that all the shenanigans in the corridors of government and global finance markets somehow don’t affect us. It is just like watching a tennis match – we are merely spectators. We are sooo wrong.