In Praise of Complex Financial Instruments, Things in California Could Be Worse

The State of California will be bankrupt in 44 days.

But it could be a lot worse. Perhaps the only redeeming quality of the financial crisis, or at least of the complicated MDS and MDS-derived securities that are blamed for the financial crisis, may be that they saved the state from a deeper, earlier, harder bankruptcy. Here is how I see it: This state, perhaps after Florida, has the highest home foreclosure rate in America. We made the most bad loans. We have the worst defaults. It's on a scale you can't imagine, especially in the southern half of the state.

Traditionally, home lending is local. If seven million Californians default on the mortgages (as they may), that was ten million write downs on local bank loans, which would basically destroy the entire state's network of banks, putting their assets under the receivership of the FDIC until they could sell them to another bank somewhere else, probably out of state. The loss, meanwhile, would be much worse than that seven billion in bad loans that are written down--it would be the leverage on that (if banks borrowed cash against assets to make the loans, which could be as much as 30xs the cost of the defaulted loans--around 210 billion dollars! All in CA!) and the cost of banks collapsing, which could be a true disaster for local economies, and would certainly be a disaster for savings of Californians, who traditionally owned all the interest in local banks. CALPERs would be done. Any anyone else who had any savings took a serious hit. The state would have collapsed a in the summer of 2007. The all-but-inevitable CA bailout could have cost a lot more.

Thank god for complicated financial instruments that distribute that risk geographically, such that it was shared around the world. Instead, an unsuspecting village in Norway is bankrupt and pension and sovereign wealth funds from Detroit to Dubi are eating it. Japanese elderly and trust funds on the Upper East side all take a slice of this. And California gets a pass, which we still manage to fuck up. But it could be a lot worse.

Be skeptical of financial regulation. Distributing risks can be a good thing.