"Beware of Geeks...Bearing Formulas"

Warren Buffett says it all, as reported in the 03 November 2008 print edition of the Wall Street Journal, titled "Behind AIG's Fall, Risk Models Failed to Pass Real-World Test." The article explains why the risk modeling used by AIG was one of the most significant causes of the storied insurers dramatic fall and current weakness.

As I have written in the past (Financial Crisis Primer), much of today's financial crisis is based on poor risk management. Additionally, the U.S. government had a strong role in the distortion of the mortgage and mortgage-backed securities market, creating a ripple effect felt through the credit-default swaps.

What is a credit-default swap? From the article:

"In essence, AIG sold insurance on billions of dollars of debt securities backed by everything from corporate loans to subprime mortgages to auto loans to credit-card receivables. It promised buyers of the swaps that if the debt securities defaulted, AIG would make good on them."

So, AIG had a Dr. Gary Gorton, formerly a Wharton professor and now a professor at Yale School of Management, build highly detailed models to determine "worst case scenarios" for the securities AIG was using for the credit-default swaps. While Dr. Gorton provided data based solely on the default potential of the backing securities, the AIG management was the final say on what was purchased.

So far, this sounds like a good practice. A very smart PhD economist builds a huge computer simulation to model risk. What the model didn't take into account is where this all falls apart and AIG is getting almost $100 billion in U.S. government loans.

The risk model of Dr. Gorton didn't account for the loss in value of the backing securities, nor did it account for the loss in value of AIG itself. Why? Mainly because the financial instruments used to create the credit-default swaps were so complex, and the other outside factors were near impossible to predict. In short, there were too many variables making proper risk management impossible also.

One can argue, as does a current criminal case, that AIG should have exercised better judgment in how it set up and sold credit-default swaps. One can argue that conservative risk management would have minimized these issues and allowed AIG to not require government financing. Perhaps there is another lesson in all of this. When something is too good to be true, like loose credit and cheap money, it pays not to be greedy. Just ask Lehman Brothers, or should I say, Barclays?

Financial Crisis Primer, Part II

In my previous article, "Financial Crisis Primer," I gave a very brief explanation of why there is a financial crisis in the first place.

What I failed to mention, was a solution. While I would love to take credit, I didn't come up with this, and sadly I don't remember the name of the guest on CNBC who mentioned it.

What the Treasury should do, and it appears as though they will, is ask the banks what they need in terms of recapitalization. For example, Neel Kashkari (Cash-Carry, right? Love it) pictured above, calls Citi and asks how much they need to cover existing losses on mortgages, as well as capital necessary for lending. Citi responds with a number like $15 billion (twice what they got from Abu Dhabi Investment Authority). The government in turn, gets $15 billion in prefered stock, warrants, and other financial instruments of value.

I think this is a good model. It is very similar to what Warren Buffett did with Goldman Sachs. Goldman needed some quick cash and Warren put down a cool $5 billion. In exchange, (from MSNBC):

"(Buffett got)...$5 billion worth of perpetual preferred stock getting a 10% dividend and warrants to buy $5 billion of common stock with a strike price of $115 a share. He'll be able to exercise the warrants at any time over five years."

Imagine if the Treasury could spend $120 billion, $15 billion over 8 banks, and voila, much of the financial crisis is solved. The banks get fresh capital and the US taxpayer gets a profitable investment. Unfortunately for the existing shareholder, the infusion will dillute existing shares. Oh well, caveat emptor.

In the end, I think Bernake and Paulson are trying to shorten the duration of this mess by offering US taxpayer money to purchase the worst of the worst assets as well as providing plenty of cash at the Federal Reserve Discount Window.

Many argue that the government shouldn't be spreading around taxpayer dollars. While I agree in principle, the overall market for money indicates that banks are hoarding cash and investors are fleeing for quality. For the global financial system to function smoothly, capital has to get moving again, and I think that is the plan.

Nuclear, Silver Bullet or Money Pit

When discussing the "energy crisis," one of main issues is electricity, including its generation and distribution. In the US, electricity is mainly generated by burning fossil fuels, however, nuclear power generates about 20% of nations electricity, with hydroelectric, and to a much smaller degree wind and solar rounding out the list (numbers, source EPA).

When considering what is the most efficient as well as "best" for the environment, nuclear seems to be a pretty good option. Its day to day generation of electricity doesn't produce any green house gases or other pollutants to global warming adherents fear. Were that not enough, the French produce 80% of their electricity through nuclear power. So why not more here in the US? Cheap? No. 100% Free. Trade stocks for free on Zecco.com. The Free Trading Community. www.zecco.com

In the July 7, 2008 print edition of "Business Week," there is an article titled, "Nuclear's Tangled Economics," (which is the source of all quotations in this post). It highlights presidential candidate John McCain's desire to have 100 new nuclear power plants. The article also highlights that current estimates put the cost at new plants at about $7 billion dollars. While that number is expected to grow as the cost of materials to build the plants grow, the question is whether it makes sense for power companies to build them.

One the first issues any such project is going to contend with is the cost of regulation. Fortunately, the US has standards for building new plants, as well as more efficient regulation. However, some power companies have decided to drop their projects. Most notably, MidAmerican Energy Holdings, "... a gas and electric utility owned by Warren Buffet's Berkshire Hathaway, shelved its own nuke plan earlier this year, saying it no longer made economic sense." Protect your Medical Identity with TrustedID. $1,000,000 Warranty & Great Customer Service

While Berkshire Hathaway shareholders should be grateful for the careful financial management of the company, they may also consider that NRG Energy, Dominion Resources, Duke Energy, and "...six other companies have already leaped to file applications to construct and operate new plants largely because of incentives Congress has put in place." The incentives are not just tax credits, but also $18.5 billion in loan guarantees. Considering the status of the credit markets, the loan guarantees can make all of the difference. eFax Annual Subscription

While nuclear energy is clearly one the best, proven, and clean technologies for electricity generation, it isn't without commercial risk. Each power company is going to have to review the risks, their capital positions, and the economic climate to determine is building a new, nuclear power plant is right for the share holders.