Socialize this

Carl Leahey of consulting firm Decision Economics commented to Reuters today on U.S. Treasury Secretary Hank Paulson's plan to buy up the financial industry's bad assets:

What is happening now is what people have worried about for decades, that when the financial system blows up, the average American taxpayer has to foot the bill, socializing the losses, but privatizing the gains. Wall Street has discovered a great business where the upside is potentially unlimited, but the downside is ultimately put on the taxpayers' tab."

This really gets to the crux of modern finance. The argument may seem an unimpeachable critique of Wall Street's greed and selfishness, but it's easy to unfairly characterize Wall Street's practices. Yes, securitization and insurance, two areas in which the modern financial industry really excels, are all about privatizing gains and socializing losses.

But then again, with a fire insurance policy, you can enjoy your private abode with peace of mind. If your house burns down, the cost of your claim gets socialized across the other customers paying premiums to your insurance company. It is a legitimate method for risk dispersal and enables us to enjoy a higher standard of living.

In fact, the real problem is that AIG just didn't socialize its potential losses enough. It was unwise to hold such large amounts of credit default swaps (insurance they issued on bonds), ultimately leading to its troubles. Those could have been sold to various investors, thus socializing any potential losses!

So it's important to make the point: What is reprehensible here is that losses have now been socialized to taxpayers. This is because outsized risks were taken due to the availability of easy credit and the upwards march of housing prices, exacerbated by poor risk management and defective bond ratings schemes. In the future, many new regulations will be required.

"Privatizing gains, socializing losses," though? There shouldn't be an inherent stigma to this concept. We live with it every day.