- In the world of finance when one talks about systemic risk they are saying the type of risk being taken cannot be diversified. One way to look at it is gambling like a game of poker. The game is well known and easy to play so it will make for easy analogy. Because the game is based on random groupings of cards there is an inherent risk that you will be dealt a bad hand. The difference here is that you are betting or hedging that you have a better or less-worse hand than the other players but during the 2007-2009 financial crisis, the hands had to be shown and more than expected had 7 2 off-suit. This may not be such a big deal in a friendly game, but when it’s the economies of the world it’s a big expletive deleted deal. On the global scale this was catastrophic because the sector that was affected was directly tied to more than financial markets.
There are many bets to place in the world, some with low risk and some with medium and high, but with systemic risk its like jumping out of a plane and when your parachute doesn’t open, instead of fear you feel prepared for this because you planned ahead and tied yourself to the next person with a parachute. The problem with this method of diversification is that instead of taking the fall that you deserve for jumping out of a plane, you kill every other parachute-carrying victim near you. Not dissimilar to jumping out of a plane, these bets had no purpose besides personal greed.
1.2) The first channel mentioned in the Swagel article was that of holdings of Lehman commercial paper. These commercial papers are short term and unsecured debts that must be paid back so when Lehman brothers went bankrupt, the holders of their commercial papers were effectively burnt on their return on investment. When it became apparent that Lehman was a metaphorical flaming dumpster fire, it was, for some, already too late and the downward pressure was too much. The biggest problem with Lehman was that even though it was clearly insolvent to those in the inner circle, it was still rated triple A. How people responsible for this were not publicly hanged is beyond me.
I mentioned how these loans must be paid back and there in lies the second channel. Because the UK government had seized Lehman assets but didn’t discern between client assets and Lehman assets many were in limbo. This increased the downward pressure of Lehman holdings even further. This is where we heard the term “from Wallstreet to Mainstreet” implying that this problem was no longer just a problem of the wealthy but the entire world. In my opinion this systemic risk was not just a complete failure of global businesses, but also an example of the ineptitude of global financial institutions and the governments that allowed this to happen .
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