Amy’s Third Birthday

…was yesterday. Happy Birthday, Amy! Yes, she’s still amazing, but anyone who reads this site knows I think that. Here are some pictures of the occasion. There’s also some video, but I haven’t even posted the Christmas video so who knows when that will appear. Besides, thanks to a battery error I wasn’t able to get video of the best part – Amy blowing out the candles on her cake for the first time. :( Oh well, I’m sure there will be other occasions.

Distributing Risk

The other day I got into my car somewhere in the middle of an NPR piece about “private equity” firms, of which venture capitalists are the most prominent example. According to the story, such firms used to risk mostly their own money or that of their own direct clients, but nowadays they package up the debt (money owed to them by the companies they invest in) and sell it to other institutions such as hedge funds and even banks. Then someone came on to claim that this was a good thing because it spread the risk and reduced the chance that any one private-equity firm would go under. “Hold on just a minute,” I thought, “why is spreading this risk a good thing?” If you consider the usual examples of distributing risk, such as health insurance, they tend to have two properties.

  • They distribute involuntary risk, such as that of getting sick or injured.
  • They distribute risk upward, away from those who can least afford to bear the cost associated with that risk.

The second point is not just “don’t feel sorry for rich people” callousness, but has practical implications as well. Poor people can’t afford sudden additional expenses. If they have to pay unanticipated medical expenses, for example, they’re likely to do things that create further costs for them and for society – bankruptcy, malnutrition, further injury or illness due to overwork, neglect or abandonment of children. That’s not a problem for the wealthy, who can pretty much shrug off the same loss. Protecting the poor from sudden catastrophic expenses reduces the total cost of an adverse event, and is thus good for everyone – even those better off who grumble about footing the bill.

How does the shift of entirely voluntary risk (speculative investment) downward from the private-equity firms and their clients, fit into that picture? Simply put, it doesn’t. The true bearers of that risk were neither fully informed nor asked for consent. Bank customers were never given a choice to open accounts with a bank that won’t (note future tense) buy debt from incompetent or irresponsible private equity firms. If FDIC-insured accounts are involved, every taxpayer is assuming a share of that risk without having given consent. All that distributing risk does in this case is encourage the private equity firms to make even riskier investments. Can you say “dot bomb”? I knew you could. This is the same “moral hazard” some prattle about with respect to health insurance, where those who can push the cost of consuming something onto others will consume more, only in this case the hazard is real. People don’t get sick just because they have insurance, but private equity firms might make stupider investments when they bear less of the risk. You can also be sure that the potential rewards are nowhere as distributed as the risk, thanks to the magic of different share classes. Those who can shed risk but keep returns will speculate far more aggressively than those who can not – or, being moral, choose not to – do those things.

Speculative investment risk should remain with the speculators, not distributed to the uninformed, unconsenting, and unwary. Speculative investment is important for the economy, but if we lower the funding bar too far we end up with too many resources – human, financial, and other – tied up in junk companies instead of doing something with some actual chance of succeeding. Gamble with your own money, guys.