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Friday, July 06, 2007

Subprime debt as a form of gambling

Those who are concerned about Bear Stearns and the subprime mortgage fiasco should read Paul Tastain's article in today's Daily Reckoning. He explains in detail how junk lending has gone from risky investment, to default insurance and ultimately to a kind of gambling. Some of the worst of this product has been bought by institutional investors, such as pension funds who have been almost forced to buy it by legislative pressure to increase bond holdings. He guesstimates potential losses in the region of $72 billion, or 20 times what it cost to bail out LTCM

These are certainly large figures, but maybe we should look at them in context. Interpreting the Russell 3000 Index data on this site, total US equities were worth around $15 trillion in 2005, and obviously rather more now. The 2007 estimated Federal Budget outlay is $2.655 trillion. That would make the putative $72 billion junk mortgage loss only about 0.5% of US investments overall, or some 2.6% of US government expenditure.

But the article is a wonderfully clear example of how systemic risk is created and expanded.

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