Take less risk and earn less; you’ll be richer in the end.

“Risk is a part of God’s game, alike for men and nations.” – Warren Buffet

I teach contracts.  I litigated over contracts for almost twelve years.  One of the hardest lessons to get across to students and clients alike is that the value of a contract does not depend on the amount that the contract promises will be paid if it is breached.  Rather, it is the amount that can be collected that determines the value.  If someone lacks the ability to pay what he owes under a contract, he can’t be forced to, even if he loses a lawsuit and is under court order to pay.  You can’t squeeze water from a stone.  There is thus always a risk you will not be able to collect what you’re owed for breach of contract even if the breaching party has all the desire in the world to pay: he may simply be unable to.  This lesson is central to today’s post.

I expressed a blanket condemnation of journalists the other day.  The generalization, like any generalization, was a gross misrepresentation of reality.  Joe Nocera of the New York Times is an outstanding journalist, and he works in a field particularly difficult to write about effectively — financial reporting.  Most financial reporters (in newspapers, online, and on television), like most legal journalists, have a very difficult time explaining their subject matter in terms that are clear to reasonably intelligent human beings not educated in the subject matter about which they write.  To be effective, they can’t get by merely spouting jargon like “credit-default swaps” and cliches like the one that’s been going around that even the Wall Street gurus couldn’t understand the complex financial instruments that were central to our dire financial situation.

The incomprehensibility of the transactions and the jargon is a myth propagated by people who profit by our ignorance; they myth is passed on by journalists and stockbrokers and “experts” of all sorts who don’t understand what they’re being told or that they’re being used.

Nocera is an unusual exception to the ignorance of most journalists in this specialized area full of jargon intended to mystify .  His column today is an exceptionally lucid explanation of the disastrous decisions that led to AIG’s ruin and the necessities that require we taxpayers  pay the billions or trillions of dollars AIG owes.

First, there were the mortgage-backed securities (the main type of asset now described as “toxic”) bought in disastrously huge numbers over the last several years because they seemed to offer a very high interest rate with little risk.  When you are offered to buy something with that combination, run! Investors in Bernie Madoff’s fraudulent “fund” have certainly learned that lesson.  But the rule holds even for legal, non-fraudulent investments, investments like mortgage-backed securities.

In essence, each mortgage-backed security constituted a tiny fraction of a group of mortgages originated by mortgage companies in conjunction with home loans.  Through a chain of transactions, the rights of the mortgage lenders — that is, the right to be paid the monthly mortgage payments — were packaged together into “securities” and sold by investment banks to investors (including individuals, banks, pension funds, mutual funds, investment banks, major universities, etc. — including, astoundingly, AIG).

In addition, however, the investment banks that put together and sold the “mortgage-backed securities” entered into agreements with AIG under which AIG insured the securities.  In other words, the buyer of a mortgage-backed security “knew” that he would be paid by AIG even if the home owners whose loan payments funded his security failed to make those payments.  This “insurance” that AIG sold to the investment banks  to guarantee payment on the securities the investment banks were selling to investors is what is called a “credit-default” swap.  It is, in essence, a guaranty that if the people responsible for paying the money owed to you under a mortgage-backed security you own fail to pay, the guarantor (in this case, AIG) would.

The investors thus felt they had no risk.  If all else failed, AIG would pay the money they had purchased the rights to. Among many other investors, banks had purchased enormous numbers of these mortgage backed securities.

The investment bankers who had packaged the underlying mortgages into mortgage-backed securities and marketed them to investors had it made — because of the seeming riskless securities they were selling, they were selling a lot of them and raking in huge fees for their work.

Finally, AIG had it made — it made money for selling the credit-default swaps that guaranteed payment to the buyers of mortgage backed securities.  It could even buy mortgage-backed securities and, astonishly, did.

The problem is that this structure hinged on the assumption that there was no real risk a large enough number of home owners would fail to make the mortgage payments on which the structure depended.  Home prices continued to go up.  Even people who had bought houses they could not afford could always re-finance their homes when they needed the money because their homes were worth more than they were when the previous mortgage had been sold.

Then the underlying assumption failed.  House prices plummeted.  Defaults on mortgage payments rose to numbers unimagined by AIG, the banks, and the investors in mortgage-backed securities.  The investors were not being paid the money owed them by home owners.  Thus, AIG was obligated to pay that money to those investors pursuant to the obligations AIG had assumed under the credit-default swaps.

AIG did not have the money to pay these obligations.  This fact is rather remarkable given that AIG is the world’s largest insurance company and maintains reserves it calculates are required to pay off expected losses on the typical forms of insurance it sells — liability insurance to businesses, etc.  Even apart from the fact of its lack of reserves, the number and amount of defaults on the mortgage-backed securities were enormously higher than AIG had anticipated. So AIG became insolvent — it owed more than it owned.

The banks that had purchased so many of the mortgage-backed securities became insolvent too because those securities they held were now worthless.  How could it be that the they were legally allowed to put an amount of the money they held into such risky investments?  Because under the so-called “regulations” put into place during the Clinton administration (part of the complete abandonment of the federal government’s oversight of Wall Street), the banks had reported the face value of the securities as assets but reported that there was zero risk of a loss in their value.  The banks didn’t think there was any risk — AIG’s credit-default swaps “guaranteed” the face value of the securities would be paid!

There is always risk.  The problem is that people focus on some risks and ignore others.  They often ignore the risk someone simply will not be able to pay his debt.  Especially, if the “person” owing the debt seems as sound as AIG.

The more you pay for a product, the less risk you are taking that it is defective.  The higher rate of interest a lender is paying, the higher the risk the borrower is taking. It makes perfect sense.  If you’re invested in something secure (like Treasury Bonds backed by the U.S.), you know it is almost certain you’ll be paid the principal and interest the bond promises.  If, on the other hand, you’re invested in an enterprise that poses a high risk of failure, you will be paid a higher rate of interest in return for taking that risk.  The potentially higher return “makes up for” the chance of total failure.

I’m one of those who’s expected an economic disaster (though not of these proportions) for several years, but I knew we were doomed when I heard  last year on the radio some business executive extolling a huge deal his company had just made.  His company had purchased the division of another company.  The executive explained ebulliently that the deal was one on which his company “could not lose.“  The reason, he explained, was that if the purchased division did not meet certain performance benchmarks, the selling company had contractually bound itself to buy the division back.

I nearly drove off the road in astonishment at the level of stupidity being expressed.  What if the selling company didn’t have the assets to buy back the company?  What then?  The buying company would be stuck with having overpaid for an under-performing asset.

There is always risk.  Typically, the higher the risk of the investment, the higher the interest rate it will pay.  The high interest rate paid by those of these high risk securities that retain their value make up for the number of these high risk securities that will be unable to pay.  Bonds of this sort are called “junk bonds” for a reason.

But people are greedy.  If someone they know is making more money than they are in their savings, they want to invest in their friend is investing in.  So people flock to securities that promise greater value.  They lose sight of the risk, especially when underlying values are rising and the people who remember these lessons have largely died off.

What’s the lesson? If someone’s offering you a much higher return on an investment than you’re earning on a safe investment, turn it down unless you can afford to lose it all.  Resist the temptation even if all your friends think they’re making out like gangbusters in those higher paying investments. Don’t buy snake oil.  It didn’t go out of circulation with the death of the Wild West.