"economic Pearl Harbor"

Once again Warren Buffet knows how to distill things to their essence. This is indeed an "economic Pearl Harbor." Every time it seems to be getting better it takes a dive for the worse and sets new lows - just one calamity after another. Word to the wise, get used to it. If you look at the long slow downturn during the Great Depression, which took years to bottom, you will see some similarities - sadly.

I spent several years litigating and arbitrating over reinsurance spirals. Let me explain. A company would insure a risk at a premium it knew to be too low, but it could bundle these risks and reinsure them (insurance for insurance) at even more ridiculous rates. Thus, you could pass on say 95% of the risk for 90% of the premium. Kinda like printing money.

Why would the reinsurer take that risk? Because capital was plentiful at the time and they knew they could reinsure their reinsurance (called a retrocession) at a profitable rate and that retrocessionaire could pass it on to another and so forth and so on. Each player passed on a large percentage of their risk for a somewhat lesser percentage of their premium, and each found buyers (for a while) as they all thought there would be another willing sucker to take it the next step in the spiral. Eventually, however, the buck has to stop somewhere. Given the nature of servicing insurance claims and reporting them up the ranks, however, it could take many years for the buck to start working its way up the spiral, so you may have years between the time the initial claim is made and the reinsurer at the end of the spiral finds out they are the stuckee. Now there was some fraud and collusion going on, and that is where the litigation focused, but the the process overall was not unlike some of today's intricate financial products.

In the reinsurance arena, there were a fairly limited number of usual suspects - probably less than 20 total - that were active players. The dollars at risk there were relatively small, just a few billion, compared to the dollars at play today. Yet unwinding these messes and figuring them out was incredibly complex and it is still being worked out today, even though the spirals I speak of were created in the 1990s. This does not bode well for the mess we face today, not in the least.

I am not sure what the answer is here. Nonetheless, we need some out-of-the-box thinking. For example, perhaps setting up an agency to take a look at credit default swap contracts, build a database of same, and figure out off-sets for winding them down. Some effort in this direction has already taken place but we need more. The next step may be some legislative effort to force the rest to be cancelled, commuted or otherwise taken care of for, perhaps, return of premium, plus gain. Those who have no underlying bond or debt they are protecting simply get return of premium and the contract is torn up. This process will undoubtedly take government support, but disposing of the CDS market and making it illegal going forward is a necessary step. These products have proven to be a road block to the recovery and I will be damned if this world should go into a depression over the sanctity of these particular contracts, many of which are simply gambling. We have still probably fifty trillion in notional value of these instruments out there and there is just no credible way for this mess to be cleaned up with these landmines still there, waiting to blow up. Clear the mine field first.

There are other toxic financial products that perhaps need to be addressed in similar fashion, but we need to start acting at the root of the problem and stop throwing money at institutions and hope in time all will be well.

Disclosures: None