MBIA says in the worst case scenario, it would suffer a $10 billion loss on the $673 billion it has insured. Nevermind that they only have a small fraction of that in actual capital. According to them, the probability of the worst case happening is 1 in 10,000. Counterparty risk is based upon this kind of thinking - telling everyone that things are okay because the risks are so small that only idiots would worry about it. Under that logic, I assure you that I am a giant idiot (bigger than my 6′ 5″ 250lbs.) I worry about counterparty risk and especially, the failure of the monolines. On a bigger scale, I worry about the failure of our financial system that has been built upon practices that promise to hedge risk while, in fact, they are the risk. CDOs were specifically constructed to supposedly reduce exposure to loss and enhance yields by blending some bad stuff with the good stuff. Maybe the risk of the worst case scenario was 1 in 10,000 for that too. Now it’s 1 in 1.

At some point, we need to come to grips with reality. The experts in risk and derivatives are the ones that created this mess. So which experts in risk will solve it? The same ones? Some government official? Some regulator?

We have a systemic failure and I have hinted at it repeatedly in prior posts. For years, financial engineers have engineered. Fiduciaries like pension funds and state/local government pools have bought it. They are sitting with a sizable percentage of assets based upon investment grade ratings that were premised upon this “don’t worry, the risk of loss is 1 in 10,000″ mentality. Now they are infected with SIVs, CDOs, Asset-Backed Commercial Paper that they cannot sell. Giving these assets anything less than an investment grade rating will precipitate a meltdown. Fiduciary rules require that these funds only hold investment grade assets. Who are they going to sell that stuff to? We are talking about trillions of dollars. And no one knows what the assets are worth because everyone (except for a few like E-Trade) have been afraid to sell them. Instead, the approach is to just take the hit through billions of writedowns - holding onto them hoping for a day when Humpty-Dumpty can be put back together again. The odds of that happening? I think it’s at least 1 in 10,000.