Forum Post: How It Happens - The Socialization of “Big Finance” Losses and the Privatization of Its Gains

There’s no doubt that the financial instruments used in transactions causing the above may be complex (not always) and unless one is working with them on a daily basis or studying them it should not be expected that one would understand them quickly. Nevertheless, do not be fooled by their complexity as the resulting transaction usually boils down to this:

The bankers/traders bet heavily that an event, which they have statistically, not realistically, calculated (using imperfect and heavily criticized financial models) as highly unlikely to occur. Because the risk of the event occurring and creating a loss is deemed highly unlikely by these “false-experts”, the parties (bankers/traders) to the transaction are required to put up very little money to secure the transaction. However, if the event that the bankers/traders assume will not occur does in fact occur, then the losses from the transaction will dwarf by multiples the amount of money the bankers/traders have and they will go bust. The bankers/traders are fully aware, before entering the transaction, of these potential losses but ignore them, however, because of their perceived improbability. Because the negative events that cause these transactions to create catastrophic losses are statistically improbable, these transactions can go on for years without any hiccups and will fool the traders/bankers and regulators into believing they are “good trades”. For those years, while the going is good, the bankers/traders will be paid large bonuses for these “good trades” and these charlatans (bankers/traders) will be celebrated and labeled by society as talented or geniuses (bolstered by their Harvard and Wharton MBAs). Then, as it always does in financial markets (see reflexivity*), the improbable event occurs. The transactions suffer catastrophic losses beyond the ability of the bankers/traders to cover and society has to step in and cover the loss or else “the economy will collapse” (sound familiar?). Meanwhile the bankers/traders keep all of their bonus money and homes in Greenwich, Darien, Westport, New Canaan, Scarsdale, etc. (you get the idea – sorry for keeping it short, Westchester ) and defend their actions by stating that “their models predicted that the event was highly unlikely to happen” or “how could we have known that event was going to happen” or even better, “we’re doing God’s work”. Needless to say, it is hypocritical that pro-capitalists (bankers/traders) engage in, defend and lobby for a behavior that causes losses to be socialized and gains privatized and which is certainly not what free market capitalism is about.

*It’s argued that, theoretically, the act of placing a trade in the financial markets will affect the very probabilities you calculated before placing the trade, often in a way unfavorable to the trade you placed.