Spread the Risk; Spread the Love

We'd bet you love your neighbor a lot more than you think. By simply participating in capitalism you're helping mitigate risk to specific individuals and making the world a better place.

The underappreciated power of globalization is one of our continuing themes. So long as injurious government protectionism and regulation doesn't drastically impede its progress, globalization is a force that will drive prosperity for decades to come. As developed countries get more sophisticated and developing countries move toward modern infrastructures and financial systems, capital markets will continue their advance at an exponential clip. (See our past commentary: "Deriving Stable Markets")

One of the features of capital markets development is the principle of spreading risk across a society. Many think about capitalism as the way in which capital (money and resources) is allocated throughout society by way of free markets. This is true; but few realize risk can be (and is) spread around in a similar way…and that this is a good thing.

Through highly developed financial instruments and open markets with millions of participants, we're able to spread risk away from the singular lenders and lendees, enabling others to shoulder some of the risk with the promise of interest payments. Most of the time we call this sort of thing insurance. But it can be much more than that.

Such lofty statements in themselves don't mean much to most people. It's all very ambiguous and theoretical. How does it work in practice? Today, a couple great examples.

Securitization is the process of creating a financial instrument by combining other financial assets and then marketing them to investors. For instance, a bank can group a bunch of loans together and sell them to the market at an interest rate. This not only spreads the risk, but also allows lenders to access even more capital to do more lending or engage in other prosperous activities.

This goes on all over the world and in innumerable different forms—creating a network of risk sharing that's unimaginably vast. But not just vast…also more stable. Such a web of interconnection is strong and promotes durability throughout an economy, making financial meltdowns and other catastrophes less likely.

One type of asset-backed security in the news today is mortgage backed securities (MBS), which is a group of mortgage loans packaged together and then sold. Purchasing a mortgage-backed security is basically the same as lending money to a home buyer or business. The bank essentially acts as a middleman between the home-buyer and the investment markets. This both mitigates the amount of risk on any specific entity and also allows for riskier behavior as those who seek bigger returns invest in securities with high paying yields, which in turn lend to those with lower credit ratings.

The perversity of the whole thing is that many believe this is bad. Instead of seeing risk as being spread thinner, we tend to think of it as everyone exposing themselves to the same degree of risk. Today's headlines, panic-stricken about subprime mortgage markets, fail to realize how well most of the high yield mortgage risk is shared across giant institutions—how stable the market actually is. Yes, there will be downturns, and yes, people will lose money. But the prospect of economic ruin is minute.

Second, a tremendous new innovation in the insurance markets has sprouted, allowing people to safeguard themselves from identity theft.

What Is Identity Theft Insurance?
By Theresa Agovino, International Business Times

For less than $75 a year you can protect yourself from identity theft up to a hundred thousand bucks! And you can bet as more institutions and individuals participate, rates will go down because more people are helping to shoulder the risk.

What wondrous and wonderful things! A mere two examples depict a world of highly efficient safeguards. These fruits of capitalism are (mostly) bereft of lumbering government red tape and match the needs of the community and the individual nicely. The next time you participate in the global markets, remember, you're not just spreading the risk, you're spreading the love.