Wall Street's 'normal accident'

Here's one more thing to worry about: The precarious state of a group of companies called monoline insurers, which basically guarantee that if a bond defaults they will cover interest and principal. You might have run into them when buying muni bonds, where they got their start. MBIA and Ambac are among the biggest – and they’re both in financial trouble. The New Yorker's James Surowiecki picks up the story from there:

Unfortunately, a sleepy, straightforward business wasn’t good enough for the insurers. Like everyone else in recent years, they wanted to cash in on the housing and lending boom. In order to expand, they started insuring the complex securities that Wall Street created by packaging mortgages, including subprime ones, for investors. This was a lucrative business—M.B.I.A.’s revenues rose nearly a hundred and forty per cent between 2001 and 2006—but it rested on a false assumption: that the insurers knew how risky these securities really were. They didn’t. Instead, they gravely underestimated how likely the loans were to go bad, which meant that they didn’t charge enough for the insurance they were offering, and didn’t put away enough to cover the claims.

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The potential collapse of monoline insurers looks like a classic example of what the sociologist Charles Perrow called a “normal accident.” In examining disasters like the Challenger explosion and the near-meltdown at Three Mile Island, Perrow argued that while the events were unforeseeable they were also, in some sense, inevitable, because of the complexity and the interconnectedness of the systems involved. When you have systems with lots of moving parts, he said, some of them are bound to fail. And if they are tightly linked to one another—as in our current financial system—then the failure of just a few parts cascades through the system. In essence, the more complicated and intertwined the system is, the smaller the margin of safety.