POWIP Piece of Work In Progress

Betting on failure

There's a good overview of the core issue of credit default swaps in the NYT:

Should people be able to bet on your death? How about your financial failure?
….
None of this argument would be taking place if regulators had done their jobs years ago and classified credit-default swaps as insurance.
As it happened, however, clever people on Wall Street followed the prescription laid down by Humpty Dumpty in Lewis Carroll’s “Through the Looking Glass:”
“When I use a word,” Humpty Dumpty said, in rather a scornful tone, “it means just what I choose it to mean — neither more nor less.”
When Alice protested, Humpty Dumpty replied that the issue was “which is to be master — that’s all.”

More at the link that's well worth reading.

Of course, insurance is highly regulated and requires putting money aside (reserves and capital) to back up the promises being made.

Thing is, CDSs aren't the only type of “insurance” out there – all sorts of options and swaps are essentially promises, but generally no collateral seems to be required to back them. Part of the way options-writers got out of these requirements was showing methods of hedging the options so that the payoffs would be sure to be covered – such as using cash and shorting stocks to cover a put option payoff.

So CDSs would have been a lot more expensive to write if those making the promises had to reserve like other insurance products. And thus not as many would have been written, and not as many investors would have found them attractive.

But the other problem, which is popping up in the Goldman Sachs CDO situation, is asymmetrical information: when one side of the deal has a lot more information on the likelihood of failure, and is underpaying for the “protection”. Those going “naked” on CDOs and CDSs were betting that failure was much more likely than the prices they were paying for their positions would indicate.

The same thing is going on in the life insurance industry, by the way, in the arguments over STOLI. STOLI is where a third party with no insurable interest gets a person to buy a life insurance policy, carefully picked (both the policy and the person) such that the premiums are way out of line with the covered person's actual mortality rates. For STOLI to work well (just like life insurance), a lot of people need to be involved, because sometimes the people will live longer than expected and the investment takes a loss. Just like when one buys an underpriced CDS: sometimes the covered debt instrument will not default.

The issue is, though, that those holding CDSs, naked or not, could be directly involved in whether the covered debt defaults by not cooperating in a bankruptcy deal. To bring this back to STOLI, this is like the investor being the person who gets to decide if the person gets medical care. There's a pretty large conflict of interest there.

Part of the issue is that in the CDS world, all of these conflicts seem to be legal. (STOLI is on hazier ground, due to all the insurance regulation, which is done state-by-state. Many STOLI arrangements have been struck down in various states, so it's a very risky business for an investor to get involved in.)

I don't know if the financial regulation bill that just passed the Senate (and now needs to be reconciled with the House bill) will deal with this situation, but if it does, I wouldn't be surprised if a new, fancy-pants instrument were invented to rout the intended regs.

Because people who are seeking profits tend to be a cleverer bunch than your run-of-the-mill bureaucrat or politician.

So write more rules, but don't think it will prevent the next financial meltdown.

MORE BETTING ON DEATH: STOAs: stranger-originated annuities

Meep

Meep is a member of the Irish Catholic mafia, having a suspiciously high number of green-eyed, red-haired friends. While she doesn’t have red hair herself [except when she goes into the sun (rare for any vampire)], she does have green eyes. She’s a raving Papist and is a life actuary on the side [i.e., she counts dead people]. An amateur pain-in-the-ass [willing to go pro!], she likes covering retirement, mortality, math, and education issues.