Unlicensed insurance: Credit Default Swaps (CDS’s): Part 1, the ‘neverpay’ policy

December 8, 2008 | Capital markets, Finance, Innovations, Subprime, US News

“I bet I’ll die soon.”

“We bet you’ll live a long time.”

– The essential bargain in life insurance



“I’ll take that bet.”


When you buy life insurance, you’re selling a risk (that you’ll die) and the insurer is buying that risk.  You’re paying the insurer to buy it. 


I who control my lifespan bet I will die, and you who have no say in it bet I won’t.  Talk about agency risk!


Because of its perverse incentives, I’ve always found the profession on insurance among the most curious financial products humanity’s ever invented.  The insurance-craving-murderous-spouse has been a staple of noir fiction ever since Fred MacMurray in 1944’s Double Indemnity (even the title screams insurance!) and smooth Ray Milland in 1954’s Dial M for Murder.



Dial M for money?


Yet, so accustomed are we to this curiously reversed transaction that we think it the quintessence of excruciating boredom – yet the dynamics of life insurance are exactly the same as those in credit default swaps (CDSs), now being demonized as the indecipherable TLAs of high finance.



I was a credit default swap once


Leave it to The Economist to defend the heretofore journalistically indefensible:

Some of the criticism heaped on credit-default swaps is misguided

The market needs sorting out nonetheless

THEY are, says a former securities regulator, a “Ponzi scheme” that no self-respecting firm should touch.  Eric Dinallo, the insurance superintendent of New York state, calls them a “catastrophic enabler” of the dark forces that have swept through financial markets.



Dinallo doesn’t like catastrophic enablers …



… although his former boss was an expert in being enabled


Alan Greenspan, who used to be a cheerleader, has disowned them in “shocked disbelief”.


That being the best kind of disbelief to have, I suppose.



This is as shocked as I get


Until last year credit-default swaps (CDSs) were hailed as a wonder of modern finance. These derivatives allow sellers to take on new credit exposure and buyers to insure against companies or governments failing to honour their debts.


Wikipedia has an extensive and really quite good explanation, from which the following is extracted:



What is a credit default swap?  From nowandfutures.com.


Credit default swap


A contract between Buyer and Seller regarding a Debt in which:


·         As long as there is no default on the Debt, the Buyer pays the Seller periodic amounts (premiums).

·         If the Debt defaults, the Seller pays the Buyer a lump sum, and the CDS ends.


Importantly, Buyer and Seller can write a CDS even if neither owns the Debt.


Thus, if Phyllis Dietrichson thinks her husband Dietrichson might die, she can buy a CDS from Walter Neff, and if Dietrichson dies, she wins big.



“See, if I kick the bucket, see, she gets double the money, see?”


In the CDS world, Phyllis doesn’t even have to be married to the man, or even very friendly with him; she’s just buying upside if something untoward happens to him.



Are any of these poisonous?


Because a CDS is a side bet between two parties on the health of a third, any two sufficiently nefarious parties can create a CDS – indeed, they can print up as many of these side bets as anybody wants to accept.


The notional value of outstanding CDSs exploded from almost nil a decade ago to $62 trillion at the end of 2007—though it slipped to $55 trillion in the first half of this year and has since continued to fall.


To place those scarcely believable numbers in some kind of context, the notion al CDS exposure adds up to something like ten times the size of Fannie Mae’s loan portfolio.



I’m much bigger than you are


Traded privately, or “over the counter”, by banks, they seemed to prove that large, newfangled markets could function perfectly well with minimal regulation.


While floating crap games are a lot of fun, you shouldn’t play if you can’t afford to lose everything you stake. 


That view now looks quaint. Since September a wave of large defaults and near-misses, involving tottering banks, brokers, insurers and America’s giant mortgage agencies, Fannie Mae and Freddie Mac, has sent the CDS market reeling. Concern that CDSs are partly to blame for wild swings in financial shares has frayed nerves further.


The failure in mid-September of Lehman Brothers showed that the main systemic risk posed by CDSs came not from widespread losses on underlying debts but from the demise of a big dealer.


What’s the gamblers’ biggest risk?  That the bookie goes bust.  The bookie holds everybody’s stake.



Everybody’s mad because we couldn’t cover all the bets we wrote


The aftershock spread well beyond derivatives. Almost as traumatic was the rescue of American International Group (AIG), a huge insurer that had sold credit protection on some $440 billion of elaborate structures packed with mortgages and corporate debt, known as collateralised-debt obligations (CDOs). Had AIG been allowed to go bust, the swaps market might well have unravelled. Similar fears had led to the forced sale of Bear Stearns in March.


Foul-ups with derivatives are hardly uncommon, but CDSs have been causing particular consternation.


CDSs were and are powerful tools, and it’s clear they were used with abandon.  That’s not the tools’ fault. 


By themselves, tools just create leverage and choice.  In doing that – in giving us the power to do effortlessly what before was difficult or impossible – they invite us to over-reach. 


Last month JPMorgan’s Blythe Masters, one of the market’s founders, urged regulators to distinguish between tools and their users: “Tools that transfer risk can also increase systemic risk if major counterparties fail to manage their exposures properly.”



Masters of JP Morgan: Blithely mastering a new universe?


Tools invented man, Arthur C. Clarke once wrote, meaning that they stimulated human cognition because with tools we could think of things we never imagined before.  Financial tools do the same thing, and human curiosity mingled with human ego means that the first experimenters



I’ll try it myself!


To begin with, CDSs allowed companies to make insanely huge bets.



Big bets, baby!  I make big bets!


[1] One reason is the broad threat of “counterparty risk”—the possibility that a seller or buyer cannot meet its obligations.


A bust bookie busts all the punters.


If counterparties pay up, CDSs are a zero-sum game: what the seller loses, the buyer gains.



How do you make a profit out of that?


In general, government should have no business interfering in zero-sum fair games played by independent parties dealing at arm’s length, both fully informed and neither under an undue compulsion to act.  I can rattle off that phrasing because it’s the definition of fair market value.


Counterparty risk upsets the symmetry. It is tempting to write lots of swaps in good times, when pay-outs seem improbable, without putting aside enough cash to cover the potential losses.


As Monty Python put it:


Vicar: It’s about this letter you sent me regarding my insurance claim.  It says something about filling my mouth in with cement.

Devious: Oh well, that’s just insurance jargon, you know.



That’s just insurance jargon, you know


Vicar: But my car was hit by a lorry while standing in the garage and you refuse to pay my claim.

Devious: (rising and crossing to a filing cabinet) Oh well, reverend Morrison … in your policy … it states quite clearly that no claim you make will be paid.

Vicar: Oh dear.

Devious: You see, you unfortunately plumped for our ‘Neverpay’ policy, which, you know, if you never claim is very worthwhile … but you had to claim, and, well, there it is.

Vicar: Oh dear, oh dear.


If that weren’t enough to worry you, consider this:


[Continued tomorrow in Part 2.]