insurance

Insurable Interests

When you purchase fire insurance on your own home, you are said to have an insurable interest. That is, you have an interest in something and you’d like to insure it against a certain risk. In the case of fire insurance, the insurable interest is your house and the risk is fire burning your house down. Through an insurance policy, and in exchange for a fee, you can effectively transfer, to some 3rd party, financial exposure to the risk that your insurable interest (house) will burn down.

When you purchase protection on a bond through a credit default swap, you may or may not own the underlying bond. As such, you may or may not have something analogous to an insurable interest. David Merkel over at The Aleph Blog brought this issue to my attention in a comment on one of my many rants about credit default swaps. Although you should read his article in its entirety, his argument goes like this: just like you wouldn’t want someone you don’t know taking out a life insurance policy on you (because that would give them an incentive to contribute to your death), corporation ABC doesn’t want swap dealers selling protection on their bonds to those who don’t own them (since these buyers would profit from ABC’s failure). Technically, ABC wouldn’t want protection being sold to those that have a negative economic interest in ABC’s debt.

Courting Disaster

We might find it objectionable that one person takes out an insurance policy on the life of another. This is understandable. After all, we don’t want to incentivize murder. But we already incentivize creating illness. Doctors, hospitals, and pharmaceutical companies all have incentives to create illnesses that only they can cure, thus diverting money from other economic endeavors their way. More importantly, even if you don’t accept the “it’s no big deal” argument, insurance contracts have a feature that prevents the creation of incentives to destroy life and property: they are voluntary, just like derivatives.

In order for you to purchase a policy on my life, someone has to sell it to you. And like most businesses, insurance businesses are not engaged in an altruistic endeavour. So, when you come knocking on their door asking them to issue a $100 million policy on my life, they will be suspicious, and rightfully so. They will probably realize that given the fact that you are not me, $100 million is probably enough money to provide you with an incentive to have me end up under a bus. And of course, they will not issue the policy. But not because they care whether or not I end up under a bus. Rather, they will not issue the policy because it’s a terrible business decision. They know that it doesn’t cost much to kill someone, and therefore, as a general idea, issuing life insurance policies to those who have no interest in the preservation of the insured life is a bad business decision. The same applies to policies on cars, houses, etc that the policy holder doesn’t own. As is evident, the concept of an insurable interest is simply a reflection of common sense business decisions.

You Sunk My Battleship

So why do swap dealers sell protection on ABC’s bonds to people that don’t own them? Isn’t that the same as selling a policy on my life to you? Aren’t they worried that the protection buyer will go out and destroy ABC? Clearly, they are not. If you read this blog often, you know that swap dealers net their exposure. So, is that why they’re not worried? No, it is not. Even though the swap dealer’s exposure is neutral, if the dealer sold protection to one party, the dealer bought protection from another. While the network of transactions can go on for a while, it must be the case that if one party is a net buyer of protection, another is a net seller. So, somewhere along the network, someone is exposed as a net buyer and another is exposed as a net seller.

So aren’t the net sellers worried that the net buyers will go out and destroy ABC? Clearly, they are not. The only practical way to gain the ability to run a company into the ground is to gain control of it. And the only practical way to gain control of it is to purchase a large stake in it. This is an enormous barrier. A would be financial assassin would have to purchase a large enough stake to gain control and at the same time purchase more than that amount in protection through credit default swaps, and do so without raising any eyebrows. If this sounds ridiculous it’s because it is. But even if you think it’s a viable strategy, ABC should be well aware that there are those in the world who would benefit from the destruction of their company. This is not unique to protection buyers, but applies also to competitors who would love to take ABC over and liquidate their assets and take over their distribution network; or plain vanilla short sellers; or environmentalist billionaires who despise ABC’s tire burning business. In short, ABC should realize that there are those who are out to get them, whatever their motive or method, and plan accordingly.

Hands Off My Ether

The fact that others are willing to sell protection on ABC to those who don’t own ABC bonds suggests that any insurable interest that ABC has is economically meaningless. For if it weren’t the case, as in the life policy examples, no one would sell protection. But they do. So, it follows that protection sellers don’t buy the arguments about the opportunities for murderous arbitrage. So what is ABC left with? An ethereal and economically meaningless right to stop other people from referencing them in private contracts. This is akin to saying “you can’t talk about me.” That is, they are left with the right to stop others from trespassing on their credit event. And that’s just strange.

Systemic Speculation

Pundits from all corners have been chiming in on the debate over derivatives. And much like the discourse that has dominated the rest of human history, reason, temperance, and facts play no role in the debate. Rather, the spectacular, outrage, and irrational blame have been the big winners lately. As a consequence, credit default swaps have been singled out as particularly dangerous to the financial system. Why credit default swaps have been targeted as opposed to other derivatives is not entirely clear to me, although I do have some theories. In this article I debunk many of the common myths about credit default swaps that are circulating in the popular press. For an explanation of how credit default swaps work, see this article.

The CDS Market Is Not The Largest Thing Known To Humanity

The media likes to focus on the size of the market, reporting shocking figures like $45 trillion and $62 trillion. These figures refer to the notional amount of the contracts, and because of netting, these figures do not provide a meaningful picture of the amount of money that will actually change hands. That is, without knowing the structure of the credit default swap market, we cannot determine the economic significance of these figures. As such, these figures should not be compared to real economic indicators such as GDP.

But even if you’re too lazy to think about how netting actually operates, why would you focus on credit default swaps? Even assuming that the media’s shocking double digit trillion dollar amounts have real economic significance, the credit default swap market is not even close in scale to the interest rate swap market, which is an even more shocking $393 trillion market. But alas, we are in the midst of a “credit crisis” and not an “interest rate crisis.” As such, headlines containing the terms “interest rate swap” will not fare as well as those containing “credit default swap” in search engines or newsstands. Perhaps one day interest rate swaps will have their moment in the sun, but for now they are an even larger and equally unregulated market that’s just as boring and uneventful as the credit default swap market.

Credit Default Swaps Do Not Facilitate “Gambling”

One of the most widely stated criticisms of credit default swaps is that they are a form of gambling. Of course, this allegation is made without any attempt to define the term “gambling.” So let’s begin by defining the term “gambling.” In my mind, the purest form of gambling involves the wager of money on the outcome of events that cannot be controlled or predicted by the person making the wager. For example, I could go to a casino and place a $50 bet that if a casino employee spins a roulette wheel and spins a ball onto the wheel, the ball will stop on the number 3. In doing so, I have posted collateral that will be lost if an event (the ball stopping on the number 3) fails to occur, but will receive a multiple of my collateral if that event does indeed occur. I have no ability to affect the outcome of the event and more importantly for our purposes, I have absolutely no way of predicting what the outcome will be. In short, my “investment” is a blind guess as to the outcome of a random event.

Now let’s compare that with someone (B) buying protection on ABC’s bonds through a credit default swap. Assume that B is as villainous as he could be: that is, assume that he doesn’t own the underlying bond. This evildoer is in effect betting upon the failure of ABC. What a nasty thing to do. And why would he do such a thing? Well, B might reasonably believe that ABC is going to fail in the near future based on market conditions and information disclosed by ABC. But why should someone profit from ABC’s failure? Because if B’s belief in ABC’s impending failure is shared by others, their collective selfish desire to profit will push the price of protection on ABC’s bonds up, which will signal to the market-at-large that the CDS market believes that there will be an event of default on ABC issued debt. That is, a market full of people who specialize in recognizing financial disasters will inadvertently share their expertise with the world.

So, in the case of the roulette wheel, we have money committed to the occurrence of an event that cannot be controlled or predicted by the person making the commitment. Moreover, this “investment” is made for no bona fide economic purpose with an expected negative return on investment. In the case of B buying protection through a CDS on a bond he did not own, we have money committed to the occurrence of an event that cannot be controlled by B but can be reasonably predicted by B, and through collective action we have the serendipitous effect of sharing information. To call the latter gambling is to call all of investing gambling. For there is no difference between the latter and buying stock, buying bonds, investing in the college education of your children, etc.

The Credit Default Swap Market Is Not An Insurance Market

Credit default swaps operate like insurance at a bilateral level. That is, if you only focus on the two parties to a credit default swap, the agreement operates like insurance for both parties. But to do so is to fail to appreciate that a credit default swap is exactly that: a swap, and not insurance. Swap dealers are large players in the swap markets that buy from one party and sell to another, and pocket the difference between the prices at which they buy and sell. In the case of a CDS dealer, dealer (D) sells protection to A and then buys protection from B, and pockets the difference in the spreads between the two transactions. If either A or B has dodgy credit, D will require collateral. Thus, D’s net exposure to the bond is neutral. While this is a simplified explanation, and in reality D’s neutrality will probably be accomplished through a much more complicated set of trades, the end goal of any swap dealer is to get close to neutral and pocket the spread.

cds-swap-dealer

That said, insurance companies such as MBIA and AIG did participate in the CDS market, but they did not follow the business model of a swap dealer. Instead, they applied the traditional insurance business model to the credit default swap market, with notoriously less than stellar results. The traditional insurance business model goes like this: issue policies, estimate liabilities on those policies using historical data, pool enough capital to cover those estimated liabilities, and hopefully profit from the returns on the capital pool and the fees charged under the policies. Thus, a traditional insurer is long on the assets it insures while a swap dealer is risk-neutral to the assets on which it is selling protection, so long as its counterparties pay. So, a swap dealer is more concerned about counterparty risk: the risk that one of its counterparties will fail to payout. As mentioned above, if either counterparty appears as if it is unable to pay, it will be required to post collateral. Additionally, as the quality of the assets on which protection is written deteriorates, more collateral will be required. Thus, even in the case of counterparty failure, collateral will mitigate losses.

This collateral feature is missing on both ends of the traditional insurance model. Better put, there is no “other end” for a traditional insurer. That is, the insurance business model does not hedge risk, it absorbs it. So if a traditional insurer sold protection on bonds that had risks it didn’t understand, e.g., mortgage backed securities, and it consequently underestimated the amount of capital it needed to store to meet liabilities, it would be in some serious trouble. A swap dealer in the same situation, even if its counterparties failed to appreciate these same risks, would be compensated gradually over the life of the agreement through collateral.

Information Overload

You’re Trespassing On My Credit Event