I have been reading the Department of the Treasury’s Blueprint for a Modernized Financial Regulatory Structure. Much of it is sensible, and the focus on rationalizing the current hodgepodge of regulation and granting the Fed increased regulatory powers over firms other than commercial banks that create credit.
I want to make a modest proposal that I hope readers who are more economically sophisticated than I am can flesh out or shoot down, as appropriate. The notional value of all of the credit default swaps floating around out there is more than forty trillion (with a “t”) dollars. The basic purpose of a credit default swap is to hedge, or insure, against the risk that some firm will suffer a default or other problem with its credit. So, for example, if I am a bond investor, I might buy a swap from a third party to protect against the risk of nonpayment. The amount I pay is like an insurance premium. But the value of the swaps dwarfs the amount of the risk insured. This is because speculators with no risk to hedge against use swaps to bet on the credit of firms that issue bonds. The huge notional value of the swaps is one of the reasons why the failure of a big player in the derivatives market (so-called “counterparty risk”) would be so disastrous.
So here is my proposal: just as in the insurance market, why not require an “insurable interest” as a prerequisite to buying a credit default swap? To make the idea intuitive, I can buy life insurance on my own life, or my wife’s life, but not on the Queen of England’s life. I can insure my house against fire, but not your house against fire (unless I hold the mortgage on your house or the like). The “insurable interest” rule serves to dampen speculative froth in the insurance market. A similar rule would have the same effect in the derivatives market by confining swaps to their original purpose, namely, hedging against risk.
Thoughts?
TedF
sabutai says
…sounds good to me considering I don’t know what in hell you’re talking about.
<
p>I say this only to make clear that the absence of reaction to your post may not be disagreement, but confusion…
tedf says
If I have the chance, I will try translating this into English. I’m not sure it can easily done, which, incidentally, is part of the problem in the financial markets now–the complexity of what’s going on and what’s being traded is more than even market participants can really understand.
<
p>TedF
sabutai says
I’ve tried reading summaries of the proposals, but it’s not something I understood. I’ll admit though that as soon as the Bush administration wants to change something to do with money, I become veeeerrry suspicious…
charley-on-the-mta says
David E, can you explain any of this?
jimcaralis says
A young healthy credit default swap well insured is, at a year old, a most delicious nourishing and wholesome investment.
jimcaralis says
I agree. This becomes especially perilous when there is some short selling of said company going on as well…
jimcaralis says
The WSJ has an article today on the need for regulation on credit default swaps. Here is an outtake.
<
p>
<
p>An attempt to further explains Credit Default Swaps.
<
p>Say I think Sabutai is a terrible driver so I am going to take out an insurance policy on his car (I don’t need to own his car) Now he totals his car (trying to read BMG on his PDA). I get paid the same amount Sabutai gets paid from his insurance company. Sabutai needs to hand over his car to get his money and I need to hand over the cash equivalent of the value of his totaled car to get my money.
<
p>To make things more interesting and far more complicated, I can legally try to damage is car (or in financial terms short his stock) to increase the chance he may get into an accident. So yes this is an area ripe for regulation.
trickle-up says
Taking a shot at this even though I don’t follow all of it.
<
p>Risk is a difficult concept. The public, and the policy makers who elect them, generally do not value it well–or at all. So the idea of requiring insurance on some financial transactions has merit. The cost of the insurance also shows the cost of the risk.
<
p>In a mature market for such insurance, insurers would charge so that riskier transactions cost more, providing an additional incentive for bankers and hedge-fund managers to be prudent, perhaps even an answer to the moral hazard of being too big to fail.
<
p>But Ted, it seems to me that $40 trillion is not just too big to fail–it’s too big to insure. You can’t insure the entire economy, because if the economy fails, there’s no pot of money big enough to pay off the claims.
<
p>Or is your point something else altogether?
tedf says
Trickle Up, I’m not sure we’re on the same page. See my post below, which I hope makes my point clearer. Basically, I’m saying that people have purchased insurance with a face value of many times the risk that is being insured, so when the credit defaults occur, huge losses also occur in the speculative market for swaps that can cause firms to fail. (Of course, huge paper gains also occur–the folks who purchased credit protection by buying the swaps should make a profit, but they won’t if their counterparties–the insurers–don’t have the money to pay out).
<
p>TedF
tedf says
I told Sabutai I’d try to rephrase my point more clearly. Here goes:
<
p>Imagine that you could buy insurance against the risk that the gold in Fort Knox would be stolen. Now, if the gold were stolen, you wouldn’t suffer any loss, because the gold doesn’t belong to you. But you might buy (or sell) such an insurance policy anyway, in order to speculate on the security at Fort Knox, the value of the gold, etc. And lots of other speculators might join in. So suddenly, there will be a market for theft insurance on the gold at Fort Knox. The government, which actually does own the gold and which would suffer a loss if the gold were stolen, might also buy insurance. But the government, unlike others in the market, would not be speculating. It would be hedging against a real risk of loss.
<
p>According to Wikipedia, there are about 150 million ounces of gold at Fort Knox, worth roughly $150 billion (gold has been close to $1,000 per ounce recently). Now, everyone knows Fort Knox is impregnable, so theft insurance should be pretty cheap. Let’s say you can buy a policy insuring the $150 billion against theft for $1,000. You believe the market has underestimated the risk of theft, so you buy a policy, as do other speculators. People who believe the market has properly priced the risk of theft sell insurance in return for the premium.
<
p>Now suppose there are lots of people with exactly the same thought you had. They all buy $1,000 theft insurance policies. Insurers are on the hook for hundreds of billions of dollars, but no one worries, because the risk of theft is so low.
<
p>Enter Bruce Willis. He tunnels through bedrock. He sneaks up on the crack troops guarding the gold and karate chops them from behind. He loads the gold onto his waiting semi-trailers and makes his getaway. You get the idea.
<
p>Suddenly, the insurers have trillions of dollars in liability that they can’t possibly pay. They underestimated the risk and therefore didn’t set aside enough reserves to cover the loss. They all go bankrupt, and the economy goes down the tubes.
<
p>In real life, this doesn’t happen in the insurance markets, because you and I can’t buy insurance on the gold in Fort Knox. This is because we don’t have an “insurable interest” in it. Basically, you wouldn’t suffer any loss if the gold were stolen, so you can’t by insurance to protect yourself against that risk. The government can insure against the risk of theft because it owns the gold; but the total value of the insurance doesn’t exceed the value of the gold. Also, the government regulates insurers and makes sure, ideally, that they keep enough reserves to pay claims. (This is not to deny the other circumstances in which insurers can underestimate risk and go under, e.g., catastrophic natural disasters).
<
p>A credit default swap is, functionally, pretty much like an insurance policy. The two salient differences are, first, anyone can insure against any risk of default, regardless whether they have a real interest in the bond issuers against whose defaults they are insuring; and second, the government sets no reserve requirements.
<
p>So when, as we’ve seen in the subprime mortgage market, the market turns out to have grossly underestimated the risk of default, issuers of the insurance (i.e., sellers of credit default swaps) face losses that can dwarf the amount of the defaults, and because the government hasn’t set reserve requirements, they don’t have the money to pay.
<
p>Hence the problem, and, I think, a solution.
<
p>TedF