Credit Derivatives for Dummies: "Insurable Interests"

Heard a discussion of credit derivatives on PBS last night by their business "expert," Paul Solman, and was disappointed that he totally ignored what I consider to be the WORST thing about derivatives.

As Solman explained, credit derivatives are like insurance. If you hold debt of a company, e.g., the company issued bonds or other securities that you bought, and you're nervous about the company's ability to make the agreed payments, you can buy a credit derivative to insure that if the company does go bankrupt, you'll still collect the amount they owe you.

But back up for a moment.  With respect to other, regular kinds of insurance, you can buy insurance for your own house or other property to cover your losses in case of fire, flood, etc. But you canNOT buy insurance on a house in which you have no ownership interest, because you're deemed not to have a sufficient interest in its NOT burning down. In fact, your owning insurance on a house in which you have no ownership interest gives you a positive incentive to commit arson. That's a big conflict of interests.

Owning the house, or whatever you're buying insurance for, is called "having an insurable interest." You actually have a vested interest in the property, or the life, or whatever it is that's insured -- you have a vested interest in its NOT being destroyed, so you're unlikely to abuse the insurance system to, say, merely gamble speculatively on its destruction, let alone actually commit arson or whatever.

Now, because credit derivatives are unregulated, not only do we have no clear idea of what's out there (although the commonly agreed estimate as of this writing is $62 TRILLION, which is several times the US's gross national product). But the worst part, which I've yet to hear anyone on the traditional media outlets including PBS or NPR explain, is that we have no idea whether most of the parties who bought and are still buying credit derivatives are doing so in order to protect the value of assets they actually own, or if they're just making speculative bets.

In other words, while some credit derivatives may have been bought by owners of bonds, mortgage-backed securities, or other securities to hedge the risks of actually owning those assets, large amounts of derivatives may well have been bought by people who were NOT purchasing insurance to protect any insurable interest, but who merely felt like betting that certain securities would crater – people who suspected that a few small bets might pay off big.

In fact, they could have been purchased by people who not only felt like betting that certain securities would fail, but who had enough inside info, if not power, to know that such failure was likely to happen, or even to help cause it to happen.

SO. The BIGGEST outrage about the bailout is that the gigantic wads of taxpayer money given to Wall St. may well be being used to pay off bets made by speculators with no insurable interest -- i.e., no real need for the money -- and who may even have helped bring about the failure of the companies they bet against.

(By comparison, the losses on the underlying "insured" assets – the home mortgages, etc. – are small potatoes; and even the bonuses bankers have been allowed to pay themselves, are trivial.)

Before we give any money to derivatives issuers like AIG, we should find out what their obligations are, including which of them are to counterparties with "insurable interests" and which are to mere speculators. Then we'd be in a position to make informed choices about how best to allocate taxpayer money.

And there's no good reason we can't find that out. We don't even need AIG's cooperation. All the government has to do is announce to the world, if you bought a derivative from AIG and you think AIG owes or could in the future owe you money on it, tell us who you are, the amount of the payment to be made, and some other info like what if any "insurable interest" it's intended to cover. And if you don't file your claim, your claim will be wiped out.

This is what happens if you or I become insolvent. It's called bankruptcy. Another thing about regular bankruptcy is, if the total of all the claims filed against you are bigger than all you've got to pay them with, then generally, the court just divides whatever you've got left among your creditors, and the remainder of your obligations is wiped out. The creditors take cents on the dollar, and eat the remainder as a loss. And they don't get reimbursed by taxpayers. This is fair because your creditors and investors had the opportunity to investigate what kind of credit risk you were before deciding to extend any credit to you; the taxpayers didn't.

Because the banks and AIG are so big, we're told, we can't afford to make their counterparty/creditors/investors eat the loss. That may be true in some cases. In others, not so much.

Yes, regulating this activity would be complicated; so is your phone, but we don't throw up our hands and say it's too hard.

You and me are sacrificing our retirements, kids' educations, etc., to make good on bets we never agreed to, placed by parties who not only stood to lose little if the catastrophes they bought insurance against weren't covered, but who in some cases actually had the power to CAUSE the catastrophes they were buying insurance against.

Nouriel Roubini, the NYU professor who predicted the current crisis, mentioned in a recent talk that throughout recorded history, there's been a more or less regular cycle of economic bubble-and-bust every ten years, with only one exception during which we managed to prevent such crises from arising for a solid fifty years: the fifty years while Glass-Steagall and other post-depression securities regulation remained in effect. Then we allowed Republicans and "New" Dems, financed by Free Marketeers, to dismantle it; and now we've got the biggest economic meltdown in history.

We need effective government to regulate markets and protect those of us who don't have the time or expertise to figure it all out. We've had effective regulation in the past, and we can have it again. It's not, really, a matter of brain-power; it's a matter of balls.

UPDATE: If you found this post worthwhile, you may want to check out my next post on this subject, More "Derivatives for Dummies": Proportionality.

FURTHER UPDATE: Vanity Fair has a great excerpt from The Big Short by Michael Lewis, on the guy who was probably the first to figure out how to make a fortune betting against bad mortgage loans, Michael Burry.

FURTHER FURTHER UPDATE: Another helpful, more recent article at Peak Watch, noting, among other things, "So far the auto industry – GM and Chrysler – have received $17.4 billion in U.S. funds after much gnashing of Congressional teeth. Meanwhile, [AIG] snapped its fingers and over the weekend Treasury officials gave it another $30 billion – bringing its total to $180 billion." The funds to AIG amount to a "nontransparent, opaque and shady bailout of [its] counter-parties: Goldman Sachs, Merrill Lynch and other domestic and foreign financial institutions." (quoting other sources).