Naked Truth on NYT Finance Column

By Chidem Kurdas

Media coverage compounds the confusion about financial problems. Take a recent piece by Floyd Norris, probably the best informed of the New York Times finance columnists. 

“Credit-default swaps are, in reality, insurance,” he writes in “Naked Truth on Default Swaps”.  The seller of a credit default swap pays the buyer of the contract if there is a default on the specified bond. Mr. Norris asks: shouldn’t CDS be subject to the principle that “you cannot buy insurance on my life, or on my house, unless you have an insurable interest”?

That would mean that you should not be able to buy a default swap on a bond unless you own the bond. But this is a false deduction, because in practice even life insurance does not work on the insurable interest principle.

There is a lively secondary market in life policies, where you can sell me the policy on your life. This will happen if you want money now and I’m willing to pay you more than the insurance company would for surrendering the policy. While there is some controversy, research shows that this life settlement market works to policyholders’ advantage, though not insurance companies’.

If default swaps follow the life insurance model, they can be held by anyone willing to pay the price. In fact the financial regulation bill that is about to become law mandates registration, central clearing and – where feasible – exchange-listing of the derivatives. This has the advantage of making their prices public and facilitating trades.

As for “naked” buying of CDS, meaning buying the swaps without owning the bonds, the US Senate voted down a proposed ban. Mr. Norris appears to take issue with this vote but then turns around and writes that he doesn’t know whether an insurable interest should be required for swaps. Given that it is not generally required for life insurance, requiring it for CDS would be extreme. The NYT column, however, shows no awareness of the life settlement market and what that might imply for default swaps.

Focusing on naked buyers obscures the real issue, which is not about the buyers but rather the sellers of swap contracts. As Mr. Norris mentions, AIG is the prime example of the danger of selling CDS without having the capital reserves to make payments in case debtors don’t meet obligations. The question of how much capital CDS sellers should have is separate from the question of who buys the contracts. Regardless of whether the buyers were naked or not, AIG was in trouble once defaults on mortgage-backed notes increased.

So naked buying is not the problem and banning it makes no sense. Why, then, is it the subject of pundit cogitations?

Gary Gensler, chairman of the Commodities Future Trading Commission, is cited by Mr. Norris on insurable interest. The CFTC is trying to protect its turf from encroachment by the Securities and Exchange Commission, now that the financial bill joins the two bureaucracies at the hip as regulators of derivatives. One guess is that the CFTC may see “nakedness” as an area for extending its oversight.

If CDS follows the life settlement pattern, it will work fairly efficiently. Despite news stories expressing distaste at some people buying other people’s life insurance, the buyers do not cause sellers to die prematurely in order to cash in on the policies! The life settlement market is sufficiently well established that the Internal Revenue Service issues rulings to clarify the tax treatment of the transactions.

Mr. Norris suggests Wall Street called the derivatives “swaps” instead of insurance in the spirit of Humpty Dumpty  using a word to mean just what he chooses it to mean. Here’s a quote from another Lewis Carroll creation, the Duchess in Alice in Wonderland:  “Take care of the sense, and the sounds will take care of themselves.”

CDS are instruments, and like any tool they can be misused. The sensible thing is to have clearinghouses for the contracts and make sure the sellers put up reserves. Apart from that, the sounds are just senseless noise.

29 thoughts on “Naked Truth on NYT Finance Column

  1. I didn’t read the Frank Norris piece and am not commenting on it.

    The requirement for an insurable interest derived from experience, particularly in insuring cargos of ships. Strange things happened when competitors were allowed to insure cargo, and insurance companies went out of business until they stopped the practice.

    You can’t insure my house against fire for reasons of moral hazard, and that is not the result of some nefarious government intervention in the property and casualty market.

    It is not at all clear that the innovation in life insurance market is a commercial success. But I consider it a distraction from the issues surrounding CDSs.

    I will harken back to the evolution of portfolio insurance and the failure of LTCM. John Merriwether observed the lesson to be learned from that failure. When someone insures his house against a hurricane, it does not increase the chance of a hurricane. But when someone employs certain financial instruments, like portfolio insurance, it can alter the probability distribution. That is moral hazard.

    CDSs developed (in part) as the financial engineers’ response to the failure of LTCM. They do not seem to have learned any lesson from that failure.

    For unhampered markets, there is a presumption that a product exists to meet a legitimate demand. No such presumption belongs to a system of crony capitalism. Modern financial markets exhibit strong elements of crony capitalism. That is the lesson of the subprime crisis.

  2. Jerry– I don’t deny that there is an issue about CDS. However, the problem is about the sellers, not whether the buyers’ not holding the bonds. AIG was a seller. It had sold immense amounts of default swaps for mortgage-backed securities at the height of the bubble and did not have the reserves to make payments once the market went down.

  3. RE “It is not at all clear that the innovation in life insurance market is a commercial success. But I consider it a distraction from the issues surrounding CDSs.”
    The reason the life settlement market comes up is that people see CDS as similar to insurance and say it should be treated in the same way. In that case, we may as well look at life insurance markets to see how they work.

    The secondary life insurance market has grown in recent years. It is a specialized kind of investment, no doubt, but there are investment firms that for years have been building diversified portfolios of insurance contracts.

  4. By the logic of the article we should ban the purchase of put options as they are a derivative bet on the failure or fall in the price of a stock.

    “One difference is that many people short stocks because they deem them overvalued, not because they think the company will go broke.”

    People often short stocks because they think the company will go broke. Enron, Lehman Brothers were certainly shorted by those who thought they would go broke.

    Nobody ever likes people who bet on businesses going under, but those who do serve an exceptionally useful function.

    The amazing things the government and other morons will come up with to solve the problem they created, an incredibly fragile banking system.

  5. Good point, Pete. It is like saying that you should not be allowed to buy a put option unless you own the stock–thereby having an “interest” in it.

  6. There is a tendency to look at the dark side of default swaps and ignore the accurate signals they provided–for instance, swap prices predicted for several years that GM would go into bankruptcy before it actually did.

  7. An insurable interest is required to write a life insurance policy on someone. That is different from trading a policy in the secondary market. The principle of insurable interest doesn’t apply to swaps, puts (Pete’s example), etc. The firms issuing these instruments have shareholders to answer to.

  8. Bill, yes, what I’m talking about is the secondary market. But what it means is that I can buy insurance on my life & sell it to you–assuming we see eye to eye on the price. So in effect, you don’t need to have an insurable interest to own the contract.

    Pete’s example of a put option is a nifty point. As for having shareholders to answer to, any public company has that. And a private company has its owners. Whether a firm writes swaps, life insurance or options, it has either shareholders or private owners to answer to. We have seen that shareholders don’t always pay a lot attention.

  9. The number one problem with all forms of derivatives is counterparty risk. The immediate effect of a policy of bailing out creditors of large financial institutions is that it reduces the incentives to monitor counterparty risk.

    The bottom line is that we know that there are “too many” derivatives contracts, and too much risk assumed in them. The taxpayer is the ultimate counterparty.

    In such an environment, no efficiency claims can be made about these financial instruments.

  10. Was the problem derivatives Jerry, or poor investment decisions? Plenty of banks with no derivatives (or very limited) exposure went out of business, right?

  11. Jerry, the risk arises from the sellers of default swaps, not the buyers. AIG wrote the contracts–it was a seller. Yes, there was a big growth in the number of contracts, but if the sellers were constrained by having to post margin, that growth would have been muted. After all, there has to be a seller for every buyer.

  12. Pete — As I said, I’m addressing the inherent problem with derivatives. Not the wider crisis on which I’ve written extensively.

    Chidem — Why weren’t the sellers “constrained by having to post margin?” The why is what I addressed in last comment.

  13. Jerry, this is why central clearing houses for swaps are the good idea and are developing–and probably would do so without the requirement in the financial regulation bill. While more complicated than futures exchanges, the basic principle is the same and indeed futures exchange operators have been setting up for the more complex derivatives.

    It may be useful to remember that futures contracts — the original derivatives, if you will — have been traded on exchanges for many decades, indeed centuries in some instances, without major problems.

  14. Pete, a whole array of media and political reactions focus on the symptom and the messenger. Regulators’ ban on short selling financial stocks in the crisis, for instance. Or Sarkozy blaming “speculators” for the euro’s current woes. There were fundamental reasons for stocks and the euro to fall, which short sellers recognized.

  15. Chidem,

    You can’t use history here because the policy of bailing out creditors wasn’t in place historically. If you don’t change that policy, you will import the risk into the clearing houses. The taxpayer will end up bailing out the members of the clearing houses (who are, after all, will be the same bad actors). The likelihood of bailouts is enhanced if they are quasi-monopolies created by legislation.

    UCLA law professor Lynn Stout has written on the history of derivatives. She argues that trading in derivatives was forced into private clearing houses by the unenforceability of many of the contracts at common law. Statutory language overturned that legal principle.

  16. Jerry,
    Yes, absolutely, the new bailing out precedent creates a huge hazard. I understand the fundemantal point you’re making. What I don’t get is why you see putting additional restrictions on market instruments as the solution to lousy policy.

    Consider, Fannie Mae is bailed out — continues to be bailed out. So does that mean that mortgages are bad and need to be banned?!

  17. Chidem,

    I’m perplexed by your question. I didn’t specify what the policy response should be. The closest I came was referencing Lynn Stout.

    I’ll quote Jim Buchanan. “How do markets work? Standing alone, this is an inappropriate and unanswerable question. It should be replaced by the question: How do markets work under this or that set of constitutional and institutional constraints?”

    I don’t know if CDSs in their present form are “market instruments.” Some of these isntruments are pure bets. What if those were governed by state gaming laws rather than federal securities law?

  18. Jerry,
    It’s an interesting question, whether a financial investment is a “pure bet” or not. At one level, any investment is a bet–when you buy a stock, you’re betting that it will go up. We’re all betting on the stock market with our IRAs, 401(k)s & so on, with government encouragement. I have not seen a systematic argument as to why that’s a good thing — and I am not disputing the benefits — but a bet that uses a derivative is bad thing.

    Any bet, of course, can go wrong and result in a loss. In fact a lot of retirement accounts are still in red from 1999, when the Dow was quite a bit higher than it is today. True, derivatives can magnify the loss. But that argument starts a slippery slope– stocks are riskier then bonds, high-yield bonds are riskier than high-grade, high-grade is riskier than sovereigns, but you don’t want Greek sovereigns, so maybe US Treasury notes? But the yield so low and there is the risk of inflation. The reason one takes risk is to get return. Again, that’s no different whether we’re talking CDS or the Dow.

  19. Just to add perspective. Objections to financial instruments have been around for a long time. We forget that until recent decades only a small percentage of the population invested in stocks, which were seen as too risky. And certainly they do have risks.

  20. There was a longstanding legal distinction, spelled out clearly in a US Supreme Court decision, between a derivatives contract in which at least one party held the underlying asset, and those in which neither party held the underlying asset. The former were enforceable, while the latter were not. (The contracts were unenforceable in courts of law, not illegal.)

    The effect of the distinction was to drive contracts into clearing houses in which there was private enforecement of the contract. That is what the financial regulation bill is attempting to accomplish.

    There was also something called “bucket shops” at the turn of the century. (It is ably explained in The Bankers by Martin Mayer.) It was basically a numbers game being run out of shady brokerage shops. They were outlawed under state gambling statutes in most states.

    In a pevious post someone explained the nature of the synthetic CDS sold by Goldman as a vehicle in which two parties can “bet” on an outcome. That is gaming wager, and I see no reason it shouldn’t be treated as such.

  21. By your argument, derivatives contracts should be classified as gambling if no underlying assets are held. Therefore these contracts should be allowed only in Atlantic City, Vegas and Indian reservations?

    I’m not sure what that would achieve. If it were to happen, default swaps and synthetic CDOs would become available much more widely than they have ever been. After all, a large population goes to casinos to gamble!

    Putting the contracts through clearinghouses is useful. Yes, some contracts are not sufficiently standardized for clearinghouses, but this is a ongoing development.

  22. I cannot fathom why arguments from authority like “longstanding legal distinction” have any impact on logical men. Lots of such were overturned later as absolutely absurd.

  23. On a similar note, how can the fact that bucket shops were often run by dishonest men be an argument against bucket shops. It would seem the lesson would be choose your bucket shop wisely. Governments are often run by men no more honest. Jurists, legislators and police have quite often been dishonest and corrupt. Why are they immune from the same critique?

    Ultimately, why should a gaming wager be treated differently than any other contract?

  24. Chidem,

    You answer begs the question. Had a different legal structure been in place, the evolution of financial instruments would likely have been different. And the contracts that existed would have migrated to clearing houses and exchanges.

    Wherever you want to draw the line between gaming and securities activities, none of this belongs in an insured depository institution; or in any firm that is going to be bailed out. Thankfully there is no proclivity to bail out casinos. So by all means, let’s move gambling back into casinos.

    Anyway, I’m done with the issue.

  25. Jerry,
    I appreciate the insights you offer, I really do. And the bailing-out proclivity is a very serious problem, for which so far I have not seen a fully effective solution.

    So, thanks for the discussion.

  26. Pete,
    “Why are they immune from the same critique?”
    Excellent question.

    It’s something James Madison noticed. Federalist Paper no. 37:
    “It is a misfortune, inseparable from human affairs, that public measures are rarely investigated with that spirit of moderation which is essential to a just estimate …”

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