Taming the Beast

Imagine that you have a life insurance policy that you no longer need.  You could let it lapse or cash it in.  You also could choose to sell it, perhaps to me.  I’ll pay you a lump sum for the policy and agree to pay any remaining premiums.  In exchange, I’ll get the payout when you die.   For you, this is a chance to turn an asset into cash.  For me it’s a short sale.  I’m betting that you will die sooner than the insurance company thinks you will.  So what I’m doing is shorting. . .you.   How short?  Try six feet under.

Transactions like this routinely occur in what is known euphemistically as the “Life Settlements” market.  While I’m not aware of an instance in which a disgruntled investor has decided to take matters into his own hands and accelerate his payout, the incentives certainly lean that way.

To keep a lid on this market, the insurance industry requires that when a life insurance policy is created, the buyer or beneficiary must have an “insurable risk,” which is a bona fide interest in the well-being of the insured.  So you can buy a policy on yourself to protect your wife and kids, and you can subsequently sell it to me.  But I can’t order up a policy on you just because I feel like it.  That’s good because allowing people to bet on the demise of anyone they choose would be an unbridled invitation to mayhem.

This is worth thinking about now, because we’re about to watch the G20 attempt to create a new ‘comprehensive regime’ to regulate financial products, companies and markets.  While the goal of healthy, stable financial markets is laudable, the outlook is gloomy.   The forecast calls for reins.  Lots of them.

That’s too bad, because a single rule change in the derivative markets would go a long way toward restoring stability.  Derivatives, which have figured prominently in every major market drop since the mid-1980s, and especially in last year’s meltdown, have nothing comparable to the life insurance industry’s “insurable risk” requirement.  But they should.  When used to hedge real risks, derivatives provide stability.  But when used for pure speculation, they amount to gambling.  Used this way, they inject pure leverage into the markets and greatly increase the very risks they are supposed to mitigate.  They aren’t the firewood, but they certainly are the lighter fluid.

Take the credit default swap, a form of derivative  and the accelerant of last year’s meltdown, as an example.  A credit default swap is an insurance policy on a bond.  Suppose you own a GM bond and you’re worried that GM might default on it.  You can go to an insurer (AIG in the good old days) and they will create a credit default swap for you.  Just like an insurance policy, you will pay a premium.  In exchange, the insurer will agree to pay you the face value of the bond if GM defaults on it.  In this case, you clearly are hedging a real risk – nothing wrong with that.

But what if you don’t own the bond?  What if you just think GM is in bad shape and you’d like to bet against it.  “Bet” is the operative word.  You could buy the same credit default swap, but in this case you are simply gambling.  The companies that issued these swaps turned themselves into casinos.  (Actually, it’s worse than that.  In a casino, every roll of the dice is separate.  In the financial markets, they are interrelated, which magnifies the risk exponentially.)

This was the hay bale that broke the camel’s back last year.  Before the crash, the aggregate amount of obligations owed by issuers of credit default swaps was a dizzying $35-55 trillion.  (The mere fact that this range is so wide demonstrates just how out of control this market was.)  To put that figure in context, the total amount of investment capital in the world is about $70 trillion.  So most credit default swaps clearly were being used to gamble rather than to hedge real risks.

What happened?  A small department in AIG’s London office turned the entire company into a giant casino.  One day, every slot machine in the joint rang up three cherries at the same time and the casino ran out of quarters.

The way to keep this from happening again seems seems pretty clear.  Require anyone purchasing a derivative contract to be able to prove that he or she has a real long or short position in the security that underlies the derivative and that the total amount of derivatives related to that position do not exceed the amount of the original investment.

This one step would shut down a network of uber-casinos that puts to shame anything Vegas has to offer.  It would return derivatives to the insurance role that was intended for them.  And it would be simpler, more transparent, easier to manage, more effective and have fewer unintended consequences than the spaghetti bowl of regulation that is likely to emerge over the next year or so.