Citi reinvents end-of-the-world insurance

By Felix Salmon
February 8, 2010
Would they?

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In hindsight, one of the silliest and most dangerous excesses of the Great Moderation was the large number of companies — foremost among them AIG, although there were lots of monoline insurers in the same trade — basically selling insurance on the world coming to an end. It’s a great trade: either the world doesn’t come to an end, and you make lots of money, or the world does come to an end, and it doesn’t matter ‘cos you’re bust anyway.

Now, however, after seeing how that trade worked out, we’re wiser, and no large and leveraged financial institution would have the chutzpah to start selling world-coming-to-an-end insurance. Would they?

Credit specialists at Citi are considering launching the first derivatives intended to pay out in the event of a financial crisis…

“The great thing about the index is that it hedges your funding costs while being very simple to trade. I believe it will reduce the systemic risk in the industry, akin to how the advent of swaps means people don’t worry about interest-rate exposures any more – they just pay a fee to hedge it,” [says Citi's Terry Benzschawel].

Like a swap, the contracts envisaged by Citi would be entered into without an up-front premium, with money changing hands according to the index’s movements around a fair strike value.

I’d forgive you if your eyes started rolling after just the first four words: the phrase “credit specialists at Citi” is not exactly the kind of thing which instills enormous confidence in analysts and investors these days. After all, it was credit specialists at Citi who ended up losing the bank billions of dollars on trades which were meant to be too safe to fail. And this trade is in many ways even worse than the one put on by AIG, because Citi doesn’t even get any insurance premiums up front, but still needs to pay out enormously in the event of a crisis.

We learned in the crash of 1987 that when financial markets start selling products which insure a portfolio against catastrophic loss, the very existence of those products can destabilize the market and make it more prone to crashing. And, of course, we learned that such insurance has a tendency not to get paid out on exactly when it’s most needed. But heaven forfend that the market should ever learn from its mistakes.

It’s crucial, in financial markets, that investors walk into risky asset classes with their eyes open, rather than kidding themselves that they can simply hedge those risks away by buying a fancy financial product from Citigroup. But the only people who can stop this from happening are the technocrats at the systemic-risk regulator we desperately need to step in and get sensible about these things. And those people, unfortunately, don’t yet exist.

(HT: Alea)

Update: Citi spokesman Alex Samuelson responds via email:

I just wanted to make clear a few points:

  1. The Liquidity Index (CLX) is a product that we are considering, but have not launched. It is true, however, that we have developed an index to track market liquidity and we have had customer inquiries over the years asking to purchase liquidity protection.
  2. In possibly trading the index, Citi would act as a market maker, not a provider of liquidity. Citi would not take any position. We are only exploring the ability to make a market in liquidity by bringing natural buyers and sellers together. This would not be a prop trading business.
  3. We believe that the CLX could be a financially useful product in that it meets a marketplace need to be able to hedge one’s risk of liquidity drying up by purchasing liquidity from those firms that are natural providers of liquidity (insurance companies, pension funds, individual money market funds).

Thus, if it moves forward, the product could allow firms that depend on financing to exist to protect themselves from spikes in liquidity and provide a mechanism for people with excess liquidity to profit from that in an easy and transparent fashion.

Update 2: David Merkel weighs in.

Liquidity derivatives are not a reasonable product.  You never want to be asking for something when it is in scarce supply, because the odds are it will be very difficult to deliver.


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“….no large and leveraged financial institution would have the chutzpah to start selling world-coming-to-an-end insurance….”

Then what would you call what the Fed is doing?

Posted by maynardGkeynes | Report as abusive

Isn’t this simply a result of the bailout? The government basically told Citi that it makes the cut when it comes to TBTF so products like this are win-win for them. If the world doesn’t come to end, they make money. If the world does come to an end, the government pays the tab and all of its clients know that. This is a win-win for everybody but the taxpayer (as usual).

Posted by spectre855 | Report as abusive

“Citi doesn’t even get any insurance premiums up front, but still needs to pay out enormously in the event of a crisis.”

I think you meant “the taxpayer needs to pay out enormously” etc.

Posted by BarryKelly | Report as abusive

Two points–
1. A risk-less capitalism is not really capitalism at all, is it? Insurance on investments, especially with no up front money in premiums, destroys all risk. Rules of any game are meant to protect the game. If some can buy insurance and others cannot, then the game is not fair and is indeed fixed. And if there is not requirement for reserve capital for insurance companies that insure investments, the whole thing is a sham. That is why every sport has rules.
2. Then the tax payer has to bail out the flowed system or else everyone is punished. It is time for the governments of democratically elected societies to reflect the majority concerns, not the investment class alone.

Posted by rabipete | Report as abusive

“But the only people who can stop this from happening are the technocrats at the systemic-risk regulator we desperately need to step in and get sensible about these things. And those people, unfortunately, don’t yet exist.”

So how about an Emergency Derivatives Tax as it seems most unlikely that any regulations will ever get put in place in time? What %age of their notional value would make buyers think twice about signing on the dotted line?

Posted by polit2k | Report as abusive

I see no real problem, provided Citi is required to set aside a bond in the full amount covered by the insurance. Perhaps they could deposit Treasury bills with the Fed; or, if you lean to a more apocalyptic end-of-the-world scenario, they could use Stephen Colbert’s triptych of gold, sheep, and women.

Absent such a bond, I agree with spectre885 and others above.

Posted by KenInIL | Report as abusive

The email from the Citi spokesman makes this story even more negative for Citi, contrary to its intended effect. I think the last crisis was a pretty good indication that our insurance companies, pension funds, and universities have already sold enough liquidity, and that our banks are completely unable to understand how much liquidity they need. When you have (debatably) America’s #1 university exiting swaps in a panic, issuing debt at the worst possible price, and halting essential and long-planned expansion at great cost to the university and the neighborhood (I’m talking about Harvard here), universities have sold enough liquidity. When you have (debatably) America’s #1 insurance company allowing a tiny unregulated division to write billions of contracts that no one understands which totally misprice credit risk and liquidity, something is awry (I don’t even know whether to characterize pre-crisis AIG as a natural buyer or seller of liquidity given the nature of their operations, marrying a long-funded insurance company with a short-term leveraged trading operation).

Not worrying about interest rate risk any more is also pretty funny. Most of the way we’ve dealt with systematic interest rate risk has been to sell a ton of adjustable-rate debt to people with unstable and inflation-vulnerable cashflows. Fortunately the Fed has been kind enough to keep those interest rates at historic lows for a long time (really we haven’t had high rates since somewhere back in the 90s). I shudder to think what will happen to all the adjustable-rate debt if the Fed ever re-acquires its Volcker-era spine. It used to be that when interest rates rose we blew up all the banks (see early 80s Fannie/Freddie problems and the S&L crisis). Now we’re going to blow up all the marginal corporations and homeowners. Hmm. Doesn’t seem an improvement.

Posted by najdorf | Report as abusive

One more note: if you can use derivatives to create a risk-free return, either that return is equal to Treasuries, you’re dealing with an idiot, or you’re taking a risk you don’t understand (you’re the idiot). Why would your derivatives counterparty be giving you a free spread over Treasuries?

Posted by najdorf | Report as abusive

Well, you know the old saying: If you’re not part of the solution there’s profit to be made prolonging the problem.

Posted by AndrewBW | Report as abusive

From Citi PR-

“In possibly trading the index, Citi would act as a market maker, not a provider of liquidity.”

Isn’t “market maker” synonymous with liquidity provider?

Posted by zerobeta | Report as abusive

True, there does not have to be an upfront premium in the structure (though it would be cleaner that way).

But there will be payments made to Citi at every reset before a liquidity crisis–and the cost likely will be greater over time than just selling the (effectively) floor.

And, of course, the odds of The Big C being able to cover its promise have been fairly stated above and around.

Posted by klhoughton | Report as abusive

I think you were exactly right in pointing out the ludicrousness of going to ‘credit specialists at Citi’ for any kind of investment advice, particularly advice on insuring your investments. However I would think of this as a kind of ‘stupid tax’ on those masochists who like repeatedly walking into walls or running into traffic to pick up spare change on the roadway. Maybe if more of these types of investors existed Citi could focus on fleecing them while giving the rest of us smart investors some half-way decent advice.


Posted by jacktrip | Report as abusive