Felix’s bicycle…

July 7, 2009

Over the weekend, Felix stole a bit of my thunder, arguing preemptively that insurance commissioners shouldn’t regulate CDS, that CDS aren’t insurance in the first place.  (A similar argument was made on Economics of Contempt.)  Personally, I like the idea of a little internecine warfare here at Reuters.  I think that means Felix and I are doing our jobs.  In fact, he makes some good points in his post, but his chief argument is fatally flawed.  I can’t let him get away with it.  (Oh, and I’ll explain the title of the post in a second)

Here’s Felix’s argument:

First, credit default swaps are not insurance, they’re swaps. A lot of journalists talk about them being “like an insurance contract” when they try to explain what they are, and that’s true, as far as it goes — they do share certain characteristics with insurance. But that doesn’t mean they are insurance. It doesn’t mean that some foolish law should be passed forcing buyers of protection to have an “insurable interest” in some underlying debt instrument, and it certainly doesn’t mean that all CDS should be regulated by some insurance commissioner somewhere.

Let’s be clear, I didn’t say CDS are “like” insurance.  I said they are insurance.  The fact that “insure” is the only verb capable of describing their function settles that argument pretty quickly.  The insurable interest argument, which is the same one made by Economics of Contempt, is totally circular.  Insurable interest isn’t a feature of insurance, it’s a feature of insurance law.  All that needs to happen to make the insurable interest doctrine apply to CDS is for legislators to pass a law requiring it, which is essentially what Assemblyman Morelle would like to do.

The question is whether that makes sense.  I argue it does.  The reason we require buyers of insurance to demonstrate an interest in the insured property is to eliminate incentives to destroy that property.

I could offer to sell a “swap” on Felix’s apartment, for instance.  Anyone who cares to wager on whether it may be destroyed by a fire can use me as their bookie.  None of the folks placing these wagers has an insurable interest in Felix’s apartment, so, I argue, the swap I’m selling is not insurance.  While I’m at it, I’ve decided I’ll be a bookmaker for all sorts of random “bespoke” wagers that speculators would like to make regarding Felix, whether he will live to age 85, for instance, or whether his bicycle will be stolen.

Using Felix’s line of argument, insurance laws don’t apply to me.  So there’s nothing to stop my bookmaking operation?  If placing wagers on Felix gets popular enough, there may be lots of money riding on whether his bicycle will get stolen.  At a certain point, a gambler with enough money on the line will have incentive to rob (or effect the robbery of) Felix’s bicycle.

Sounds absurd?  Consider gambling on professional sports.  Often someone gets paid off to throw a game, or take a fall in third round.  Gambling effects the outcome.  And so we try to keep it in a box (called “Las Vegas”) in order to protect the integrity of our games.

And so it is with CDS markets.  Does anyone seriously doubt that gamblers in CDS aren’t in some cases acting to maximize profits by forcing companies into bankruptcy?  No I can’t prove it, but I know hedgies and leveraged buyout artists.  Many are ruthless in their pursuit of alpha.  Some have no compunction about destroying property in order to maximize profits.  Wall Street is intimately familiar with this, of course.  Last autumn they were on the receiving end as speculators pounded their stocks with naked shorts in order to drive them out of business.  Hedgies smelled blood and went for the kill.  Ironic that Wall Street CEOs suddenly argued naked shorting (hell, shorting of any kind) should be temporarily abolished with respect to their own companies….

But I digress.  The larger point with CDS is systemic risk, which Felix doesn’t even bother to mention. The whole reason we have insurance laws is so that massive casinos don’t spring up that allow speculators to make all sorts of bets that put the economy at risk.  (Remember bucket shop laws Felix?)

And we haven’t even mentioned the other sensible component of insurance law that Felix forgets to mention: capital requirements.  When subprime blew up, none of the bookmakers taking the wrong side of CDS wagers actually had cash to pay out.  No, the cash was provided by the taxpayer when the primary bookmaker (AIG) blew up.

Arguing that such a system should continue to operate without sensible controls that will actually SOLVE the problem of systemic risk, it seems to me, is the very definition of insanity.

It’s true that there are other versions of financial speculation that look like insurance, but these are more tightly controlled and don’t present systemic risks.  Like puts.  These are effectively an insurance policy that can be traded by those with or without a material interest in the underlying.  But the contracts are all standardized and traded on exchanges that require substantial margin and quick cash settlement.  So systemic risk isn’t an issue.  If CDS were to be moved to regulated exchanges, insurance laws wouldn’t be needed.

That would be my preferred solution, actually.  The problem is that non-standardized contracts couldn’t be created.  I don’t think this is a problem.  I think it is the height of folly that some believe any an all risks should be “hedgeable.”  But I’ll allow that legitimate hedging (by those with a material interest in the underlying) may have some benefits.  But in that case, insurance laws regarding material interest and indemnity should apply in order to eliminate the kind of gaming that leads to systemic risk.

Felix alludes to the problem of insurable interest limiting some legitimate hedging options.  A Ford dealer who doesn’t own Ford & Co. bonds certainly has a material interest in the continuing creditworthiness of the corporation.  And so the model legislation proposed by state insurance legislators accounts for this, establishing a standard of “material interest” that would allow legitimate hedging even if the buyer doesn’t own the underlying.

Felix makes one great point: do we trust insurance regulators to handle the problem appropriately?  Yeah, they haven’t done such a great job overseeing life insurers, with that I would agree.  At the same time, we aren’t reading stories about AIG’s regular insurance units going bust.  It was the non-regulated business that blew up.  The other businesses are in far better shape.  And whether regulators are good at doing their job doesn’t mean it isn’t their job in the first place.

To Felix’s point about whether the NY dept of insurance should have jurisdiction.  Well, for one, if Wall Street wants to continue operating in NYC, they’ll obey NY laws.  But yeah, it would be better to have a strong federal insurance regime.  But while we’re waiting for that, I totally support state attempts to actually do something to get this market under control.  Morelle appears to be a rare commodity: a politician who sees a problem and is moving to fix it.  Obama-style triangulation won’t solve anything.  In the meantime, Morelle and like-minded state insurance legislators—who remain the folks who set insurance laws—are totally justified taking action.

Do I think this is a panacea?  That expanding state insurance laws to apply to CDS will solve the problem of systemic risk?  No I don’t.  Already Wall Street is marketing new “insurance” products to dodge capital requirements.  But expanding insurance laws is a good start.

For me, the chief lesson of the financial crisis is that without MUCH stronger capital adequacy requirements for ALL financial institutions, we won’t actually rebuild a proper foundation for the economy.

In conclusion I would ask Felix, and any one else who argues that state insurance regulators should leave CDS alone, what do you propose to eliminate the systemic risk that these markets create?  It’s not enough to say that we should just let companies like AIG fail.  I would love to see that, believe me.  But it isn’t possible without bringing down the world financial system.  In future, it seems to me we would like to avoid having to make that choice between bailouts and systemic collapse.  Companies and markets should never be so big they can’t be allowed to fail.

Failure is the best regulator of all.  It should always be a viable option.


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In the comments section of Felix’s post, Chris Whalen of IRA tries to school Felix


CDS are not swaps. There is no exchange of value between the parties. CSD are what are known as “barrier options” in the insurance world.


Chris Whalen

Posted by Mark G. | Report as abusive


I have to agree with you, that whatever it is called “insurance” or not, the risk underlying the instrument and the collective use of the instruments (systemic application) presents a risk profile that has high convexity, which means a huge assymetry in realization of risk event relative to the time of cash paid. The risk profile as such requires a regulatory or at a bear minimum some form of transparency.

The only way I would agree to non-regulated CDS, is if the CDS entities were fully stand alone and thus the counterparty would have to assess the risks of the offering party. The risk of an “embedded” CDS operation inside a major institution, means goosed earnings and a hidden time bomb (a la) AIG. The CDS entity inside AIG points at the AAA AIG rating and AIG gets valued higher as a function of the extra cashflows from the CDS rev stream. In the end the the structure obfuscates the risks and values of the main entity and the CDS sub entity. So CDS yes, but stand alone (not SPV) like is the way I would vote.

Posted by nick gogerty | Report as abusive

Good point Nick! Take a look at the model legislation, you’ll see that the state legislators have your concerns in mind. Credit default insurers would have to be monolines, or a totally segregated balance sheet, in order to provide more of the transparency that is so clearly needed.

Posted by Rolfe Winkler | Report as abusive

You are correct. CDS’s are insurance. The ability to buy insurance without an insurable interest is what Felix and the banks want to protect. To be able to gamble on an occurrence rather than protect against loss resulting from the occurrence is to be tempted to cause the occurrence (moral hazard). There is evidence that Goldman and others had vested interests in “certain” corporate defaults — using CDS’s — and may have contributed to those occurrences. Willem Buiter discusses the same thing:
http://blogs.ft.com/maverecon/2009/06/th e-magical-world-of-credit-default-swaps- once-again/

Posted by JD Swampfox | Report as abusive

As far as the hedge funds go, they wouldn’t hesitate two seconds to force someone into bankruptcy for a big payout. Think of Orson Welles’ character in The Third Man, when he asks Joseph Cotton while they’re on the Ferris Wheel–“If I offered you 20,000 pounds for each dot down there, would you really tell me to keep my money?” As for naked shorting, if the broker/dealers and exchanges would enforce their own rules it wouldn’t be a problem–just greed there as well.

Insurable interest is a vital part of an effective and sustainable insurance framework. The greed involved in trading CDS’s has kept them from being treated this way. It has to stop–end of story.

Posted by But What do I Know? | Report as abusive

Purchasing a CDS without holding an insurable interest in the underlying risk is no different than placing a bet on a horse race. It is outright gambling.

In states where gaming/gambling is allowed, it is highly regulated. Insurance is a form of gambling and it is tightly regulated.

As I recall, an exemption from NY’s “bucket shop” (gambling)law was obtained in order to facilitate the sale of CDS. If CDS did not fall under a category of gambling, why would an exemption be required?

Posted by Steve in Ks | Report as abusive

[…] No loans are happening in the jumbo market.Felix’s bicycle… – Rolfe Winkler […]

Posted by Links: 2009-07-08 – Credit Writedowns | Report as abusive

Again, I’m sympathetic to the need to insure debt, but you are missing the point of the centrality of insurable interest as to whether or not something is insurance. It is not simply that the law defines insurable interest to be a part of insurance as you suggest, but rather that it is essential that it do so. Perhaps a simple example would serve to better bring this into focus.

Let’s say you go out and buy some life insurance on yourself. Your motivation is clear: Provide financial relief to loved ones in the event of your passing. Let’s say I charge you $100 a month for it.

Somewhere far away another person you don’t even know wants to buy the same amount of life insurance, but not on himself, on you! Is this the same transaction? In other words, can I charge the same $100 a month? Of course not. But why?

Well obviously, in your case, you want insurance, but you DON’T want to die. In the second case however, the far away person wants the same insurance, but quite clearly, he DOES want you to die. In your case, you’re quite likely to work WITH me in the contract. In the second case, the far person will quite likely work AGAINST me in the contract, and so I have to charge him (a lot!) more. The exact same event triggers payment, but the two motivations for entering the contract are as far apart as they can be. The two contracts then are not the same product, and “insurable interest” makes all the difference.

But, you might suggest, couldn’t I just set a price somewhere in the middle? Absolutely not. You see, if I did, you could just keep buying insurance from me and selling it at a profit to the far away person. How about if I instead just charge the higher “far away” price to the both of you? Again, no. Why on earth would YOU pay it? You simply aren’t that much of a risk, AND YOU KNOW IT. You are not going to buy the insurance from me because in your case, it is way too expensive. (As it would be when a CDS purchaser holds the underlying security.)

Now, in insurance jargon, we say these two contracts are in different risk pools (because of motivation). If I don’t charge based on that difference in risk, either I can’t sell my product, or I will eventually almost certainly get CRUSHED by adverse selection. (AIG anyone?) And yet, with a CDS, the “insurable interest” is separable, and I the insurer have no say in its separation. The benefit of portability in a CDS allows it to move between the two risk pools, but I the insurer cannot change the premium I charge as it does. (I might not even know it has.)

And that’s why “insurable interest” is not merely a legal definition of insurance. That’s why it is central to it: Because I can’t price my product properly unless insurable interest is fixed in the contract. It is either a part of it, or it isn’t, and I have to be able to control for that.

To follow this through to it’s logical conclusion (which apparently no one yet has done, not even in Congress!), the reason there is even a discussion of this is that everyone keeps trying to force two completely different products into one box, SIMPLY BECAUSE THEY HAVE THE SAME TRIGGERING EVENT. They are not the same product, and if they are forced to be one, neither product will perform as they actually should and need to. And we will have another CDS disaster waiting down the road for us.

Posted by Benedict@Large | Report as abusive