January 1, 2009

Credit Default Swaps and Moral Hazard

In the insurance business, "moral hazard" is famously a problem. Evelyn Waugh describes in Scoop how in his fictionalized version of 1930s Addis Ababa, a taxi ride revealed "numerous gutted sites, relics of an epidemic of arson some years ago back when an Insurance Company had imprudently set up shop in the city."

Help me out here if I'm wrong, but don't credit default swaps, a financial instrument invented in the 1990s, suffer from the usual insurance contract problem of "moral hazard?" If you can make a deal so that you get compensated if your mortgage-backed security defaults, aren't you more likely to bring about a default?

If you are, say, Goldman Sachs and AIG offers to, in effect, insure for a modest price a no-doubt-fraudulent pile of mortgages you are thinking about buying from some dubious firm, why not go for it? AIG is rock solid! And if, perchance, AIG turns out not to be so solid, well, Goldman has friends in high places.

Credit default swaps have a second interesting moral hazard aspect. You don't have to be the owner of the security to get paid if it goes bust. This is kind of like being able to take out a life insurance policy on a complete stranger or your own worst enemy. The murderous marital moral hazard implicit in life insurance is a common theme in crime stories (e.g., Double Indemnity). That's an inevitable problem, but insurance companies have tightened up over the centuries on who can take out a life insurance policy on whom. Still, there was an Arsenic and Old Lace case in LA recently of two elderly women, who had murdered homeless men after taking out multiple life insurance policies on them. (They bribed the men into signing up for one, then forged their signatures on other policies).

It would certainly be interesting to learn more about the impact of both types of moral hazard.

I could see how the second kind (where third parties make bets against the financial health of firms in the securitized mortgage business) could be either bad or good for the economy, in that it could send signals that financial instruments are dubious.

My published articles are archived at iSteve.com -- Steve Sailer

21 comments:

Mark Seecof said...

Everything you say is right, but don't forget the other moral hazard: the force which persuades an insurer to collect premiums without making provision (perhaps without intending ever) to pay off in case the insured-against event comes to pass.* It's clear that far too many firms wrote CDS's then collected and spent the premiums without creating any reserves against the possible default of the creditors in question. The "lock up" in the CDS market is largely due to the manifest inability of CDS writers to pay all their gambling debts now.

(Of course, a lot of CDS writers claim they were suckered by fraudulent ratings on securities they insured. I'm sure some were, but I don't regard that as a complete excuse.)

(*In regular insurance markets, say, homeowners or auto, the other moral hazard produces crooked denial of claims. Having collected the premiums in advance, the crooked insurance company is in a strong position when it denies a claim-- the insured typically has little money or time for lawsuits; the insurance company litigates at leisure.)

beowulf said...

New York's insurance commissioner agreed with you and said he'd cancel credit swaps that couldn't produce an underlying security. Surprise surprise, the Feds jumped in and preempted him by... setting up a new financial market.

Federalism apparently means using state laws if its weaker on big business than federal regulation would be (funny how there's no federal insurance commissioner) and using federal law when its weaker than state regulation would be (e.g. FCC regulations can trump local zoning laws when a wireless carrier wants to build a new cell tower).
A fine Republic we have.

Rather than questioning the underlying economic rationale and legality of credit default swaps, the SEC and CFTC have decided to facilitate the proliferation of these financial derivatives by licensing “casinos” for gaming of these contracts.
http://seekingalpha.com/article/112471-stupid-is-as-stupid-does-the-sec-and-cftc-legalize-electronic-gambling

Henry Canaday said...

In mature business insurance markets, moral hazard is supposed to work the other way. Your insurance rates, even your ability to get insurance, depend on your ability to satisfy the insurer that you are taking only limited risks and thus serve as a check on excessive risk-taking. For example, an airline seeking insurance against crashes must satisfy sophisticated insurance consortia that it is running a safe operation.

But these are markets where insurance firms and underwriters have a lot of experience with assessing risks of very specific kinds and very deep information networks on their clients. The risks of the new-age mortgage markets were so novel, I don't think the insuring firms knew much about what was really going on. They were just one more level removed from the underlying risk factors, the reliability of millions of borrowers and the true value of millions of homes. They may have been even more reliant on recent default rates and costs, which were unreliable while housing prices were still rising.

AIG, by the way, owns one of the biggest aircraft leasing firms, ILFC. During one of the (frequent) collapses in airline finance, the leasing firm sought acquisition by the insurance giant because the diversified insurance business was supposed to give the always chaotic aircraft leasing business some financial robustness.

When the sub-prime crisis broke, I thought, uh oh, we have been financing housing like we have been financing aircraft purchases and leases by airlines. The differences were 1) everybody who invests in aircraft knows that half the ultimate buyers, airlines, are going to go bust once a decade and 2) aircraft financing worldwide is tens of billions of dollars a year, enough to break companies but not an economy, while housing is trillions of dollars a year. Size matters.

anon-2 said...

Credit default swaps and derivatives are much more to blame for the present mess. Steve -- making out loans and mortgages to immigrants, minorities and others with low to non-existent qualifications is 10% of the story compared to Wall Street derivatives schemes

My humble opinion

Anonymous said...

When you write posts on economics it reminds me of Malcolm Gladwell. And not in a good way.

Anonymous said...

If you look at Credit Default Swaps as insurance, then you bring up a good point about "insurable interest" -- the requirement in modern insurance that you can only insure something against loss if you will suffer from its loss (i.e., no buying life insurance policies on strangers). On the other hand, if you look at them as a form of hedging, speculating, or shorting, then there is no requirement to have the equivalent of an "insurable interest" in securities that you short.

Shorting, in fact, has some salutary benefits. Shorts make money by exposing nonsense on corporate balance sheets. Shorts saw the weakness in LEH, FNM, FRE, etc., before those companies (and the government) acknowledged it. The difference with real shorting (not naked shorting, which is illegal) is that it's transparent (you can see the short interest on a stock) and you have to put up more money to short a stock than you do to buy a CDS. Some have suggested requiring CDS to be listed on exchanges with similar requirements.

- Fred

Vernunft said...

"insurance companies have tightened up over the centuries on who can take out a life insurance policy on whom"

Pretty sure it's been the insurable interest doctrine that's limited it legally.

Anonymous said...

I'm not one of those lefties who thinks that the free enterprise system is a rigged game that will end only when the workers of the world revolt and break their chains. But I gotta admire the brazenness, the unmitigated gall, with which Goldman Sachs ripped America off on this one.
Collect the high interest on the crappy CDOs till they go bust, then turn to AIG to get paid. Oh, AIG can't pay? No problem; one of our own has the Big Office at Treasury, so just have Uncle Sam funnel the money through AIG to GS. AIG still can't pay? So{{Shrugging our shoulders}}, give AIG more money. After all, it's too big to fail, right? I mean, if AIG fails, those poor, poor insureds all across America!! Oh, the humanity!


Except by law, none of the reserves of AIG's subsidiaries (the real insurance companies) can be used to pay the CDSs; the insureds are safe and sound. As AIG has been telling its employees in company-wide morale-boosting emails about 3 times a week, the routine underwriting and claims processing of the subs is in solid shape. Only CDS counterparties like GS would get screwed by bankrupcy. So, before somebody notices that 800 lb. gorilla, we need a distraction! OMIGOD! LOOK OVER THERE: THAT'S A $700 BILLION DOLLAR HOLE! MAYBE TWICE THAT!! MAYBE TRILLIONS AND TRILLIONS!!
AIG's bailout is now a rounding error. Plus, just for good measure, the one chump that's allowed to go under is GS's sole remaining competitor, Lehman. Oh, the humanity!

And they got away with it in broad daylight. They knew they would.

I hate to post anonymously, but this time I gotta. I'm not a big playa, but ya never know who reads blog comments.

Anonymous said...

So Wall Street has a monster wave of bogus insurance. That's nothing new. Wall Street and the Europeans (sound familiar?) embraced the same sort of scam back in the Panic of 1873. Back then it was fraudulent railroad insurance paper shuffling of some sort... which essentially melted down the world for a couple of decades.

So what. The relevant question here and for the future for Californians is what is it like to buy insurance in Mexico? Do they even have it in places like TJ? Can we get some decapitation coverage down there, Steve? Because I think we will need it in Redondo Beach by, say, 2018.

And is the insurance game as fruitful as the bookstore business in Mexico? How about the computer business? How about the biogenetics research business south of the border? Or what now, is Cali going to become another brainless boom/bust commodity exporter like Brazil?

Steve, I'm trying to think of recent national news events that originated in Los Angeles proper. Besides an earthquake or riot? Maybe Addis Ababa is not a bad comparison.

Love the blog. Love the way you rarely discuss local events in Los Angeles or even the California issues. Which is amusing because LA and California used to be a place worth talking about. Yes, if the internet existed in 1959, 1969, 1979, or even 1989 there would be a lot more interesting stuff for a West Coast blogger to pass on to the rest of the country and the world.

But now it's 2009. And those days are gone.

Steve, do you read any bloggers from Latin America? Are there any in Mexico City? There is that one blog that reports on the ongoing crisis in Argentina. I think it's called "When the Sh*t Never Stops Hitting the Fan" or something like that.

Denninger is right, you know. Those California IOUs are a warning.

Anonymous said...

I agree with the anon who said we need a lot more coverage of the Los Angeles area -

Steve - you are here and many of your readers are here so let's have more stories of local interest -

if you don't want a lot of local discussion, how about sponsoring a section of isteve for an ongoing discussion of local issues - something like a thread that always appears in a corner of your home page ?

(I am posting this from the 90402)

Anonymous said...

Oh, California. You broke my heart.

CJ said...

Comparing derivatives to real insurance quickly reveals obvious differences. Your neighbors don't take out fire insurance on your house, true enough, but maybe the most important one is that fire/flood/car insurance agents don't make $10 million in bonuses in six or seven years and then retire to an acreage in Connecticut. Here's one of the best simple explanations of the derivatives problem that I've found:

AIG's Dangerous Collapse
& A Credit Derivatives Risk Primer


Please note that I have no opinion on this writer's own financial advising; I'm endorsing his excellent exposition of the current situation.

Cancel Our Debt said...

After this Second Great Depression (call it GD2) settles in, we will realize the need to run banks like utilities: for the public good, under strict regulation and profit control.

And we will have a better world because of it.

daveg said...

Who was oppossed to regulation?

Ms. Born was concerned that unfettered, opaque trading could “threaten our regulated markets or, indeed, our economy without any federal agency knowing about it,” she said in Congressional testimony. She called for greater disclosure of trades and reserves to cushion against losses.

Ms. Born’s views incited fierce opposition from Mr. Greenspan and Robert E. Rubin, the Treasury secretary then. Treasury lawyers concluded that merely discussing new rules threatened the derivatives market. Mr. Greenspan warned that too many rules would damage Wall Street, prompting traders to take their business overseas.

“Greenspan told Brooksley that she essentially didn’t know what she was doing and she’d cause a financial crisis,” said Michael Greenberger, who was a senior director at the commission.


Now you know.

Legacy

Anonymous said...

"After this Second Great Depression (call it GD2) settles in, we will realize the need to run banks like utilities: for the public good, under strict regulation and profit control.

And we will have a better world because of it."

Cancel Our Debts, you funny!
Don't you realize it was "to run the banks in the public interest" that got us in this mess?

Please read the book "The Creature from Jekyll Island" by G. Edward Griffin and discover how, in 1913, America was schnookered by sneaky bankers, who passed the law -- "in the public interest," of course -- that instituted the Federal Reserve System.
The whole Federal Reserve System is a fraud. A cabal. The absolute opposite of free markets. And written by sneaky bankers who wanted a monopoly but marketed it as "in the public interest."

What is needed is NOT more regulation, that the sneaky can get written to their advantage, as we've had since 1913, but a RETURN to free markets!

Note: The Federal Reserve System legislation was instituted in 1913 to "prevent bank runs and to prevent panics and to smooth out the business cycle." Yay! Prosperity forever! Right?
Uh, well, within 17 years, we had the first Great Depression. Now comes GD2. And you want to continue trying that which has proven it does not work???

Don't blame the free markets for this. Blame giant corporations with their giant bucks, able to buy off politicians so that legislation can be written to give the Giant Corp. a monopoly.

Goldman Sachs, Exhibit 1.

You DO realize that King Hank Paulson, the Treasury Sec'y who engineered the abominable "bailouts" to "protect the public interest" came from Goldman Sachs, right? And promptly saw to it that GS suffered not at all for its foolishness?

Lucius Vorenus said...

Anonymous: I'm not one of those lefties who thinks that the free enterprise system is a rigged game that will end only when the workers of the world revolt and break their chains. But I gotta admire the brazenness, the unmitigated gall, with which Goldman Sachs ripped America off on this one.
Collect the high interest on the crappy CDOs till they go bust, then turn to AIG to get paid...


Huh?

What you're describing IS leftist economics - in a nutshell.

Lucius Vorenus said...

Cancel Our Debt: After this Second Great Depression (call it GD2) settles in, we will realize the need to run banks like utilities: for the public good, under strict regulation and profit control. And we will have a better world because of it.

It's not a second great depression - it's a second dark age [DA II], and it's coming upon us because elites the world over have rendered their souls to the pagan religion of nihilism, and, in the process, have completely ceased making babies:

IQ and the Wealth of Nations
en.wikipedia.org

List of countries and territories by fertility rate
en.wikipedia.org

Bret Ludwig said...

Moral hazard is one of the classic arguments in studying insurance. It is not at all well taught to today's MBAs.

Neither is another, the "insuror's dilemma". If an activity is inherently non-risky enough, people won't buy insurance at all. For example, old cars with little value are insured only for legally mandated liability. If an insurer acts to reduce his own risk too vigorously, he will put himself out of work. What insurers optimally do is therefore create a situation with high perceived but much lower actual risk.

Anonymous said...

Steve,

I think you're mixing together moral hazard and adverse selection. Or maybe the CDS situation does that.

Moral hazard is where I buy heart attack insurance, and then decide to eat fried chicken every day, because my risk is covered. That is, I have some way to decrease my risk, but I don't bother, because I've bought insurance, so now it's your risk instead.

Adverse selection is where I get a cholesterol test on my own, and then rush out and buy heart attack insurance when I find out my numbers are bad. That is, I may not be able to do much about my risk, but I know my risk better than the insurance company does. (This is closely related to the market for lemons.)

I don't think most folks buying credit protection are in a position to have a big impact on whether the company defaults. (Say, if GE bought credit protection on itself, or GM bought credit protection on Delphi, that would be a big issue, right?) But it seems almost inevitable to me that speculators buying credit protection are doing it because they think they understand the default risk better than the sellers. Since the sellers seem not to have understood what they were doing in a lot of cases (like AIG), they were probably right.

beowulf said...

Excellent 60 Minutes piece on credit swaps from October.
http://www.cbsnews.com/stories/2008/10/26/60minutes/main4546199.shtml

Mr. Anon said...

"Bret Ludwig said...

What insurers optimally do is therefore create a situation with high perceived but much lower actual risk."

Or, alternatively, they pay legislators to pass laws favorable to their interests, such as mandatory insurance laws.