Revisiting Insurable Interest

I didn’t think I’d see a proposal like this one which would (seemingly) bar investors from purchasing default protection via the credit default swaps [CDS] on corporations without owning the underlying bonds. But here it is. (It would also force the creation of a clearinghouse for CDS, something I have been more dubious about — it will work for large liquid exposures, but not others.) This is more restrictive than I would recommend; consider my earlier piece, Rethinking Insurable Interest.

My basic idea is that people, even artificial people like corporations, have a right to restrict who takes life insurance out on them, aside from those that already have a financial interest in the well being of the company. Also, gambling should be opposed on public policy grounds. Most of the CDS market is just a series of side bets, with little or no true hedging going on.

Now, what I am suggesting is controversial, though less so than the proposed bill. There is a very good blog called Derivative Dribble, that took issue with what I wrote in my piece. The author, Charles Davi, asked me to comment on it, and I ran short of time, and never did. This proposed bill gives me a chance to comment on his piece, and for you to read his logic. It is a clear statement of what those that have an economic interest in the size of the CDS business will say.

My argument with Derivative Dribble is this: He brushes past my moral arguments and focuses on the right of two parties to be able to contract freely. (Also, his argument about incentivizing illness is just weird, and does not apply to the discussion at hand.) Merely because a life insurance company has an economic interest in not selling insurance to someone who might harm the insured, does not mean that the insurable interest argument relies on the self-interest of the insurer. It is a statement of public policy that we don’t allow parties with no insurable interest to make bets on the lives of others. It arose out of many incidents where insured parties got murdered. Innocent people have a right to not be concerned that someone has an incentive to kill them.

In the same way, corporations have a right to not have to worry about being harmed by those that might have an economic interest in their demise. This is not just for the good of the management; many laborers, suppliers, pensioners, and other stakeholders lose when a firm goes bust. There are situations where parties controlling the financing of a firm in trouble have acquired CDS protection greater than that of their likely economic loss. Given that the ability of the firm to refinance in such a situation is limited, this virtually guarantees the demise of the firm.

The right to free contract is limited in our culture, and in most cultures. Even an economic libertarian like me knows that. This is one of the areas where the right to contract should be limited, so that corporations do not have to be looking over their shoulder to see if someone has an interest in their demise.

Comments

[athena:]

Too little, too late, the damage is done and the bills will keep coming.

Jan 29 03:00 PM

[Tony Petroski:]

At last, some sense on this matter. I agree that a party should have an insurable interest and that interest be limited to the underlying risk, i.e., a party shouldn't collect double or triple on their "loss."

Jan 29 05:04 PM

[Big Al45:]

Agree completely with the author. CDS purchases should be limited to those having an insurable interest.

However, I doubt that anything will be done to regulate CDSs. Our politicians have been bought by the investment banks and hedge funds that use CDS's to "earn' their profits.

Jan 29 05:07 PM

[Tom Armistead:]

Exactly right. CDS are insurance and should be regulated as such, with a requirment of insurable interest and adequate capital.

In the insurance field, it has long been known that lack of insurable interest creates moral hazard. Speculators have taken out CDS protection and then done everything in their power to create losses. It is the financial equivalent of arson or murder for profit. As a matter of public policy insurable interest should be required for any insurance contract.

I intend to write (again) to my Senators and congressmen to push for passage of the bill which will rectify this glaring ommission in financial regulation

Jan 29 05:41 PM

[Bill Herbert:]

Good points. The CDS market is ludicrous, if you ask me.

Just a bunch of predatory behavior - bordering on racketeering.

Jan 29 10:28 PM

[ain't no fo...:]

I've been talking about moral hazard and insurable interest for 6 months now and am glad people are finally catching on. These "swaps" are called that for one reason and one reason only - so that they don't come under the review of state insurance regulators who would've shut down many of them because there was no insurable interest on the part of the party holding them. They were death insurance policies from day one, as the financial companies knew, so they came up with the name "swaps" as a way to keep these products hidden far from the eye of responsible entities and the public at large.

And those who knew what they were (are you listening Mr. Cox??????) did absolutely nothing to limit their spread because it was THEIR friends who were profiting from the practice.

Jan 30 11:11 AM

[MichaelSchm...:]

From a policy perspective there seems to be a pretty clear difference between murder and corporate defaults. Granted, the requirement that an insured retain an insurable interest extends beyond life insurance policies and applies to most traditional insurance products. Even then, in all policies for which there is an insurable interest requirement (e.g., life and property policies are the simplest to think about), there is an element of control over the insured event that simply is not present with CDS -- it is relatively easy to kill someone else or burn down a house, but it is far more difficult for an unrelated third-party to cause a corporate default or other credit event. The tools available to even the most nefarious and wealthy short are blunt and indirect -- while they may exacerbate a weak company's problems, intentional spreading of misinformation, naked short-selling and bidding up the cost of protection never caused a bond default. Too much debt relative to cash, generally poor planning over the business cycle, liquidity imbalances -- i.e., factors controlled by management, not third-parties -- are the cause of corporate defaults.

Also, couching the debate in terms of "insurable interest" is a little misleading, at least to the extent that the author is equating "insurable interest" with "owning the referenced bond or underlying instrument." Insurable interest is a fairly loose concept, and presumably would be satisfied in the CDS context by having sold protection on the referenced instrument, owning equity in the referenced company (if the CDS is on a company), being short puts/long calls on the equity, etc. Permitting someone to buy protection on a company because they were also short equity puts seems to be the sort of speculation the author suggests is bad. Further, it would be very difficult to develop sensible buyer-side regulations that took into account the various ways in which a protection buyer could have an "insurable interest" in the referenced instrument and even more difficult (and expensive) to enforce.

I agree that regulation of CDS is important and needed, but I think the regulation should be focused on protection sellers not protection buyers.

Jan 30 12:40 PM

[Between The...:]

My concerns are not as much about the insurable interest, which has its place in the discussion of future CDS regulation, but nominal value of CDS compared to the underlying. The value of all debt issued by BofA is only about $600B, yet there is evidence of trillions of CDS being written on their debt. At some point, the CDS notionals dwarf the actual value of the company (a scant $30B market cap for BoA) to the point that the behavior of players in the industry is skewed. In sports gambling, when the value of bets placed on the game greatly exceeds the importance of the game itself, the likelihood of point-shaving and other malfeasance increases dramatically. CDS are no different from sports gambling in that sense.
Heck, the government could make the taxpayer a ton of money by buying a ton of CDS on C, JPM, BoA, and then yanking the TARP rug out from beneath their feet. Should we let Lehman fail? Let me call over to my friends at GS. CDS portfolio on Lehman is small? What about the other guys? Lots? Ok, let the MF burn. (I'm not saying this happened, but the moral hazard is there).
What if JPM is the writer of $1T of CDS on Citi? JPM might as well pay Citi's debt payments to keep it afloat, as it has more to lose on a default than on the debt alone. JPM might not even want to compete against Citi as to weaken its "rival" and then have to pay out a huge CDS were it to "win". It is market distortion all around.
In an even more bizzare situation, Citi could intentionally default, restructure at something like 99cents on the dollar (all that is required is a "credit event"), and cripple its CDS writers (JPM and MS for sure, likely others) who also happen to be its rivals. Sure, this would make bondholders concerned for further debt issuance, but no one (except the Federal governement) is foolish enough to make loans to Citi going forward anyway.

Feb 03 07:26 PM