Once upon a time there was a prosperous little village, called USville, nestled beside a river, with a view across fields of grain to a distant mountain range, shrouded in a purple haze on sunny days. One day was very much like another, and the citizens lived happy and tranquil lives, for the most part.
One day when the train stopped at the station, a group of strangers, well dressed and prosperous looking, got off and promptly booked the most expensive rooms at the local hotel. From there they went on to rent all available office space in the downtown area, placing their firm names on the doors in gilt lettering. When asked what their businesses entailed, they replied that it was similar to banking or insurance, financial in nature, but extremely innovative, the latest thing. Certainly these gentlemen were prosperous: they joined all the right clubs, contributed to charity, and got awful close to the mayor and the town council, awful quick.
Soon enough they had customers. Larry the Slummer started working for them, showing their wares to anyone who would listen. He carried a sample with him. It was a fancy package of papers, very similar to an insurance policy in its overall appearance. He proudly showed it to Tom the Bookkeeper. Tom took one look at it and declared: “It's an insurance policy; I know one when I see it, it's got all the engraving around the edges, the fine print, and the weasel words, the whereases and the wherefores and the due diligence and dispatch and the care custody and control and all that folderol.
But Larry said, “no it isn't: it covers your neighbor's house, not your own; and it pays if the cow kicks over a lantern or if a meteor hits or if you set the fire yourself. If it were an insurance policy, it wouldn't cover your neighbor's house: they wouldn't let you do it that way; and it wouldn't cover if you did it. If it were insurance, it would be illegal; but it's not illegal, so it's not insurance. Beside, it says it references the house, and insurance as anyone knows covers things. Referencing is not covering, so it isn't insurance: no way, no how. And further, it doesn't have an amount of insurance. It's a notional amount. If you don't know the difference between insurance and notional then you obviously are some kind of an ignorant rube.”
Soon all the villagers were buying and selling the curious instruments, many of them obtaining as many as twenty or thirty, referencing not only their neighbor's houses but also the potato chip factory, the fireworks works, several local gin mills, the courthouse, and the town halls of neighboring villages, for large notional amounts.
One of the newcomers, the fattest and most prosperous of them all, developed an innovation. He bundled the instruments and packaged them all up in a huge document, some of them ran to as much as 300 pages of fine print, with several pages of definitions, clarifications, and obfuscations. They had exclusions, they had exceptions to the exclusions, they had inclusions, and non-inclusions. The residents took them home in wheelbarrows.
This individual, Sack Goodman, was a weekly guest at the mayor's home, knew him well, his wife, his kids, his dog, his cat: he was on good terms with all of them. He ran an open lunch at the finest eatery in town, where all the most prominent citizens, including the entire town council, stopped by for a bite and deep conversations on the intricacies of financial enrichment.
These new businessmen spent quite a bit of money, so the overall effect on the town's economy was startling – soon everybody had money and invested it in more and more of the mysterious securities, so similar to insurance, yet so different. This went on for years, and everyone got richer, and the financiers were the toast of the town: they had created a new era of prosperity, where all were better off, with no end in sight. These new financial instruments created the security: anyone knows that if you buy insurance nothing happens, so although the new-fangled financial things were not insurance, it worked the same way, with so much of it referencing the whole town several times over for huge notional amounts nothing was going to happen.
But something did happen. It started slowly, various tool sheds and outhouses burned down, mysteriously, and the owners of the securities collected in due course. But then rumors began to fly: the potato chip factory, it seemed, was doomed. The securities referencing it became extremely expensive: anyone who had the good fortune to own one was an instant millionaire. It was pointed out, that being a frame building, and full of boiling oil, that it was at risk of catastrophic spontaneous combustion, with a total loss more likely than not. Any one who did not have an instrument referencing the structure rushed to buy one before the inevitable occurred.
From there it spread to the fireworks works. That too was doomed. It seems that with all the gunpowder lying around and again a frame building that catastrophe was unavoidable. As before, anyone who held an instrument (not insurance) referencing (not covering) the structure was an instant millionaire. With the number of instruments outstanding, the notional amounts exceeded the value of the whole village, guaranteeing immense profits when the inevitable occurred.
Richard (Dicky) Foulds, the owner of the fireworks works, Lockman Brothers, was incensed: “They're spreading rumors that my plant is going to burn. It's difficult to get help anyway, but with all this talk nobody wants to work with me anymore and I am going to be put out of business. He made his case before the town council, and to the mayor in person, but all he got was a series of stern lectures on fire safety, people telling him to add fire extinguishers or install a sprinkler system, conduct fire drills, stop using gunpowder in his products, etc. Foulds got very huffy, said the building was as good as fireproof, safer than a concrete bunker, or pig iron under water.
Of course the fireworks works exploded in the middle of the night. It went up in flames, incendiaries lighting up the night, rockets exploding overhead – the entire town turned out to watch it, then hurried home to retrieve their financial instruments referencing the building for large notional amounts. Many were disappointed to learn that their own dwellings had been torched - the sparks from the fireworks works had ignited most of the town, which was blazing furiously. They promptly went to what was left of the offices to collect, but discovered that many of the mysterious strangers had disappeared.
Sack Goodman, however, was still there, affable as ever. When they applied to him for payment, he informed them that they owed him money. They cried out in anger and frustration: “how can that be? We have these instruments referencing the fireworks works for large notional amounts, as well as these packaged documents referencing every other structure in town, many of them several times, all for large notional amounts. We are totally secure against any and all losses, safe and secure from all harm.”
Sack explained it to them: as it turned out, if these instruments had been insurance, which of course they were not, the townspeople were in fact the sellers of protection, and not the buyers. Further, if any of the buildings were even touched by a spark, that was a loss, and the entire notional amount became due. It was a “trigger clause,” he said, a necessary protection in these hazardous times. “That's my way of doing God's work,” he intoned, “I write financial instruments that nobody can understand and I collect coming and going. It's perfectly legal, and I have done nothing inappropriate. Greed is good, self-regulating and self-correcting.”
Tom the Bookkeeper was mildly eccentric, nobody paid him much attention. But he was there, and he kept insisting, “It's insurance, I know an insurance policy when I see it, the engraved borders, the fine print, the weasel words.” Larry the Slummer was there at the mayor's elbow, whispering “it's not insurance, referencing is not covering, you can cover your neighbors house, or any other building in town, which you couldn't do if it was insurance, because any fool knows you can't insure something unless you own it. Besides a notional amount is not an amount of insurance. If you don't know that then no way are you a savvy mayor, fit to associate with savvy businessmen.”
Finally the village idiot settled it: “Goodman here has bought insurance from you, covering all your houses, as well as the fireworks works, and he is now attempting to collect. I'm the village idiot: and though it is a pity, it is so. But any idiot can see that these newfangled financial instruments are insurance and all this talk about referencing and notional is just a smokescreen. You guys are even dumber than me.” Those were simpler times, and cruel, political correctness had not been invented yet.
The next day they all got together and helped each other rebuild the town from scratch. And they made some new laws, that referencing was the same as insuring, and notional was the same as amount, and they were all sadder and wiser men after that debacle. And they made another law, bankers could only bank, and insurers could only insure, and if it wasn't banking or insurance it was gambling and that was against the law.
Disclosure: The author is a citizen of USville.