A Modest (Financial) Proposal

I heard on the news that President Obama has instructed the Justice Department to conduct an investigation into the oil commodities market to determine whether the recent run-up in oil prices is the result (or partly the result) of market manipulation and/or speculating. I don't really have an opinion about this one way or the other -- at least for right now, I don't have sufficient information to form an opinion -- but it did remind me of something I've been thinking about for a while now.

Might there not be a recognizable benefit to eliminating (declaring illegal) all "naked derivatives trading?"

A large part of why the financial crisis became so bad, so big, was "naked" trading in Credit Derivative Swaps. Now, a "CDS" may sound complicated, but it essentially is just a type of insurance.

For example, suppose you own a bond (or a "market-backed security") or any other type of financial instrument that guaranteed a future payment in, say, 5 years and that had a face value of $100 million. Just as with regular Americans and their homes, this would be a pretty significant asset to have in your portfolio, and so you might want to take out insurance on it -- just the way regular middle-class Americans do on their homes. So, you could go to AIG, just for example, and purchase a CDS. And in exchange for a annual premium payment of, say, $2 million, AIG would insure that if the bond subsequently proved to be worthless AIG would pay you the full face value of the bond.

Five years of $2 million premium payments would knock your net payout on the bond from $100 million to $90 million, but you would have the security of having eliminated the risk that you might lose the entire $100 million. Not bad.

But "naked" derivative trading allowed Walls Street firms who did not own underlying bonds/mortgage-backed securities to purchase insurance on those same bonds anyway. AIG, which apparently believed the ratings agencies' AAA status on these things, figured the bonds could never fail and so thought the premium payments it was racking up constituted "free money." (It apparently never occurred to AIG -- or, more accurately, to AIG's subsidiary, AIG Financial Products, which was really issuing the insurance policies -- to wonder why all of these Wall Street banks, supposedly the brightest of the brightest, were willing to give it all of this "free money.") Accordingly, AIG issued insurance policy on insurance policy covering the same financial assets, happily taking home millions and millions each year in premium payments.

But think about what this means. Suppose AIG issued 20 different policies on the same $100 million bond. Now, instead of being on the hook for a potential $100 million loss if the bond defaulted, AIG would be on the hook for $2 BILLION. This is a substantial increase in liability, all of which turns on whether one single event occurs -- the same bond turns out to be worthless. No matter how unlikely you may think a future event is, the more money you gamble against that event occurring the more disastrous it will be for you if that event does, in fact, come to pass. This is exactly what happened when the music abruptly stopped in the game of financial musical chairs the big investment firms were playing a few years ago.

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But really, what social purpose did it serve to allow investment banks to purchase insurance policies on financial instruments that they were not themselves invested in? How is this not just sheer gambling?  Place a $2 million bet - once a year - with the chance of winning $100 million. If the banks actually owned the bond in question, then purchasing insurance on the bond makes sense, because they would just be limiting their risk.  But if you don't own the bond, then you are just making a gamble.

Generally speaking, I am not allowed to purchase fire insurance on my neighbor's home. For one thing, there is no social value to my doing so. For another, it does tend to give me a motive to engage in a little bit of arson.

And doesn't it seem to you that something similar may have happened with the financial markets? After all Bank of America was one of the banks most heavily invested in CDS's, which insured mortgage-backed securities that consisted of a whole lot of subprime mortgages all bundled together. Is it a coincidence that Bank of America had a substantial interest in Countrywide Mortgage, the single greatest issuer of subprime mortgages in America?

Similarly, we know that Goldman Sachs got together with one of its richest individual investors and created a mortgage-backed security that consisted of only the worst of the worst mortgages they could cherry-pick. These mortgages were expected to fail. And then the investor and Goldman Sachs sold the security they had created to other investors, purchased CDS's on that security, waited for it to fail, and then demanded full payment on their insurance policies.

In fact, the more you look at things like this, the less it looks like gambling. A closer analogy would be paying an electrician to install wiring in your new home, trusting he has done a competent job because you certainly are not competent to judge the wiring job yourself, and then -- when your house burns down due to substandard wiring -- watching as the electrician cashes in on the insurance policy he took out on your home.