Greece, Default and Insurable Interests

You'll be reading more in coming weeks about credit-default swaps on Greek debt. The Fed seems to be interested (finally) and the do-nothings on Capitol Hill might decide to pretend they're doing something.

I've been raging over the danger of credit default swaps for years. A credit default swap is an insurance contract, only it doesn't have the word "insurance" in it. Therefore, it's not regulated like insurance. You might enter into a credit default swap against, say, General Motors bonds. If GM defaults on those bonds, the swap pays you the notional amount of the contract. This is a sensible tool if you own $10 million of these bonds. You worry about default, but you don't want to sell the bonds. So, you buy insurance against loss. Same as you do for your house or your car.

However, a central and bedrock principle of the insurance world is that, in order to buy insurance against some calamity, you have to be at risk of that calamity. I can buy insurance against my own house burning down, but I can't buy insurance against yours. This would create a moral hazard, in that I sit around hoping your house burns down. Who knows...if I were a nefarious type, I might even devise sinister methods to increase the odds that your house burns down. I might figure out ways to impede the fire trucks from getting to your house quickly. I cannot buy insurance unless I have an insurable interest.

The requirement of an insurable interest ensures that no more insurance is outstanding than the potential losses from the event. If a storm causes $1 million in damage, no more than $1 million will need to change hands. It would be profoundly destabilizing to have more money change hands than the losses from casualty events. We'd have the equivalent of people out in the streets stopping fire trucks from getting to fires simply so those people could realize a profit. We cannot have a system wherein certain participants hope that bad things happen to other people. Whenever a lot of (wealthy, influential) people hope that something happens, it generally tends to happen.

The existence of this moral hazard, and the need to outlaw it, was figured out hundreds of years ago. Lloyd's of London has had this policy in effect during its nearly 400 year existence. It is not a new notion that requires new concepts of regulation.

Credit default swaps are a end-run around the requirement that one have an insurable interest. Big banks, hedge funds and other speculators at one point ran the outstanding volume of credit default swaps into the trillions of dollars, against mere billions in potential losses. This is because the contracts can be bought by investors who don't even own any of the subject bonds. This no more a tenable outcome in the financial markets as it is in the casualty insurance market.

There is a very simple piece of regulation that will fix this problem: Credit default contracts need to be called what they are: insurance. And insurance can only be purchased by those at risk of the involved loss. It's really a rather simple concept that has served us well for hundreds of years. But, as usual, the lobbyists will fight back and true reform will probably remain elusive.