Regulate Cds As Insurance: Rolfe Winkler

[D Vardy's Shadow]

http://www.guardian.co.uk/business/feedarticle/8594315

Does this smell like mass fraud to anyone?

from the quoted article: Selling insurance is pretty boring thanks to regulations that date back to 18th-century England. In a recently published paper in the Connecticut Insurance Law Journal (http://link.reuters.com/fyv38c ), Arthur Kimball-Stanley argues that, in its earliest days, insurance policies were often used to gamble. Policies could be purchased for items that weren't yours, and for amounts greater than the insured property was worth. The moral hazard is obvious: Unregulated insurance gave speculators incentives to destroy property.

Are CDS speculators actively destroying property? Take Delphi Corp . When the auto-parts maker filed bankruptcy last fall, investors held $20 billion worth of CDS that referenced only $2.0 billion worth of bonds.

This looks like 'Springtime for Hitler' fraud to me. But nobody seems to understand what 'Springtime for Hitler' fraud is, whenever I mention it.

Edited July 7, 2009 by D Vardy's Shadow

[Dave Spart]

That is not what I am saying at all you cretin. Did you partake in the thread many aeons back where we all discussed this? What is the point in going over the same old ground again.

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Aren't they the lyrics to an old Status Quo hit?

[Dave Spart]

from the quoted article: Selling insurance is pretty boring thanks to regulations that date back to 18th-century England. In a recently published paper in the Connecticut Insurance Law Journal (http://link.reuters.com/fyv38c ), Arthur Kimball-Stanley argues that, in its earliest days, insurance policies were often used to gamble. Policies could be purchased for items that weren't yours, and for amounts greater than the insured property was worth. The moral hazard is obvious: Unregulated insurance gave speculators incentives to destroy property.

Are CDS speculators actively destroying property? Take Delphi Corp . When the auto-parts maker filed bankruptcy last fall, investors held $20 billion worth of CDS that referenced only $2.0 billion worth of bonds.

This looks like 'Springtime for Hitler' fraud to me. But nobody seems to understand what 'Springtime for Hitler' fraud is, whenever I mention it.

Google search.

Pray tell. I'm all ears. Vas is das?

[three pint princess]

Decide for yourself whether it is used as insurance or not.

You could shorten that video by asking what % of companies will go bust and be unable to pay their debt for ever out of the total

invested. And if that's 15% then having 150 Billion for a Trillion isn't so bad you end up still ok. As long as the payout is not messed with.

[the wizard]

Actually, I think that CDS are amongst the more sensible financial products. If you don't think that insurance creates value then you should ask yourself why people pay for unemployment insurance or health insurance. There are issues with counterparty risk, but these aren't specific to credit derivatives.

However, if we start creating regulations based around stupid arguments over what is insurance, what is a derivative and what is gambling, then the regulation will be terrible. Regulations - all laws - should be grounded in reality and not arbitrary classifications.

[Tiger Woods?]

Actually, I think that CDS are amongst the more sensible financial products. If you don't think that insurance creates value then you should ask yourself why people pay for unemployment insurance or health insurance. There are issues with counterparty risk, but these aren't specific to credit derivatives.

However, if we start creating regulations based around stupid arguments over what is insurance, what is a derivative and what is gambling, then the regulation will be terrible. Regulations - all laws - should be grounded in reality and not arbitrary classifications.

The problem with some sorts of insurance is that they allow people/institutions to take more risks. Those risks are not cost free to society when the underlyings are mortgages, as more risk translates to accepting more leverage which means more real cost to the average wannabe home owner. Paying ridiculous sums for dirt is just nuts and cannot be good for the economy. It is a misallocation of resources and effort.

[D Vardy's Shadow]

Google search.

Pray tell. I'm all ears. Vas is das?

'Springtime for Hitler' fraud. It is the fraud carried out in the musical in thestory line - nothing to do with putting on the show in the real world. At core, an asset producing a return, but with a risk of substantial loss is sold more than once over, at which point, the people selling the asset have a vested interest in turning it to loss.

ie

• sell twice over

• reduce value to 25%

• pay out 25% twice over

• PROFIT!

[interestrateripoff]

Actually, I think that CDS are amongst the more sensible financial products. If you don't think that insurance creates value then you should ask yourself why people pay for unemployment insurance or health insurance. There are issues with counterparty risk, but these aren't specific to credit derivatives.

But the idea with the above insurance is that the company hardly pays out or makes the premiums so high because your likely to claim it's unaffordable.

[Joey Buttafueco Jr]

If collateral posting was enough, why did AIG need an external $100 billion to pay off their obligations?

$100 billion is $330 for every man woman and child in the US. Iirc AIG has had nearly $200 billion straight from the taxpayer. Isn't that proof of a flaw? If AIG was a "small" problem, I would hate to see a big one.

Moreover, my point is that CDSs allowed institutions holding large CDO positions to claim/believe they were protected/hedged...hence allowing further increases...but all this did in the case of AIG was remove the risk from one institution (allowing it to expand its holdings and hence the securitisation mess) to another (AIG) and hence to the taxpayer.

The double whammy to the average Joe is that house prices were also bloated by securitisation, and whilst there were some winners, on average, I suspect the average member of society has lost (in the end due to financial friction, i.e. increased mortgage interest, excess consumption with little utility etc.) So, you pay more for your house and you pay more taxes to bail out the system that created the conditions in which you had to over pay for your house (or more correctly, the piece of earth lying under it.)

I just cannot see how it can be argued that CDSs have been innocent in this whole mess? Meerkat listed a number of points in post 17 which I presume were meant to imply CDSs are/were a harmless sideshow. I don't believe it, and in the case of AIG it appears that 4 of the checks, which make a single CDS contract harmless didn't stop a herd of them causing massive problems.

My point is a simple one - we need to differentiate the types of CDS that AIG were dicking about with (which I for one am not defending), and those that are written on corporates. Completely different.

"If collateral posting was enough, why did AIG need an external $100 billion to pay off their obligations?"

IIRC AIG were AAA at the time and didn't need to post collateral. For CDS written on corporates, the notionals are massively smaller, the trading is both ways (rather than pure writer of protection like AIG - effectively selling out of money put options), and not all eggs are in one basket (not all names go bust at once)

Edited July 8, 2009 by Noel

[Tiger Woods?]

My point is a simple one - we need to differentiate the types of CDS that were dicking about with (which I for one am not defending), and those that are written on corporates. Completely different.

Sure thing, but you end up coming across as an apologist for the indefensible.

"If collateral posting was enough, why did AIG need an external $100 billion to pay off their obligations?"

IIRC AIG were AAA at the time and didn't need to post collateral. For CDS written on corporates, the notionals are massively smaller, the trading is both ways (rather than pure writer of protection like AIG - effectively selling out of money put options), and not all eggs are in one basket (not all names go bust at once)

This is the difference between insurance and gambling. As you said, what AIG did was gamble by selling puts. I've got no problem with the use of derivatives to stabilise/derisk cash flows, but as I think I argued with you some months ago, the size of the notional on outstanding OTC derivatives, whilst clearly overstating what is at risk, suggests that there is a lot of gambling going on, as the notional values of the underlyings are more than a rough estimate of the "value of everything."

Also, in the case most relevant to HPC, I suspect CDSs allowed securitisation to get even more out of control than they otherwise would have. Whilst this hasn't been the sole cause of the mess that we are in, the housing market is one that will directly affect many, and we should be protected from it. I'm just not convinced that modern financial innovation has improved the well being of the masses - rather, quite the opposite.

[aa3]

Its alarming to me that the government hasn't regulated cds yet. Great countries and companies make mistakes, then recognize them and take corrective action.

What I see in the western nations is the states are so incompetent/weak/corrupted that when exploits are found and pushed they don't close them. The analogy is often used close the barn door after the horses have fled. Well this is like just leaving the barn door open even as you buy new horses.

Why would any investor buy investments in these countries where there is poor regulations, blatant fraud, quasi fraud, constant accounting 'irregularities' and 'mis-estimates' - with no or very rare prosecution of the fraudsters.

[Meerkat]

The CDSs created to provide insurance for the CDOs? We all know that securitisation is perfectly harmless. Over $100 billion of US taxpayers money didn't flow out to the banks through the bailout of AIG's CDSs

Yep, I agree, there was no problem.

That was sarcasm in case it wasn't obvious. You can argue that it was the CDOs (or whatever else you like) but CDSs "allowed" banks to take even bigger risks 'cause they had bought "insurance". Of course AIG had insurance too...provided by the taxpayer. This is the problem. CDSs are zero sum only until one counterparty becomes insolvent. This seems to be a blind spot for everyone who comes on here defending the (over)use of derivatives during the past decade...the counterparties involved were huge companies, their positions were clearly highly correlated, and their failure has had real effect...which kind of makes a laughing stock of your point number 5 in post 17 above. Clearly AIG were amateuers (or crooked). Similarly, credit may not deteriorate overnight, but it certainly deteriorated fast enough to destroy a few banks and insurers (your point 1). Point number 2 was dealt with above, and as for point number 3, clearly AIGs VaR calcs were out too.

I take your criticism. In fact at the time of posting I thought of expanding on CDO's and VaR - as you say, if it is not calculated adequately and risk accounted for properly, then it's either gross negligence or recklesness and definitely something you would have thought an insurer must have a clue about, putting it ironically. I am no lawyer and cannot comment further on possible legal punishment, but I can guess smaller crooks would be imprisoned while the big ones bailed out, paid nice bonuses etc. But it has nothing to do with CDS as a derivative/speculative instrument within a reason.

[Meerkat]

My point is a simple one - we need to differentiate the types of CDS that were dicking about with (which I for one am not defending), and those that are written on corporates. Completely different.

I completely agree to this.

[Tiger Woods?]

I take your criticism. In fact at the time of posting I thought of expanding on CDO's and VaR - as you say, if it is not calculated adequately and risk accounted for properly, then it's either gross negligence or recklesness and definitely something you would have thought an insurer must have a clue about, putting it ironically. I am no lawyer and cannot comment further on possible legal punishment, but I can guess smaller crooks would be imprisoned while the big ones bailed out, paid nice bonuses etc. But it has nothing to do with CDS as a derivative/speculative instrument within a reason.

The problem is that the pay and career structures are such that in the good times there is strong short term incentive to ignores proper risk controls, not just from the bonus boys, but also from the shareholders (e.g. see how Llyods was punished in the years up to 2008 by shareholdres who thought they were being too cautious). Non-pliant risk managers are given the sack (e.g. the HBoS case) as they are seen as unreasonably standing in the way of profit$ during the "new and wonderful paradigm".

In summary, the argument that CDSs are harmless is, in my opinion, rather similar to the NRA's "guns don't kill people". Everything has to be evaluated under the assumption that venal, cupid, (and possibly stupid) people are going to be involved. Nothing is wrong with CDOs, CDSs, etc., other than the fact that people will abuse them and these tools allow them to cause much more havoc than they would be able to if they didn't have them (or their use was more controlled). This mess would not have happened if lending institutions had to keep most of the risk on their own books. There would be vastly fewer liar loans, vastly less mortgage fraud, lower LTVs etc. Sometimes all insurance does is allow people to behave more recklessly. Perhaps we need to limit the amount of risk that banks can move off their books to focus their institutional minds on what they are actually doing. It's difficult to know where to draw the line, but certainly things have been far too lax in the past decade.

Edited July 8, 2009 by D'oh

[Meerkat]

The problem is that the pay and career structures are such that in the good times there is strong short term incentive to ignores proper risk controls, not just from the bonus boys, but also from the shareholders (e.g. see how Llyods was punished in the years up to 2008 by shareholdres who thought they were being too cautious). Non-pliant risk managers are given the sack (e.g. the HBoS case) as they are seen as unreasonably standing in the way of profit$ during the "new and wonderful paradigm".

In summary, the argument that CDSs are harmless is, in my opinion, rather similar to the NRA's "guns don't kill people". Everything has to be evaluated under the assumption that venal, cupid, (and possibly stupid) people are going to be involved. Nothing is wrong with CDOs, CDSs, etc., other than the fact that people will abuse them and these tools allow them to cause much more havoc than they would be able to if they didn't have them (or their use was more controlled). This mess would not have happened if lending institutions had to keep most of the risk on their own books. There would be vastly fewer liar loans, vastly less mortgage fraud, lower LTVs etc. Sometimes all insurance does is allow people to behave more recklessly. Perhaps we need to limit the amount of risk that banks can move off their books to focus their institutional minds on what they are actually doing. It's difficult to know where to draw the line, but certainly things have been far too lax in the past decade.

I think you have clearly answered yourself: the problem is not with CDSs. The problem is with moral hazard, business ethics, understanding of risk and proper accounting/reporting. The problems are exactly in liar loans in your context. The problem is very basic. The dear leaders and media would love to "transfer" the weight of the trouble onto more "sophisticated" shoulders that 99.99% of society have no understanding of. Convenient. And shout for more regulation where it is exactly not needed.

Edit:

Perhaps we need to limit the amount of risk that banks can move off their books to focus their institutional minds on what they are actually doing

That's not a bad idea by the way. The problem was at the very bottom, so why not to tackle it at that level rather than unnecessary complicate the whole situation by finding a convenient scapegoat. Edited July 8, 2009 by Meerkat

[Tiger Woods?]

I think you have clearly answered yourself: the problem is not with CDSs. The problem is with moral hazard, business ethics, understanding of risk and proper accounting/reporting. The problems are exactly in liar loans in your context. The problem is very basic. The dear leaders and media would love to "transfer" the weight of the trouble onto more "sophisticated" shoulders that 99.99% of society have no understanding of. Convenient. And shout for more regulation where it is exactly not needed.

Edit: That's not a bad idea by the way. The problem was at the very bottom, so why not to tackle it at that level rather than unnecessary complicate the whole situation by finding a convenient scapegoat.

This is where we differ, I suppose. Whilst I agree with you that, as an abstract entity, a single CDO is pretty harmless, their existence in large numbers, in combination with basic human behaviour leads to liar loans. I don't think you can just tackle it at the ground level. Derivatives CANNOT be taken out of this context. Governments don't want regulators to spoil the party, so make them toothless; department heads push long term risk for short term bonuses etc. So, I do think that part of the trouble is with the existence of CDOs/CDSs. There is also blame to be placed on the government and its regulators. There is blame to be placed on those who lied on loan applications. There is blame to be placed on mortgage brokers. There is blame to be placed on valuers and real estate agents. There is blame to be placed on ratings agencies. There is blame to be placed on the media, especially the BBC which should not be driven by political or commercial interests, in failing to educate the public in economic history instead of ramping away with the best of the VIs. There is probably even blame to be placed on Japan and China.

The way I look at it, WWI would have happened regardless of the existence of the machine gun, but the machine gun made matters much, much worse and prolonged the slaughter. CDOs and the associated CDSs performed the same role in the property aspect of this crisis.

I think we will have to agree to differ, but can you really assert that without securitisation and the sort of insurance provided by CDSs that this bubble would have gotten as big and as bad as it did? I just cannot see that it would have gotten so crazy without these instruments to siphon off and/or hide/obfuscate risk.

Edited July 8, 2009 by D'oh