An Insurance Blog by Jason Galanis
Just recently I (Jason Galanis) was taken aback when my daughter, who was smart enough to stay out of my business, asked me whether a Credit Default Swap was insurance or a derivative. My answer must have seemed haltingly disingenuous as I informed her back that it was quite frankly both. Insurance to the extent that it provides a guarantee on a bond yearly for a basis point percentage of its value. It was a derivative to the extent that it, like a call option, had an underlying relationship with a security.
The real trick with Credit Default Swaps, however, is they were never treated as insurance products thus never had to secure any reserves against what payouts might be made. And that is understandable as they were created in the laboratory that was the investment bank of JP Morgan. Their true brilliance may have been the fact that they straddled both worlds without firmly placing a foot in either camp.
However, when the credit crisis began in 2008 these seemingly simple innocuous instruments almost bankrupted the insurance giant AIG. How was it that people at the top layer of sophistication made so many mistakes. The answer is that the economy, like the space shuttle, is a giant complex machine for which no one knows all the answers and no one can see everything going on at once.
It started at home in America with the mortgage business where sub prime lending hit a peak. Every family was looking to buy a home and would be entrepreneurs were looking to buy several as investment properties. This was enabled by the banks need to lend which was fed from the markets need for paper. This paper was created from the invention of another derivative no more pernicious than the CDS but one which could be used improperly enough to almost cause another Great Depression; the MBS.
Mortgage Backed Securities had been around since Salomon Brothers put them together decades earlier. The difference was the quality of paper that was filling the new bond. Shrewd businessmen had convinced rating agencies of the actuarial sense that the US housing market had never significantly headed downwards and as such any grouping of mortgage bonds deserved a triple A rating. This was the classic example of extremely elite investment bankers getting over on their lesser counterparts who very likely wished they were sitting in the chair across the table.
Nevertheless, neither CDSs nor the MBSs are responsible for the turmoil afterwards. Both were innovative instruments that have the power to do a lot of good for mankind. It is the human error and greed that turned what should have been helpful tools into “weapons of mass destruction”. So how was it that they created the demise of insurance giant American International Group? That is a story for my next posting.
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