The Case for the Share Standard – Part II

In Part I, I described the Share Standard as the principle that every transaction relating to corporate stock should be backed by actual shares of that stock. I believe that implementation of the Share Standard would prevent the kind of meltdown we have recently experienced. Indeed, I submit that much of the nonproductive speculation infecting the markets is the result of the Share Standard not applying. And, more important, I believe that the attendant mischief, once tolerable because not sufficiently scaled to do damage, has become intolerable with advances in financial and information technology.

Before making the policy argument, I want to continue to catalog the most common stock transactions and their status under the Share Standard. So far, we've seen that purchases and sales of stock actually owned satisfy the Share Standard. Covered calls also satisfy the Standard, but only so long as they remain covered, i.e., for so long as the writer holds the shares subject to the call. Thus, if the Share Standard were in effect, covered calls would have to be sold with the shares to which they relate as a single package, or the call would have to be repurchased before the shares are sold.

It is also clear that “naked” short selling – selling shares that the seller has not even borrowed – violates the Share Standard. But what about traditional short selling? Here an analogy to the gold standard may be useful. Under the gold standard, I can issue money that can be redeemed for gold if I own the gold and have not issued more money than I have gold. Suppose, though, that I wanted to issue money against borrowed gold. Sounds odd, but if the owner gives me custody and control of the gold, and permission to redeem money with it, I could issue good money against that gold.

Traditional short selling meets this model because the borrower does get title and thus the power to deliver the borrowed shares. The shares are tied up against being used to support other other transactions (other than subsequent sale by the buyer). So long as only one person can use the shares to support a net zero position (one long and one short), so that the net long position of all trades equals the net shares outstanding, the Share Standard is satisfied. And short selling meets that test.

Returning to derivatives, put options follow the same logic as call options. A “covered” put - a put against shares one owns - is within the Standard, but a naked put - the right to sell shares one does not own (unless one owns a call against them) - is not. This is where the Share Standard begins to pay its way as a mischief deterrent. A put is to a company's shares what a credit default swap is to its debt. Indeed, one imagines that the defense offered for the issuance of naked credit default swaps was that they were like naked puts, and “everyone knows” that naked puts are OK; they've been around for years. But a naked CDS is simply an insurance policy on the life of a company in which the holder has no insurable interest, so a naked put must be the same thing. Even if the technology doesn't exist to exploit the moral hazard in naked puts – or the naked CDS provided a better opportunity – the complete lack of benefit to the "society” (i.e., the market), suggests that naked puts should be banned.

The systemic damage done by credit default swaps is greater than the damage done by naked puts because credit default swaps do not have market-based counterparties. When I buy a put, someone else sells one. The sellers of puts are diffuse, so the risk of loss is diffuse. With credit default swaps, one seller may be responsible for billions of dollars of risk. But systemic damage can be done through effects other than concentrated risk. The “innocent” victims of naked CDS contracts are the companies on whose “lives” they are issued. Those companies became attractive targets for bear raids, implemented through transactions that could not have occurred if the Share Standard had been in force.

To put the matter another way, there is every reason to believe that naked CDS contracts created an incentive for unscrupulous traders to mount bear raids on innocent companies with the object of using a drop in their stock price to call into question their credit ratings, which would start a death spiral for the company and make the short sales and the CDS contracts pay off handsomely, at least if the party writing the CDS honored them. But if naked CDS contracts can cause this sort of damage to third parties, the fact that they are analogous to naked puts suggests that naked puts are themselves subject to manipulation.

It may be that the scale of the options market makes it impractical to buy enough puts to justify a bear raid, but that ignores the fact that a bear raid provides its own reward, so that the naked put is just gravy. In any event, I'm not aware of a “good” use for a naked put that cannot be served by some other device that conforms to the Share Standard, so I don't know why they would be allowed except for the inconvenience of policing a ban.

I should point out that my concern here is precluding mischief, not preserving conceptual purity. Thus, I would not argue that the Share Standard apply to transactions in ETFs or investment companies. Such entities are petty much immune to bear attacks and short squeezes, and all the other things that can go wrong if the Share Standard is not enforced.

Which brings me to the best thing about the Share Standard: whereas it is a radical change in the regulatory environment, it is not a complex and intrusive regulation. A list of barred transactions and exempt securities is all that would be required. (The exempt securities list is important. Just as fiat money expands the opportunities for economic growth, the ability to bet for or against the market, or business sectors may add liquidity and equilibrium to the overall market. At least, I would be open to someone making that case, because the opportunities for mischief are dramatically reduced by imposing the Share Standard on individual stocks.

Update, 5/24/10. Germany seems to be getting the idea. Javol!

The Case for the Share Standard – Part I

You all remember the gold standard. Some trogs still push it today as a remedy for so-called “fiat” currency. I think the gold standard invokes a sound premise, even if the actual standard itself fails to make the best use of it.

The premise behind the gold standard is that money is a token of worth. If I own the only piece of gold in the world, and gold is the only thing of value in the world, I can say to a neighbor “If you survey my land, I will give you 1/1000 of my gold, and, rather than burden me with cutting it and you with storing it, I'll just give you a piece of paper that says you can have the gold if you want it. You can give the paper to anyone you want in exchange for something they do for you. And I'll promise to store the gold where you can see that it's there.”

That's money created on the gold standard. My neighbor accepts the paper because he knows I have the gold and that his piece of paper is “convertible” into it at any time. The problem with the gold standard is that I also own my land. Why not promise him a piece of the land? Well, it's awkward to cut up land to redeem a piece of it, and land is not fungible. But it has value – or should – and so I should be able to use it at collateral in the creation of money. I mean, if I could so use it, I could get more things done, creating more jobs in the economy, etc.

The gold standard is just too limiting once the technology exists to use other things as stores of value. And when enough things can be used as stores of value, it become most efficient to create a central bank to issue money, first on the pledge of actual things of value, but then on the credible promise of the creation of unspecified things of value, or even on the promise of tax revenues. And so it becomes possible for governments to generate money that isn't really tied to a reliable store of value.

All this means is that that fiat money is like fire. You can cook with it, and you can smoke in bed and burn your house down. But I'm not here about the gold standard, so its fate will have to wait. I'm here about the Share Standard. I just mentioned the gold standard to provide some conceptual underpinning.

The Share Standard is the principle that every transaction relating to corporate stock should be backed by actual shares of that stock. For example, when I buy or sell a share, I am “betting” that the stock will perform in a certain way relative to other opportunities, but to do so I actually have to change the number of shares of stock owned by people (including myself). I will own more or fewer shares, and the guy on the other side of the trade will own a correspondingly different number. Our trade will be “in” the market and part of the market.

The case for the Share Standard is very simple: the ability to bet on the market without actually participating in the market creates conceptual opportunities for mischief, and the convergence of aggregated money, technology, and deregulation have made the mischief a reality.

The Share Standard does not preclude sophisticated derivative instruments. If I sell someone an option to buy shares I own at a fixed strike price, the option relates to actual shares that I control, and there won't be any more options written than are readily available to satisfy them if they are exercised. Because the option is backed by real shares, it is consistent with the Share Standard. To stay true to the gold standard analogy, however, it is important that I continue to hold the shares. If I sell the shares, the option becomes a "naked" call, and the Share Standard is violated.

Under present law, I can write a call option on shares I don't own. There is no way of knowing whether there will be shares available to meet the promise of such an option. I may have to buy shares to meet my obligation under the option contract, and the need to buy shares when lots of other issuers of naked calls are trying to buy them creates an artificially high demand for shares (in the sense that the demand is not driven by belief in the underlying company's prospects relative to the price of the shares). That sort of buying frenzy cannot happen if all of the options issued are exercisable against people who already own shares. The covered call meets the Share Standard, but the naked call does not.

In the real world, of course, naked calls are rarely exercised. The buyer is “betting” on an increase in the share price, not looking to acquire the shares on the cheap. So, as a practical matter, many “in the money” calls are just sold back the people who wrote them for something like the difference between the current value of the stock and the strike price of the option, and the buying frenzy is averted. But one could imagine a powerful option holder buying up shares in anticipation of the expiration, and then demanding actual delivery. He could sell his own shares to the option writer at an artificially heightened price so that the latter can redeliver them at the strike price. And then sell the option stock into the high market as it settles back down. I don't know whether this sort of thing goes on, but the technology and wealth exist to make it feasible, and the availability of naked calls makes it possible.

The share standard is especially relevant to the short side of the market because of an important assymetry: it is easier to wreck a company than to make it succeed by manipulating its stock price. We'll consider the short side in Part II.

We don't need no stinkin' counterparties.

The latest outrage is that AIG took the TARP money it got to pay its counterparties and gave it to – wait for it – its counterparties. Yikes. What's next? Will the FDIC start paying depositors of failed banks without due regard to their political popularity? And what about those promises AIG made to its pension customers. Some of those guys are rich. Why should they get bailed out? And plaintiff's lawyers. Everybody hates them. Why are their fees being paid by taxpayer money? Where will it end?

I say it stops now. Every recipient of TARP funds must sign a pledge that for every dollar it receives from the program, it will increase by one dollar the amount it lends to people with bad credit. That is the only way Mr. Cuomo can be sure that no one who doesn't need the money gets any money. I understand that this approach may pose certain risks to the global financial system, but this is a demagocracy, and there are Gubernatorial races to be considered. We just cannot have people who already have money getting more of it, even if restoring their confidence in the system is why the money was given out in the first place.

Defending the Brand

Why do people buy Tylenol instead of generic acetaminophen? They're the same medicine. Yet lots of people do buy Tylenol. Why? They trust the brand! They believe a bottle labeled Tylenol will contain pure, safe, acetaminophen. That other bottle? Who knows. We don't know who makes it. The brand matters.

Why did our trading partners buy US AAA-rated securities? Lots of credit worthy entities are out there borrowing and paying more interest. Why go for the expensive paper? It's the brand. US AAA-rated. Aside from Treasuries, there is nothing more secure, nothing more reliable. If lenders couldn't trust that rating, borrowers would have to pay an enormous premium to get money. Investors who once looked only at the rating would have to inspect issuers in far greater detail and then form their own fallible judgments, discounting along the way for their own fallibility. Some might stop lending entirely to anyone but the Treasury.

That, indeed, is what happened to our credit markets. The silly interest rates at which our fast-spending government is able to borrow these days result from its having the only good brand name of any seller of dollar-denominated paper. Plenty of "generics" are out there, but they are rated by outfits with tarnished brands. Why would anyone trust those ratings? And the underwriters themselves? Can we count on their probity? Their financial strength? Not hardly.

This, then, is the real challenge facing the stewards of our economy. How do we restore the brand? How do our trading partners find the confidence to lend to and through our financial institutions rather than to the U.S. Treasury?

The rescue and bail-out efforts underway make sense if viewed through the lens of brand protection. In effect, the Fed, the Treasury and the FDIC have collaborated to make good on every AAA-rated piece of paper they can – I hope they find a way to disavow credit default swaps in the hands of non-creditors – visiting losses on the equity holders of the entities that issued them and absorbing the rest on behalf of the US consumer. I say “consumer” rather than “taxpayer,” because it is our continued ability to consume that is at stake. We need to understand that it is as consumers that we have banded together to keep the credit flowing. The tax system just does the bookkeeping.

We also need to understand that no institution has been bailed out for its own sake. No one in government is resisting the equity losses or even the job losses at major financial institutions. What they are resisting is the failure of the brand – the failure of an American dollar-denominated, AAA-rated instrument to pay off. We need the rest of the world to believe that such documents will never cause them a loss. Who has to be saved along the way – and who has to be given a retention bonus to stay and pay – is purely coincidental. That's why all this fuss about foreign banks getting TARP money is completely misplaced. The whole point of TARP was to enable American institutions to pay their counterparties, whoever they were. It wasn't to “protect” anyone from loss, per se; it was to protect the brand by seeing to it that there was no loss to those who trusted it.

The damage to the brand has affected the components that make up the brand, and each must be restored if the brand is to be restored. For example, were we to wake up tomorrow in the presence of a ratings agency that had magically earned the credibility of the world, that agency would be unable to issue any AAA ratings because the rated entities have “toxic assets” on their books, making them unworthy of the AAA rating. Those assets were once AAA-rated themselves, but that was by the old ratings agencies whose ratings don't mean anything anymore. So, the new agency has to re-rate all the bonds on the banks' balance sheets in order to determine whether the bank itself can have a AAA rating. Even then, a market would have to develop for the re-rated assets. It's a very daunting task. And, anyway, there is no such ratings agency.

In the meantime, the banks are at least trying to establish the value of their own capital in light of the government's likely insistence that they bolster their balance sheets. The PPIP plan (see posts below) should do a good job of establishing the capital base of the banks. But then, what of the ratings agencies?

I'm afraid they may be done for. I think something like Underwriters Laboratories, an independent entity funded by users of ratings, is the way to go. Eric Dinallo, the head of the New York Insurance Department, proposed something like that this morning. That model should work, but it will take time to create such an entity. Indeed, the Government should consider nationalizing S&P, Moody's and Fitch's ratings operations, paying fair compensation for the infrastructure – the brand is not worth much – and hand them over to an independent board to merge and run. Once the reliability of ratings is restored, lending to the private sector can begin again in earnest, subject to the capital constraints discussed in my previous post.

Until then, perhaps something like real underwriting will occur, with well-capitalized investment banks standing behind the paper they sell as proof that they are not in it only for the fees. There are lots of way for the underwriter to have some skin in the game, and I don't believe it matters which one is used. But until we have a buy-side ratings agency, the only way the American brand can be saved is for the sellers of our paper to stand behind it.

Financial Bandwidth – You're gonna need a bigger pipeline.

Tom Friedman has been quoting Roy Scheider's character in Jaws on first seeing the great white shark: “You're gonna need a bigger boat.” Friedman is talking about the size of the financial bail-out, the amount of money the Government is going to have to throw at the problems of our banks and other financial institutions to get them running again. I'm not sure I agree with Friedman on that claim, but I do know that if we restrict the leverage that those institutions can carry, we're going to need a lot more capital, and I don't know where that will come from.

Sec. Geithner says that the key to avoiding future meltdowns is “capital, capital, capital.” The Secretary's position bespeaks a sound, minimalist approach to regulation. The idea is that if financial institutions have a sufficient capital base, not only will they have a cushion with which to cover losses, but also, because they have so much capital at risk, they will take less risk with the money. As I said, this is sound thinking.

The problem with the Secretary's position is that excess leverage does not arise in a vacuum. Excess leverage arises when there is more cash to move than capital available to guaranty it. Think of Wall Street as a pipeline through which import dollars flow back into the American economy. An actual oil pipeline has to be big enough and strong enough to reliably carry oil from the well to the seaport. But size and strength are competing requirements: the thicker the walls of the pipe, the less its inner diameter and the less oil it can carry. Yes, the pipeline can be strengthened by adding thickness to the outside, but only if there is room in the system for a wider pipe. In many cases, it would appear to be easier to line the inside of the pipe without changing the shape of the pipeline than to accommodate an increased gross diameter. At least one can imagine how that might be the case.

The same principles apply to the financial “pipeline” that returns dollars to the US. If the economy returns to the level of pre-crash activity, the amount of petro- and sino-dollars that need to be recycled here will return to the volume that was being processed by our 30-1 pre-crash system, and those dollars will have to flow through the same pre-crash pipeline, because that's all there is right now. But the pipe will have been narrowed by increased capital requirements.

A bank that leverages at 30-to-1 can repatriate $300B if it has $10B in capital. A bank that leverages at 12-to-1 can accommodate only $120B. So where does the other $180B go? How does it get into the country? Some of it will doubtless become bank capital, probably against the better judgment of its owners. If putting $1B at risk enables a sovereign wealth fund to invest $11B with much less risk, and at a return greater than Treasuries even with the capital haircut, that's probably a risk worth taking. Sheik Alwaleed Bin Talal already owns a ton of Citibank, so he's already providing some capital for his country's' reinvestment. But that's at pre-crash levels. Maybe he'll need to buy more. And maybe he'll have to provide capital to other banks.

But is this what we want? Our banks being bought up by foreign investors, not because they think the banks are such good investments but because that's the only way they can get bonds to buy. Under that scenario, one would expect our trading partners to by-pass the investment banks entirely, setting up their own direct investment offices and not being bothered by capital requirements. Then who will need the banks?

The question that remains to be answered by events is whether a 12-1 banking system, strong as it may be, will have the capacity to service enough of the money coming home. Or will its role be supplanted by entities created for that purpose by trading partners who find our banks too puny for their needs.

Public-Private Investment Program - A good Start (Part II)

How does a foreign investor choose a pipe for returning trade receipts to the US financial system? At the end of the day, it's all about brand power. Investors rely to a significant extent on the reputations of bankers. But the banker's brand is not the only one at work. No matter who brings them the deal, many investors insist that the deal be rated by American ratings agencies. Or maybe the investment banks won't sell them unless they are so rated. Either way, the rating is an important part of the process. Thus, if the ratings are unreliable, the credit flow seizes up, as the investors lose faith in the pipes.

The ratings problem is pervasive because everything gets rated. If an investor is unsure whether a given security is going to pay off, the investor can buy a credit default swap, or insist that the issuer buy financial guaranty insurance. But what's the first thing an investor asks about the provider of those backstops? Yep, “What's its rating?” I guess it's a bit like the actuary who carried a bomb with him on airplanes on the theory that the odds against there being two bombs on the same plane were astronomical. Two AAA-rated securities would have to blow up for the holder of AAA bonds backed by an AAA CDS to lose money.

But things are never that easy. If it turns out that the AAA rating on the underlying securities is bogus, the first natural reaction of the CDS holder is to wonder how good the CDS issuer's rating is. And as soon as enough people start to wonder about the creditworthiness of a company, it immediately becomes less credit worthy, because the doubts impair the company's ability to borrow, and a company that cannot borrow is more vulnerable than one that can borrow, and so deserves a lower rating. Thus does the mis-rating of the debt underlying a CDS – or underlying several – undermine the rating of the issuer of the CDS, without that issuer ever having lost any of its fundamental value or strength.

Before there were ratings, investors relied on the probity of investment bankers: the brand really counted for something. With the advent and predominance of ratings, investment bankers came to be relied upon more for their ingenuity – their deal-making ability – than their diligence, at least when it came to the acceptability of their offerings. Now, ratings are everything. So with ratings in disrepute, everything has become nothing.

The loss of foreign appetite for US AAA-rated paper has a more pernicious effect than merely reducing the flow of credit into the US. Many banks hold on their balance sheets loans and securities that they intend to sell to raise more money to lend. How these loans and securities are valued determines how well capitalized the bank is, and how well capitalized a bank is determines how much money it will be allowed to lend. So, while the loss of foreign dollars may impair a banks lending ability somewhat, the loss of value in its assets as a result of the foreign investors' unwillingness to buy them can shut the bank's lending down entirely. The rules for valuing bank assets are complex, but suffice it to say that suspicion about the quality of US ratings has caused enough bank assets to be devalued to cause regulatory capital issues for banks that are perfectly sound on an operations basis.

Banks' inability to value these assets reliably has caused their balance sheets to be suspect. That's why the assets themselves are considered “toxic.” The PPIP is intended to solve this problem by removing some of these toxic assets from the banks' books and, more important, by establishing for the rest a fair value that is sufficient to render the banks solvent again. Of course, it's not at all clear that the banks will want to part with any more assets than is necessary to establish a price. Once a value is established, the assets may provide as much credible capital as the cash they could get for them, and banks may conclude that the price being offered by the PPIP entities is less than the assets are worth to the bank. The prices will have to rise to historic pre-crisis levels before the banks are willing to sell new loans to the PPIP vultures.

The PPIP “detoxifies” bank assets in two ways. First, it detoxifies the ones that are actually sold; it puts them in the hands of an entity whose balance sheet is irrelevant. Second, the plan detoxifies assets that the bank holds onto; it does that by establishing a value for them thatpotential coutnerparties will take seriously. Yes, the value offered by the PPIP investor is not a true market value in the sense that the PPIP investment is subsidized, but a counterparty should not care why a bank has a buyer for its assets so long as the buyer is reliable. More important, the subsidized price offered by the PPIP investor will still be substantially less than its manager thinks the bonds will produce on a discounted present value basis. Thus, a potential counterparty deciding whether to lend to a bank that holds these assets can treat the asset as being “worth” at least the PPIP offering price in assessing the bank’s ability to repay loans.

By pricing the loans diligently, and taking a risk on them, the PPIP investor effectively stands in for the discredited ratings agencies. The PPIP manager is saying, in effect, “we at the management company have kicked these tires, and we think the loans will pay off sufficiently to cover our offering price and then some.” That is a source of confidence to potential bank counterparties (the aforementioned foreign investors), which is why the program may be very helpful in restarting the flow of money and credit.

Public-Private Investment Program - A good Start (Part I).

I like the Public-Private Investment Program. It effectively restores mark-to-model accounting by creating entities that will offer a mark-to-model price for banks' distressed assets. The banks are allowed to use mark-to-model accounting for such assets in seized up markets, but the rules are unclear, and no one would trust the banks' models anyway, so what would be the point? By creating entities with skin in the game, Messrs. Geithner and Bernanke and Ms. Bair have ingeniously allowed the banks to use mark-to-model accounting by getting someone credible to do the modeling. That's really very cool.

To understand how the PPIP fits into the "big picture," it’s important to understand why the credit markets don’t work now. And that starts with the trade deficit.

When we were not running a significant trade deficit, our banking system was essentially self-sustaining. Some part of the money we made found its way to banks, where it was recycled. And since the money we didn't save became money someone else earned, a part of that was also recycled, ad infinitum. At the end of the day, the money the economy needs was either printed by the government or recycled by savers.

But now that we are running a large trade deficit, much of the money we spend goes abroad to pay for things like oil and toys. This diversion of our money has two consequences: we need to borrow from abroad to finance things we would have financed ourselves, and foreigners have to lend to us to make the dollars they receive worth having. The recycling process continues, but with the money detoured through Dubai and Shanghai.

And New York. When there is no trade deficit, we deposit our money in our local banks. Yes, some money goes to Wall Street for investment, but we store a lot of it nearby where it can be relent to other Americans. Trade dollars do not come in through local bank deposits. They come in through money center (i.e., New York) banks and through the purchase of Wall Street securities that package loans created by banks and other lenders.

If you think of the flow of funds as a plumbing arrangement, the new setup has new pipes, and new pipes need to meet several requirements that there is no reason to believe they will meet without careful attention to their design.

Capacity. The first requirement of a pipe is that it have sufficient bandwidth to carry the water. There must be few bottlenecks in the inflow process. The entities involved must be able to operate on the scale required to process enormous volumes of money. This requirement does not exist in the non-trade-deficit scenario, where individual depositors make independent decisions and deposit their money in a wide array of banks which aggregate it into lendable pools. In the trade deficit world, the returning money is aggregated before it gets to New York; the depositors are large institutions and they want to deal with a small number of trusted large institutions. That's how we get the “too big to fail” problem.

Outflow filter. Even entities large enough to handle massive inflows of capital need a place to put the money they take in. I suspect that foreign investors returning trade deficit dollars through Wall Street are seeking, on average, greater safety than American investors would have sought if they were investing the money themselves. After all, people can speculate at home; a major attraction of investing here is (was?) safety. So we need to create securities with the right risk profile for the returning money. The problem is that American users of capital don't want or need capital with the risk characteristics that the foreign lenders are offering. Wall Street is thus charged with the job of restructuring investments to produce securities with the risk profile that foreign investors want. That process has problems, as shall see.

Leakage. Pipes can leak. The unprecedented increase in money flowing into the country through Wall Street has created opportunities for chicanery, temptations to corruption, and other ills that cause money to disappear. Liar loans, bear raids, naked shorting and credit default swaps, and corruptible ratings agencies all happen because new piping is vulnerable to corrosion. Regulation is a remedy, but remember that thickening the walls of a pipe may decrease its diameter, a metaphor that works very well for the effect of excess regulation of financial activity.

The current mess can be described as a case of the new plumbing springing a leak and foreign investors losing so much confidence in it that they have switched to an alternative inflow pipe – the U.S Treasury. The job facing our financial system, players and regulators alike, is to restore confidence in the private plumbing. The Treasury pipe just doesn't have the volume to handle the money our trading partners will need to invest if they are to continue to supply us with the oil we need and the toys we want. Obviously, reducing our demand for imports and increasing the world's demand for our exports will relieve the pressure, too, but that's a longer term project.

What Were They Thinking? – Moral Hazard and Credit Default Swaps

The subject of moral hazard comes up a lot in conversations about the Federal bail-out of financial institutions. Moral hazard is the tendency of people to be careless about risks they are insured against. If borrowers will be bailed out, the argument goes, lenders won’t pay attention to whether they’re worthy of credit.

“Moral hazard” is a technical-sounding term, but it describes a very easily grasped bit of human nature: people who perceive less risk take more chances. This simple truth applies to just about everything we do to reduce risk. For example, studies show that bicyclists who wear helmets have more accidents than those who do not. The injuries are not as severe, on average, but that’s the point. Less at risk, less caution.

Because moral hazard reflects how real people react to real situations, the only way to determine how much moral hazard a particular risk-reduction device creates is to look at the risks perceived. Insurance on one’s own life “works” because people do not engage in significantly more risky behavior on account of their lives being insured. Money cannot compensate us for the loss of our own life.

Life insurance on someone else’s life is another story. If the someone else is a loved one, we can expect that the owner of the insurance will not do anything to endanger the insured. Still, whenever insurance pays one person if another suffers harm, there are opportunities for what lawyers euphemistically refer to as “mischief,” so state law routinely forbids the purchase of insurance on someone else without that person’s permission.

And all states prohibit the issuance of insurance on the life of someone in whom the purchaser has no insurable interest at all. If people could buy insurance on total strangers, the temptation to foul play would be unavoidable and unacceptable. What constitutes an insurable interest is not always clear, but that’s because an insurable interest is a subjective thing: either you care whether someone dies or you don’t. But the law is clear that where there is no insurable interest, there can be no insurance.

A key aspect of life insurance (and insurance like health, fire, and auto) is that people have non-financial reasons for avoiding the relevant risk. In the financial realm, however, where only money is at risk, that risk can be completely eliminated, leaving the purchaser no reason to make any effort at all to avoid the loss. For that reason, most insurance arrangements that insure financial loss provide for “co-insurance”: deductibles, co-payments, or both. Those devices give the insured some skin in the game, and thereby reduce the moral hazard in the arrangement.

These observations point to three kinds of insurance arrangements, whatever they are called, that create especially high risk of moral hazard and, in some cases, the risk of intentional harm:

• Insurance that fully compensates for loss


• Insurance that pays on a third party’s misfortune


• Insurance that is not supported by an insurable interest

How does a Credit Default Swap (CDS) stack up to these criteria? A CDS, as an amazing number of people now know, is a contract that pays off if a company defaults on its debts. The CDS doesn't actually pay off the debt; it pays an amount equal to the default, whether or not the holder of the CDS was actually owed any money by the defaulting company.

Thus, a CDS:

• provides full financial indemnity against a purely financial loss.


• pays when a third party fails.


• can be purchased by someone who doesn’t hold the insured’s debt.

A moral hazard hat trick! As might be imagined, sharp operators took advantage of these flaws, buying CDS contracts on vulnerable companies whose debt they did not hold, then using various strategies, including so-called naked short selling, to bring those companies down to collect on the CDS contracts.

Regulators should have seen this coming. After all, Credit Default Swaps violate every relevant principle of underwriting and public policy. Why, then, are they legal? I can only guess that insurance people were not asked to think about them, or if they were asked, that their answers were ignored. (Insurance is such an arcane thing and all.) Instead, in what can most charitably be called an act of boneheaded stupidity, Congress tried in the Commodities Futures Modernization Act of 2000 to put CDS contracts outside the reach of state insurance laws. (Like all derivatives, naked CDS contracts expand the capacity of the system to move money. That's their only "good" point: if, as was the case before the melt-down, there is too much money coming ashore from abroad to process through the existing markets, fake securities may be necessary. But not these.)

States divide on what to do about life insurance policies written on a third party in whom the purchaser has no insurable interest. In some states, the contract is not enforced. In the more enlightened states, however, if the owner of the policy has not lied to the insurer, the latter is held as much to blame as the owner for the existence of the policy and so is made to honor the contract. But the proceeds are redirected from the purchaser to the estate of the deceased, even where the death is not actually caused by the purchaser.

Perhaps because financial services lawyers rather than insurance and tort lawyers have been consulted about Credit Default Swaps, the purported Federal preemption of state laws appears to be getting more respect than it deserves. Eventually, however, some clever tort lawyer will figure out how to get past the CFMA’s preemption language, and the proceeds of naked CDS contracts will go to the creditors whose loans their CDS contracts caused to go bad. Then they can go to work on the damage inflicted by naked short sellers. But that at least looks like another subject…