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…