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.

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…