Credit default swaps held without an underlying “Insurable Interest” violate public policy– and should be deemed NOT legally enforceable, ab initio and nunc pro tunc. Reverse all the transactions and the speculator manipulators get their premiums back– instead of allowing them to destroy the entire world economy.
Failure of financial journalists to at least explore/discuss this critical thesis regarding the looming credit default swaps deathstar is another example of how they have been “captured” by Wall Street, have helped to institutionalize corruption in the financial markets (by their intransigence, and worse), and of the fact that they no longer serve the public by speaking truth to power– no matter how they may occasionally pretend otherwise.
By David Merkel CFA
Let’s take a short break from “all credit crisis, all the time.” I want to talk about an issue that troubles us in a number of ways. The legal doctrine of “insurable interest” [II] is critical to the life insurance industry. II states that only those with a direct economic or (sometimes) sentimental interest can seek to buy life insurance on another person. The sentimental interest is limited to close family, and sometimes friends, if approved by the insured.
This protection exists for several reasons:
- Insurance exists to reduce risk, not promote gambling.
- The tax-favored nature of life insurance relies on the idea that it is helping people who would be harmed by the death of the insured. Absent that, the IRS will eliminate those favors.
- We don’t want to raise the risk of murder by allowing anyone to take out insurance on another person. Even though murder by the policyholder would invalidate the claim, that can be hard to catch.
Now, those who know me as a life actuary know where I am going next. I’m going to complain about stranger-owned life insurance, viatical settlements, premium financing and the like. Good guess; I’ve written about those before. I’ve turned down job offers in that area for ethical reasons. You only get one reputation in the business, so you better guard it carefully.
But, that’s not what I am going to write about, much as I think that many of those practices should be outlawed. I’m going to write about credit default swaps.
Wait. What do credit default swaps have to do with insurable interest? Legally, nothing at present. This article will suggest that there should be a link.
Insurable interest exists to protect the insured, a natural person, against increased risk of death from policyholders seeking to do him harm. Corporations are corporate persons under the legal code. Should they not get the same protection?
Credit default swaps pay off when a corporation “dies.” I know there are additional complexities here, but play along with me for now. There are parties that get hurt when a corporation dies:
- Sponsored pension funds
- Debt/loan holders
- And maybe more…
They have an insurable interest in the continued well-being of the corporation. They should be allowed to issue credit default swaps to the degree that it allows them to hedge their exposure, and no more. Any excess exposure is gambling, not insurance, and should be forbidden by law.
Yes, like Charlie Munger, I believe that gambling should not be legal on public policy grounds. Credit default swaps are not insurance as the regulators define today, but they should be regulated as insurance, and only financial guarantee insurers should be allowed to insure it, and those seeking insurance should prove insurable interest, or the contract is null and void.
Now, if you see my logic, forward this article to your Senators and Congressmen. Let’s change the dynamic that has introduced so much speculation into the bond markets, where there is more credit default swaps than there are bonds available.
At a time like this, when many things are coming unhinged, this is just one more thing to set right, so that we can have a more stable financial system.
This entry was posted on Friday, October 10th, 2008 at 12:47 am and is filed under Best Articles, Ethics, Insurance, Structured Products and Derivatives. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.
- Tom Fisher Says:
October 10th, 20087:53 am at
- David, this hits the nail on the head. I’ve been hoping that one of the long-term outcomes of the current crisis will be a move to transparency and order in CDS and other currently-unregulated instruments. Part of the reason the credit markets have dried up is that no one is sure who’s holding which derivatives.
- Estragon Says:
October 10th, 200810:06 am at
- Just a thought, but if insurable interest is required for a US CDS to be valid, what’s to stop a market from developing elsewhere?
- David Merkel Says:
October 10th, 200810:25 am at
- Estragon, I thought about that, and though you could not keep a parallel market from developing, you could deny the enforcability of contracts via US courts to US parties not validly entering into such contracts.
- donald durr Says:
October 10th, 200810:20 pm at
- Earlier this evening, I told a friend about my scheme for paring the swaps mess down to size.
- For the SEC to declare all swaps transactions null and void where the holder has no direct financial interest in the underlying,and all swaps held by any holder which are in excess of the holder’s interest in the underlying. Premiums paid to the seller to be returned to the holder.
Now, how big is the problem?
- I see no difference between swaps and betting on the ponies with a guy named Sal in the parking lot at Churchill downs. What is the first thing the cops do when they bust Sal?
- zgveritas Says:
October 11th, 200811:56 am at
- The swaps problem is elephant in the room and poses the most danger to our financial system as a whole the way I see it. I am glad you are bringing this up. I think you need to keep searching for a solution to the problem via this forum until it gains traction in the business media.
- I would like to punish hedge-funders who wrote default insurance in violation of state and federal insurance laws or fraud statutes. Or take away their trading licenses. This will be hard to do since no one will come forward and expose themselves. Also many are offshore. It could be better to tax gains from “premiums” or from realized profits on “credit events” at 100% where there was no insurable interest just speculation.
- One problem that will arise with insurable interest is that are certainly hedges that are legitimate but indirect. I could hedge my Dow index longs by owning CDS on individual Dow components.
- Barry Says:
October 11th, 20083:40 pm at
- Risk management/transfer requires both speculator and hedgers. Speculators often provide the liquidity to make hedging possible in the first place.
- The Chicago futures exchanges thrive becuase of but literally thousands of speculators with no ‘insurable interest’ are willing to one side or the ohter in an interest rate transaction.
- The real problem with CDS (as structured now) is that that they are options for which there is no underlying hedge. The only hedge for CDS is to find someone to take some or all of the other side. And in many cases, these people are, God forbid, speculators with no insurable interest.
- dlr Says:
October 14th, 20084:53 pm at
- An even bigger elephant in the room is the fact that brokerages and most hedge funds are legally allowed to have margin accounts with as little as 15% of their own money. This is irresponsible beyond belief.
- David Merkel Says:
October 14th, 200811:31 pm at
- dlr, do you have any evidence for this? This could just be the new portfolio margining rules, which require other risk offsets.
- Lawrence Kramer Says:
October 16th, 20085:57 pm at
- Excellent article, which I found by Googling on , because I thought this was a useful idea and wanted to see if anyone had blogged on it.
- I would add to your thought that no regulatory action needs to be taken to blow this thing up. All that has to happen is for the issuer of a CDS to refuse to pay, claiming that the CDS is an unenforceable “wagering contract” under applicable law. I don’t know what jurisdiction would hear this claim – there may even be arbitration provisions – but public policy arguments trump all others, and it would seem to me that somewhere there is a judge who is willing to disallow a claim on a CDS, especially when evidence is presented that the claimant actually participated in a short atttack intended to take down the “insured” business.
- Beyond having their CDS’s voided, the holders of these things may also be held liable for the destruction of the insured business. I’m not sure what the theory would be, but lawyers like to say that there is no wrong without a remedy, and although there are cases where that maxim is wrong, there are many more where judges make it right.
- Staying tuned is definitely in order. Good Work!
- Lawrence Kramer Says:
October 16th, 20085:59 pm at
- For some reason, your software swallowed the thing I Googled on: it was the ting you’d expect for this article to emerge as the first hit.
- Lawrence Kramer Says:
October 16th, 20089:26 pm at
- It’s worth noting that the CMFA preempts state gaming laws. Still, I would think a pretty good case could be made that a CDS without an “insurable interest” is against public policy for the reason that it promotes the destruction of the insured thing. Many states rely on that rationale, which is entirely unrelated to gambling, in holding life insurance policies void or their proceeds payable to the insured’s heirs where the policyholder has no insurable interest. Such state action does not appear to be preempted by the language of the CMFA, but I haven’t researched the subject.
- Tom Armistead Says:
October 25th, 20087:07 pm at
- Very good article – I hold the same opinion about insurable interest and have been writing to my congressmen and state and federal regulators on the issue.
- Credit default swaps should be regulated as insurance, with a requirement of insurable interest as well as supervision of capital adequacy.
- I suspect that “naked” cds are unenforceable as a matter of public policy…