- moral hazard. 1. The risk that an insured will destroy property or allow it to be destroyed (usu. by burning) in order to collect the insurance proceeds. 2. The insured's potential interest, if any, in the burning of the property.
- There is also an athletic converse increasingly evident to anyone who closely watches college and pro football, too. I am seeing more and more receivers, running backs, and defensive backs who wear no padding whatsoever below the shoulder pads, given the hyper-competitive quest for that fraction-of-a-second acceleration edge.
...in the past few decades a particular idea has taken hold among prominent American economists which has also been a powerful impediment to the expansion of health insurance. The idea is known as “moral hazard.” Health economists in other Western nations do not share this obsession. Nor do most Americans. But moral hazard has profoundly shaped the way think tanks formulate policy and the way experts argue and the way health insurers structure their plans and the way legislation and regulations have been written. The health-care mess isn’t merely the unintentional result of political dysfunction, in other words. It is also the deliberate consequence of the way in which American policymakers have come to think about insurance. “Moral hazard” is the term economists use to describe the fact that insurance can change the behavior of the person being insured. If your office gives you and your co-workers all the free Pepsi you want—if your employer, in effect, offers universal Pepsi insurance—you’ll drink more Pepsi than you would have otherwise. If you have a no-deductible fire-insurance policy, you may be a little less diligent in clearing the brush away from your house. The savings-and-loan crisis of the nineteen-eighties was created, in large part, by the fact that the federal government insured savings deposits of up to a hundred thousand dollars, and so the newly deregulated S. & L.s made far riskier investments than they would have otherwise. Insurance can have the paradoxical effect of producing risky and wasteful behavior. Economists spend a great deal of time thinking about such moral hazard for good reason. Insurance is an attempt to make human life safer and more secure. But, if those efforts can backfire and produce riskier behavior, providing insurance becomes a much more complicated and problematic endeavor. In 1968, the economist Mark Pauly argued that moral hazard played an enormous role in medicine, and, as John Nyman writes in his book “The Theory of the Demand for Health Insurance,” Pauly’s paper has become the “single most influential article in the health economics literature.” Nyman, an economist at the University of Minnesota, says that the fear of moral hazard lies behind the thicket of co-payments and deductibles and utilization reviews which characterizes the American health-insurance system. Fear of moral hazard, Nyman writes, also explains “the general lack of enthusiasm by U.S. health economists for the expansion of health insurance coverage (for example, national health insurance or expanded Medicare benefits) in the U.S.” What Nyman is saying is that when your insurance company requires that you make a twenty-dollar co-payment for a visit to the doctor, or when your plan includes an annual five-hundred-dollar or thousand-dollar deductible, it’s not simply an attempt to get you to pick up a larger share of your health costs. It is an attempt to make your use of the health-care system more efficient. Making you responsible for a share of the costs, the argument runs, will reduce moral hazard: you’ll no longer grab one of those free Pepsis when you aren’t really thirsty. That’s also why Nyman says that the notion of moral hazard is behind the “lack of enthusiasm” for expansion of health insurance. If you think of insurance as producing wasteful consumption of medical services, then the fact that there are forty-five million Americans without health insurance is no longer an immediate cause for alarm. After all, it’s not as if the uninsured never go to the doctor. They spend, on average, $934 a year on medical care. A moral-hazard theorist would say that they go to the doctor when they really have to. Those of us with private insurance, by contrast, consume $2,347 worth of health care a year. If a lot of that extra $1,413 is waste, then maybe the uninsured person is the truly efficient consumer of health care. The moral-hazard argument makes sense, however, only if we consume health care in the same way that we consume other consumer goods, and to economists like Nyman this assumption is plainly absurd. We go to the doctor grudgingly, only because we’re sick. “Moral hazard is overblown,” the Princeton economist Uwe Reinhardt says. “You always hear that the demand for health care is unlimited. This is just not true. People who are very well insured, who are very rich, do you see them check into the hospital because it’s free? Do people really like to go to the doctor? Do they check into the hospital instead of playing golf?”...___ Exactly. I wouldn't go the the doctor were it "free," absent some compelling need. To be sure, you can always come up with the iconic ("anecdotalism fallacy") examples of people who engage health care services irrationally, either simply out of a mundane neurotic social need for "attention," or impelled by the more serious psychiatric clinical condition known as acute "Münchausen syndrome." For example, during my first tenure with the Nevada Medicare QIO in the early 1990's, my Sup and I tracked the acute care hospitalization travels of a Medicare beneficiary who cleary suffered from Münchausen, showing up in Admitting at a different hospital every few days, frequently in far-flung states. We tracked this patient through close to 500 admissions across several years before the patient finally died (we suspected there was a good bit of chronic "drug-seeking behavior" going on in this patient's M.O.). So, yes, of course, there will always be people who abuse any type of "entitlement" or "indemnity" system. Whether their sorry, isolated examples should drive policy is quite another matter, at least with respect to health care. But, that (rational health care policy) will be the topic of another in-depth post on another day. BACK TO THE FINANCIAL WORLD You might recall my citation of the Michael Milken quote in my prior "Tranche Warfare" post:
"In the gap between perception and reality, there's money to be made."An exemplar of true "moral hazard" (and worse) if ever there were one. Key to this idea is that of information asymmetry. If I am privy to critical relevant bargaining information and you are not, I can shape a deal to my advantage. Perhaps criminally so, in the extreme case (as Mr. Milken himself subsequently went on to learn up-close-and-personally via arrest, conviction, and incarceration). The fundamental canon of classical free-market capitalism, we do well to recall, is that of asserting the optimal economic and moral utility wrought by the aggregation of individual actors operating in pursuit of rational, focused self-interest -- abetted in this aim by the availability of universal, relevant information transparency. All cards on the table, with best-case "win-win" outcomes consequently expressed by and objectively evident in the choices made by the participants thusly expressing their value preferences. Done. How's that for encompassingly succinct? Right. Were it only the case. Beyond the requisite implications of the views of one-time Junk Bond King-of-Decision-Data-Asymmetry Michael Milkin, I give you the considerable empirical works originating with and stemming from those of "behavioral economists" Kahneman and Tversky. IRRATIONALITY, BORNE OF NAIVETE? OR PANDEMIC FRAUD? Writer Daniel Gross, commenting on the current economic fiasco, recently asserted that "while there was plenty of alleged criminal activity—ahem, Mr. Madoff—law-abiding, respectable citizens who were operating well within the confines of laws and regulations racked up the overwhelming majority of losses. Everybody—individuals, companies, institutions, and governments—got caught up in the stupidity." Really? "Overwhelming majority"? (Gimme a percentage: 80%? 83.47%? 90%?) Consider a countervailing, and IMHO considerably more learned view:
Individual “control frauds” cause greater losses than all other forms of property crime combined. They are financial super-predators. Control frauds are crimes led by the head of state or CEO that use the nation or company as a fraud vehicle. Waves of “control fraud” can cause economic collapses, damage and discredit key institutions vital to good political governance, and erode trust. The defining element of fraud is deceit – the criminal creates and then betrays trust. Fraud, therefore, is the strongest acid to eat away at trust. Endemic control fraud causes institutions and trust to become friable – to crumble – and produce economic stagnation. White-collar criminology emphasizes incentive structures. A criminogenic environment is one that has strong positive incentives to engage in crime. While economists stress incentive structures, economics ignores criminogenic environments. The weakness comes from three sources. Economic theory about fraud is underdeveloped, core neo-classical theories imply that major frauds are trivial, economists are not taught about fraud and fraud mechanisms, and neo-classical economists minimize the incidence and importance of fraud for reasons of self-interest, class and ideology. Neo-classical economics’ understanding of fraud is so weak that its policy prescriptions, if adopted wholly, produce strongly criminogenic environments that cause waves of control fraud. Neo-classical policies simultaneously make control fraud easier and more lucrative, dramatically reduce the risk of detection and prosecution by maximizing “systems capacity” problems, and encourage crime by making it easier for fraudsters to “neutralize” the social and psychological constraints against deceit and fraud. Thus the paradox: neo-classical economic triumphs produce tragedy... When Fragile becomes Friable: Endemic Control Fraud as a Cause of Economic Stagnation and Collapse, William K. Black, Executive Director, Institute for Fraud Prevention, IDEAS Workshop: Delhi, India, Financial Crime and Fragility under Financial Globalization, December 19-20, 2005 ______Back to Poster Boy Bernie (Madoff) for a moment. Recall my observation in "Tranche Warfare" -
Consider this lament by best-selling author Geneen Roth, in her recent Salon.com article "I was fleeced by Madoff": "I often asked Richard, the head of our feeder fund, how Madoff made such consistently good returns. Although Richard tried to explain it to me, it was clear he didn't know, either, because I'd leave our meetings still unable to explain to anyone else how it worked..."To which I replied:
...maybe nobody understood things because there was nothing much rational to understand. I guess the one encapsulating and overarching operative word (extending far beyond the likes of Madoff) is "fraud." _____Dr. William K. Black is a national authority on financial crime, author of "The Best Way to Rob a Bank is to Own One." From his website:
[Dr. Black] was litigation director of the Federal Home Loan Bank Board, deputy director of the FSLIC, SVP and General Counsel of the Federal Home Loan Bank of San Francisco, and Senior Deputy Chief Counsel, Office of Thrift Supervision. He was deputy director of the National Commission on Financial Institution Reform, Recovery and Enforcement.Dr. Black has graciously sent me voluminous documentation detailing his views and those of equal industry cred and kindred viewpoint. I have gone through one yellow highlighter and a red pen by now on the printouts. I will cite his comprehensive work as this post continues. It goes way beyond "mere" "moral hazard" and concomitant "stupidity." It goes to pandemic financial industry willful fraud. ______ ONE LAST THING FOR NOW ON POSTER BOY BERNIE From CBS "60 Minutes," March 1st, 2009 The Man Who Figured Out Madoff's Scheme Tells 60 Minutes Many Suspected Madoff Fraud; Says SEC Is Incapable Of Finding Fraud ______ ASYMMETRY Previously, citing an emblematic remark by Michael Milken, I alluded to "informational asymmetry" as a significant component of moral hazard. Returning to Dr. Black:
...Akerlof (1970) argued that lemons markets arose because of information asymmetry – the seller knew far more about the true quality of the goods than the buyer. Reading the article also makes clear that, though he does not stress this point, Akerlof knew that the seller in his examples was intentionally misrepresenting the quality of the goods in order to deceive (defraud) the buyer... [op cit.]Yes, but there is additional criminogenc inducement in the financial sector owing to "outcomes symmetry" -
Neo-classical economics had one additional theory about looting – but overwhelmingly interpreted it to exclude fraud. The theory was “moral hazard.” Moral hazard theory relies on asymmetry of outcomes [emphasis mine - BG]. Limited corporate liability is a common source of moral hazard. When a corporation is impaired the shareholders have a strong incentive for the firm to engage in control fraud and/or take high risks. The logic is that because of limited liability the creditors – not the shareholders – will bear the resultant losses should the fraud or excessive risks fail. Conversely, should the fraud or gamble succeed the shareholders will capture the great bulk of the financial gain. In 1993, however, virtually every economist assumed (typically, implicitly without any explanation) that S&Ls would engage only in ultra high-risk investments – not fraud. There was no basis for this assumption, as Akerlof & Romer note, fraud was a “sure thing” (1993: 5). [op cit.]I cannot but be with Dr. Black et al on this:
Because neo-classical theory is virulently hostile towards government and has no explicit theory of fraud and implicitly assumes that control fraud cannot be material, it repeatedly produces recommended praxis that, if adopted, would optimize the criminogenic environment for control fraud. When neo-classical thought triumphs societies adopt simultaneously many elements of this anti-governmental agenda. This produces waves of control fraud and crisis. [op cit.]Yes, and this is where we undeniably find ourselves today in the wake of more than a generation of overt, intellectually shallow, broad-brush Joe-The-Plumber hostility toward the sneering red-meat pejorative soundbite, "government regulation." My personal ordinary-citizen take on all of this is that "moral hazard" comprises a perhaps necessary, but insufficient condition for for the execution of pandemic fraud. The tipping-point sufficient condition comprises the evisceration of financial law/regulatory enforcement. Again, Bill Black:
As a white-collar criminologist and former financial regulator much of my research studies what causes financial markets to become profoundly dysfunctional. The FBI has been warning of an "epidemic" of mortgage fraud since September 2004. It also reports that lenders initiated 80% of these frauds. When the person that controls a seemingly legitimate business or government agency uses it as a "weapon" to defraud we categorize it as a "control fraud" ("The Organization as 'Weapon' in White Collar Crime." Wheeler & Rothman 1982; The Best Way to Rob a Bank is to Own One. Black 2005). Financial control frauds' "weapon of choice" is accounting. Control frauds cause greater financial losses than all other forms of property crime -- combined. Control fraud epidemics can arise when financial deregulation and desupervision and perverse compensation systems create a "criminogenic environment" (Big Money Crime. Calavita, Pontell & Tillman 1997.) ______From "The Two Documents Everyone Should Read to Better Understand the Crisis" 'The FBI has been warning of an "epidemic" of mortgage fraud since September 2004.' More than four years now. Not mere "moral hazard." Not mere "irrational exuberance." Not mere "stupidity." FRAUD. Unchallenged, until it was too late.
"No one was investigating Mr. Madoff at the end," Markopolos said. "So he turned himself in before anybody, in a position of authority, began a serious investigation?" Kroft asked. "That's typically how the SEC does it," Markopolos said. "They come in after the crime has been committed, they toe-tag the victims, count the bodies, and try to figure out who the crooks were after the fact, which does none of us any good. ["60 minutes"] _____Will we ever learn? REKJAVIK RUMINATIONS: A "SHORT" STORY Dr. Black posits widespread financial fraud as the driving force behind the now-global economic meltdown. The more I read, the more I have to agree. Consider the latest by Michael Lewis:
One of the hidden causes of the current global financial crisis is that the people who saw it coming had more to gain from it by taking short positions than they did by trying to publicize the problem. Plus, most of the people who could credibly charge Iceland—or, for that matter, Lehman Brothers—with financial crimes could be dismissed as crass profiteers, talking their own book."In the gap between perception and reality, there's money to be made." Read the entire Lewis article. Yes, there has again been rampant stupidity, naivete, "irrational exuberance," susceptibility to "moral hazard." Without them, fraud cannot prevail. Stupidity, naivete, and "irrational exuberance" are not criminal. Fraud is. And it should be dealt with promptly and firmly, irrespective of whether the perpetrators shower prior to or after the workday. ______ BILL BLACK UPDATE
February 24, 2009 (LPAC)--A senior regulator for the Resolution Trust Corp. during the 1980s savings-and-loan crisis demanded a "new Pecora investigation" and prompt bankruptcy receivership for U.S. banks, in a column on Huffingtonpost.com Feb. 23. William K. Black, now a University of Missouri-Kansas City economics professor, forcefully laid down two principles for action in the column, entitled "Why Is Geithner Continuing Paulson's Policy of Violating the Law?" First, the S&L debacle of the 1980s established a financial regulatory system based on legal requirement of "prompt corrective action" by regulators to put insolvent banks into receivership quickly, before their drawn-out failure would explode the demands on the funds of the FDIC. U.S.-based banks, Black says, are collectively insolvent by a margin of at least $2 trillion, possibly much more. "Paulson's and Geithner's flouting of the law" will cost at least hundreds of billions in Federal credit, he says. Black's second strong demand is for "a modern Pecora investigation.... If we were dealing with a crisis of airplane crashes and someone opposed studying the causes of the failures, we would (correctly) label him a lunatic.... It appears that only intense public pressure will suffice to overcome Congressional and Administration resistance to a Pecora investigation."_____ MARCH 7TH UPDATE I heard this segment on NPR's "This American Life" yesterday:
The collapse of the banking system explained, in just 59 minutes. Our crack economics team—the guys who explained the mortgage crisis, Alex Blumberg and NPR’s Adam Davidson—are back to help all of us understand the news. For instance, when we talk about an insolvent bank, what does it actually mean, and why are we giving hundreds of billions of dollars to rich bankers who screwed up their own businesses? Also, two guys go to New Jersey to look at a toxic asset.Click the link to listen. Nicely done, IMHO. Cuts past all the inscrutable jargon for a clear and fairly comprehensive lay-person-friendly survey of our 2009 economic circumstance. ______ CREDIT DEFAULT SWAPS UPDATE The more I read, the more concerned and angry I become. Consider this:
Remember that the reason for shoring up AIG was its credit default swaps portfolio, in which it had written lots of unhedged guarantees on the cheery assumption that there was tantamount to no risk. Insurers are state-regulated in the US, and subject to a host country requirements overseas (and AIG has substantial foreign operations). Uncle Sam has no regulatory responsibility for AIG, but was hit up nevertheless as the most logical deep pocket that could prevent a financial train wreck... ___And this:
The Fed’s moral hazard maximising strategy March 6, 2009 7:44pm The reports on the evidence given by the Vice Chairman of the Federal Reserve Board, Don Kohn, to the Senate Banking Committee about the Fed’s role in the government’s rescue of AIG, have left me speechless and weak with rage. AIG wrote CDS, that is, it sold credit default swaps that provided the buyer of the CDS (including some of the world’s largest banks) with insurance against default on bonds and other credit instruments they held. Of course the insurance was only as good as the creditworthiness of the party writing the CDS. When it was uncovered during the late summer of 2008, that AIG had nurtured a little rogue, unregulated investment banking unit in its bosom, and that the level of the credit risk it had insured was well beyond its means, the AIG counterparties, that is, the buyers of the CDS, were caught with their pants down... ___What are we to make of these "financial instruments"? The BBC aired a fairly clear and concise (and depressing) explanation back in October: I found this AIG graphic online (click to enlarge): "AIG Global Marine and Energy combines leading worldwide marine and energy insurance, risk management and loss control expertise with the unsurpassed financial capacity and global network of the AIG companies..." Diff'rent day, diff'rent "ENRON," same egregiously reckless, fraudulent M.O., it would appear. Recall how Enron had all those myriad nominally "independent business units" eventually simply trading pieces of paper back and forth, booking each inter-subsid "sale" as "revenue"? Recall their self-congratulatory PR chest-beating regarding their unsurpassed financial/risk management acumen and "unsurpassed financial capacity," blah, blah, blah? Some eerie parallels here, I would think. I return to my "Tranche Warfare" lament: We appear to have learned nothing. I also return to the admonitions of William K. Black in "The Audacity of Dopes" -
We are being played for chumps. The Bush and Obama plans could only have been designed by failed bankers -- for their principal beneficiaries are failed bankers. We already know enough to confirm that the Bush administration made us the "fool" in the market by massively overpaying for assets. The Obama administration is about to compound that scandal with a "guarantee" program. The bankers that caused the crisis designed both programs. The senior officers at big bank aren't very good lenders, but they are expert in maximizing their compensation... ___THE UNREGULATED CASINO Credit Default Swaps Explained Posted Wed Sep 24, 02:14 pm ET Posted By: Dirk van Dijk, CFA
"...If you buy a bond from, say, General Motors (GM), you are lending them money for a set interest rate for a specified length of time. You face two sets of risks in doing so. The first is that they go bankrupt and don't pay you back. The second is that interest rates rise and the bond falls in value (think of bond prices and interest rates as being on opposite sides of a see-saw). With a CDS, you could go out and find someone who will insure against the default risk. For a given premium, the seller of the CDS will pay off on the GM bond if GM goes belly up. Now, if it was from a real insurance company, the insurance company would be regulated and would have to hold enough money in reserve to pay you off in case GM actually did go belly up. This is just like how a Life Insurance company has to have enough cash on had to pay off on your policy in case you die. However, since this is an unregulated market, someone can sell you a CDS and blow the money in Las Vegas. In that case, if GM did go belly up, you would just plain be out of luck. In the case of life insurance, there are strict limits on who can take out a policy on you. You can take out a policy on your own life, and on close family members. In some circumstances you can take out a policy on your business partner, but beyond that there are not many people you can take out a policy on. You have to have what is called an insurable interest; you can't just wander the halls of the hospital looking for people who are unlikely to make it and take out life insurance policies on them. This is not true for the CDS market. You are perfectly free to take out a "life insurance policy" on GM, GE (GE) or any other firm that issues a bond, and you do not have to be holding the bond. You can even take out a "life insurance policy" on the synthetic garbage the Wall Street has been pumping out. This ability to buy insurance on things that you have no insurable interest in transformed this market into a huge casino. It is totally unregulated...Regulation of this market was specifically prohibited under the Commodity Futures Modernization Act of 2001. That provision was slipped into the bill in the dead of night by our old friend Senator Phil Gramm of Texas -- now Vice Chairman of UBS (UBS). People use this market to bet on the credit worthiness of companies, and often hedge funds will hold both long and short positions on the same underlying credit. For example (NOTE: figures are made up here, not a reflection of the actual creditworthiness of GE), the hedge fund might make a bet that it is worthwhile to get $200,000 up front and be on the hook for $10 million if GE defaults sometime in the next five years. Then after a few months, GE raises a bunch of capital which significantly strengthens its balance sheet and lowers the risk of default, so it can make a bet with someone else who would now be willing to take just $100,000 to bet that GE will not go belly up within then next five years. The hedge fund could have a perfectly matched book, so in theory they were totally indifferent if GE survives or not. However, suppose that the person who they made the bet with goes bankrupt themselves and can't pay up. That hedge fund might then have a hard time paying its counter party. This is where the fear of "cascading cross defaults" comes in. All this is to say that the CDS market has seen more growth than practically any market in the history of mankind. It is currently at over $62 TRILLION, up from under $1 Trillion a decade ago. It would not take a very big percentage of that market to fail to leave a very big mark on the world financial system..." ___That is simply insane. "COUNTERPARTY RISK" Simply the risk that a signator to a contract will not be able to make good on a financial obligation imposed by the contract. AIG et al simply ignored the risk (recall from my "Tranche Warfare" post how AIG hubristically assumed it to be microscopically negligible, on the basis of their oh-so slick "proprietary quantitative risk model"). Consider an apt analogy:
"Imagine walking down the street and finding a $100 bill. Wow, you say, this must be my lucky day. To take advantage of this good fortune you decide to go to the race track. After reading the racing sheet you place a bet in the 3rd race on the long shot 'Never Wins'. 'Never Wins' has finished last in every race that he has run. Also in the race is the favorite, 'Always Wins'. 'Always Wins' has finished in first place in every race that he has run. You still go ahead and make the bet because you strongly believe that today 'Never Wins' will win. The bet is made for $100 and the odds are 100 - 1, if he wins your payoff will be $10,000. It turns out that on this day a number of other bettors feel the same way as you and they place the same identical $100 bet that you did. The track executives while monitoring the incoming bets notice the large size of 'Never Wins' bets but they do not change the odds as they are so confident that history is on their side. After all 'Never Wins' never wins and 'Always Wins' always wins. At race time you take your seat. The bell rings and 12 horses bounce out of the gate but five of them run into each other and fall to the ground. Then four more horses fall into a puddle and stumble onto the ground. Out of the three horses remaining, one gets disqualified as his jockey falls off. There are now two horses left - your horse the 100 - 1 long shot 'Never Wins' and the great champion 'Always Wins'. 'Always Wins' is about 10 lengths ahead of 'Never Wins'. As they reach the final turn, a bird flies into 'Always Win's' eyes; he becomes temporarily blinded and stops running. About 10 seconds later, the long shot 'Never Wins' runs right by 'Always Wins' and crosses the finish line in first place. You jump up with excitement and are beaming with joy. Time to collect. You say to yourself, what were the chances of all of those things happening in one race? As you approach the pay off window, you see a large crowd gathered around and they seem upset. They are yelling things and asking questions and pounding on the closed payoff window. As you get closer you find out that about 200 people placed identical $100 wagers that you had and they were looking to collect their $10,000. You quickly do the math in your head and realize that the total payoff the track has to pay is $2 million. You make your way to the window and see a sign that reads, 'No More Winning Tickets on 'Never Wins' Are Going to Be Paid.' You are angry, in shock and say to yourself what about my money? Who is going to pay off my winning bet? Why did the race track take so many long shot bets? What kind of risk controls did the track have in place? How can this happen? How can the track or the counterparty not pay up? Something similar to this is going on in the financial markets today..." ___Yep. Insane. No, criminal, actually. Now, Taleb might call "Never Wins'" victory a "Black Swan." Bill Black, OTOH, would probably say that the analogy falls a bit short, in failing to acknowledge the significant ongoing presence of outright, deliberate fraud. Dr. Black would say that the dangerously enervating global economic upshot was inevitable. ______ "WALL STREET'S WORST INVENTION EVER" The Market Oracle I continue to try to fully wrap my brain around the Credit Default Swap. The following Martin Hutchinson article excerpt helps a good bit:
"...A $50 trillion credit derivatives market means there is $50 trillion of credit exposure on the dealer community, and no amount of collateral arrangements and fancy accounting can eliminate that fact. As for settlement, the dealers came up with an ingenious, but very un-foolproof scheme, whereby a mini-auction of the bankrupt credit would take place, so by buying a million or two in dodgy bonds you could corrupt the pricing of billions in credit default swaps that you held. There are two other problems with credit default swaps CDS we didn't think of in the 1980s. First, AIG stayed almost entirely on one side of the CDS market - selling credit protection - because it believed it could do so, book the premiums up-front as income, collect bonuses based on the total premiums each year and never account for the risks on the actual derivative contracts themselves. After all, the swaps were being AAA-rated mortgage backed bonds. It would never have occurred to us in the 1980s that we could do this - we weren't sufficiently in control of our auditors!). From the point of view of AIG, the company, this was extremely stupid, though it had its advantages from the traders' point of view. In the end, of course, it was all of us - the U.S. taxpayers - who were stuck paying the tab for a meal that others got to eat. However, the second - and most serious - problem with credit default swaps is their potential use by short-sellers to cause bankruptcies. Short-Sighted, Short-Selling In the so-called “rational markets” that are so beloved by the textbooks, this should theoretically be impossible. In the real world, however, it would be fairly easy to engineer - especially in a period of uncertainty, such as we have had since 2007 - for a large operator to spread rumors, push down share prices, and thus cause the market to panic. Richard S. “Dick” Fuld Jr. , the former chief executive officer of Lehman Brothers Holdings Inc. (OTC: LEHMQ ), the former CEO of Lehman, is convinced this is what happened in Lehman's case , and it has undoubtedly been tried in several others. Short-selling of shares was banned for several weeks after the Lehman bankruptcy , the reality is that neither short share sales nor share put options offer anything like the potential of credit default swaps to profit from a bankruptcy - particularly the bankruptcy of a financial institution whose debt is several times its share capital. Citigroup Inc. ( C ) and JPMorgan Chase & Co. ( JPM ), for example, each have around $1 billion in short positions outstanding in their shares. In the traded options market, Citigroup has a nominal $1.4 billion worth of put options outstanding while JP Morgan Chase has $2.1 billion - the cash value of those contracts will be a fraction of those figures. What's more, there are undisclosed amounts of over-the-counter equity options written between dealers. However, the volumes of credit default swaps were recently $65.7 billion on Citigroup and $62.4 billion on JPMorgan. Now think about the arithmetic. To sell a share short, you risk all your capital - there's no limit on how high a share of stock can rise. To buy puts, you deal only in a small market, and most puts are short-dated, so you would have to act quickly. With a CDS, however, you pay only an annual premium that is a small fraction of the principal amount involved, you acquire an asset that typically lasts several years, and you can deal in a market of over $60 billion - enough potential profit for even the greediest hedge fund. Thus, credit default swaps make causing a “run” on a bank or investment bank enticingly profitable, with a profit potential that far outweighs the cost of undertaking the operation. Because the CDS market is much larger than the market for stock options - or even the share markets themselves - the product is a standing temptation to bad guys, and a danger to the banking system. By now, it's easy to see why credit default swaps are Wall Street's worst invention. Granted, these particular derivative securities are so far only second in total losses, behind subprime mortgages, but they lack the social purpose of the home loans for borrowers with poor credit, since those mortgages at least had the somewhat redeeming benefit of putting some folks in houses. While there are a few CDS securities that genuinely hedge credit risk, almost all of them have no such benefit: They are gambling contracts, pure and simple. For the taxpayer to bail out the victims with self-inflicted CDS wounds is as ludicrous as asking us to bail out the Las Vegas casinos..." ___Yes, indeed, we have allowed our financial markets to become one huge global casino -- one essentially lacking any capital reserves with which to cover losses (thanks to increasing deregulation), one whose "card counters" were the insidious short sellers and kindred manipulators who wreaked utter havoc while lining their own pockets. Fraud. UPDATE: ANOTHER NICE VIDEO EXPLANATION: THE CRISIS OF CREDIT VISUALIZED
SOME NECESSARY HISTORY