Bailing out the bookies

Insurance is a bet intended to mitigate risk, e.g., my fire insurance is a bet, against my insurance company, that my house will burn down. Since the odds of my house burning down are reasonably small, my side of that bet is one I can afford. It’s a good deal for me, since I can’t afford to replace my house but my insurance company can. If, however, you were to bet someone that my house would burn down, that would be gambling, not insurance.

Similarly, if the holder of a bond buys a credit-fault swap (CDS) on it, he is betting that seller of that bond will default on the bond’s payments. The bond holder is thereby insuring, i.e., mitigating, his risk. But if someone who doesn’t own a bond buys a CDS on it, he’sn not insuring but simply gambling, and such a gamble is called a "naked CDS."

It turns out that AIG was taking all bets regarding the defaulting of all sorts of bond and mortgage, i.e., they were behaving as bookies. Insanely, our government is now covering those bets, including naked CDSs, for those bookies. (For details see this. h/t selise)

My first instinct is that the unseen hand should be allowed do its job in this case. Insurers who lack actuarial expertise should go bankrupt. And purchasers of insurance, like all buyers, should beware.

I can, however, see a mercy case for covering CDSs that were purchased in good faith as insurance on sound assets. Our society, sometimes unwisely, leaves portions of the social safety net to the private sector, e.g., insurers. When that portion of the safety net fails, society still needs to prevent unnecessary suffering and chaos, i.e., needs to backstop that rip in the safety net.

So, from the social-responsibility perspective, I’d recommend that the government make good on CDS’s of dilligent-but-defunct insurers provided that the insured asset (1) is a first mortgage on a home or a corporate bond rated AAA when the CDS was purchased and (2) has been continuously owned by the claimant since before the meltdown began but not long before the CDS was purchased. In such cases:

  • If the asset is a mortgage, the government should offer to purchase it for the balance now due on the principal, and no more than the CDS’s notional amount.
  • If the asset is a corporate bond, the government should offer to purchase it for the market value of the bond on that date, and no more than the notional amount.

But pragmatism doesn’t stop at social responsibility. The people of the United States get a lot of economic benefit from the U.S. dollar being the world currency. So there is the question of how much debt we should heap on the next generation to maintain the supremacy of the dollar through their lifetimes. And it is in the possibly vain hope of maintaining that economic supremacy that that our government is backing the bookies.