Monday, April 6, 2009

"Credit Default Swaps" - Insuring Against Oblivion

We were dealing the the issue of DERIVATIVES. Okay - So I put too much into the last posting. Let's start this one in the middle; without the preamble.

Let's get an example that most of us understand more easily - LIFE INSURANCE. When you buy a life insurance policy, you are betting an insurance company that you will die before you have paid more in premiums than the policy will pay to your beneficiaries. The Insurance Company takes the BET, because they know that on average, very few policy holders dies before either paying in more than the death benefit, or simply let the policy lapse after many years of paying. The insurance company, having hundreds of thousands,or millions of other people buying and dying, have sophisticated mathematicians (actuaries they are called) who prepare statistics on the probability of someone dying.

For example, if you are healthy and 30 years old, and do not race cars, and want to buy a $25,000 policy, the company will say "fine" and charge you a modest monthly premium. They can do this because they have statistical proof that very few 30 year old healthy people die. If you are 70, the chances of death before paying a lot of premiums is far greater, so the payments are much higher.

REGARDLESS OF THE SITUATION, YOU ARE BETTING THE COMPANY YOU WILL DIE WHILE YOU ARE INSURED AND BEFORE YOU HAVE PAID A FORTUNE, AND THEY ARE BETTING THAT YOU WON'T. That is gambling/betting/buying chances... The company can do this because they sell hundreds of thousands of policies and the statistics prove them right enough of the time. Basically, you and hundreds of thousands of others pay premiums, and the Insurance Company pays relatively few claims. They get to keep the profit!

To be certain that the Company has guessed correctly, it will bet another and bigger insurance company that the insurer might be wrong. The bigger company which has even more statistics takes the bet and collects easy money. It has bought a derivative - a bet not on the life of the insured, but a side bet on whether the first company will have to pay the claim. This second bet is DERIVED from the first bet -the insurance policy itself. It is equivalent to the bet on Tiger's golf game (see the prior post - great analogy & reading).

BUT, what would happen if a disease struck all of the 30-40 year olds and they died, leaving the older people only - the people who have less time to live (and pay premiums according to the math guys)? Easy - the company would not be able to pay all of the claims. The bigger company which had to pay the smaller company who issued the insurance policies might default. Both companies might go bankrupt. So, the bigger company bets with even bigger company etc. What happens is that there might be 7 bets that the 30-40 year olds will live long. If they don't, 7 companies have to pay and 7 companies might file bankruptcy.

Were any of the assumptions wrong? It was a first time event, all those young premium payers dying, but they did die. Would that make all policies bad? No. It does point out that betting that a mortgage will go bad (OKAY CALL IT INSURING AGAINST IT GOING BAD) or any other such bet is fraught with potential disastrous problems. The biggest of these is the fact that there could be 5,6,7 or 100 bets on that 30 year old's life or those mortgages.

With MBS, and the underlying mortgages, the type of Derivative is a CREDIT DEFAULT SWAP. It would be more accurate to it Credit Default Insurance, or (longer name here) "My BET that your loans will not default for which you pay me a lot of money." IT IS A SWAP OF RISK FOR MONEY. Nothing more -nothing less
How did we get here, and where do we go? (understand that there are more than $40 trillion in these Swaps and other Derivatives). The Final installment of the series will focus on how to keep the $40 trillion from wrecking (for real this time) the world economy

Author's Copyright by Richard I. Isacoff, Esq., March 2009

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