Credit Default Swaps: The Insane Problem and the Radical but Sane Solution

In this case also, I can increase my return with an inflated appraisal and decrease my investment by declaring the risk to be minuscule - meaning rated AAA by widely acclaimed rating agencies.

We can now change another assumption. Assume the playing with matches problem is removed and a new problem is substituted. A problem like the husband and wife both having low-paying jobs and no health insurance, coupled with knowledge that many employers refuse to accept illness as a legitimate reason for missing work and have iron-clad policies that require ill workers be fired for failing to report to work.

Or assume both husband and wife have no seniority and work at jobs that may not exist tomorrow because they were shipped overseas last night.

If I knew one or both of them were developing health problems or that one or both were at risk of being laid off, I would see a reasonably good shot at "winning the disaster lottery" so to speak, by buying mortgage default insurance, also known as a credit default swap, on their $400,000 house.

Then I could sit back, relax and wait for the hoped-for and expected misfortune, which will be my good fortune. As could 99 of my gambling buddies.

Back to the neighbor's home that mysteriously burned to the ground. This tragic event is a great deal for me and my 99 gambling buddies. Our biggest risk is that, having paid the insurance premiums, the home stubbornly refuses to burn to the ground.

Being capitalists, we desire to increase the odds that a disastrous fire will occur. My friends and I with fire insurance policies on my neighbor's house have two options for increasing the odds. One, teach the young child the joys and wonders of paying with matches in closets. Two, hire a professional arsonist.

Holders of credit default swaps have similar but more numerous and less risky opportunities to increase their odds of "winning the disaster lottery".

The best way would be use of fine-print, non-understandable escalator clauses that increase the hard-working couple's monthly payments by a factor of two or three. With rampant inflation, confined to core goods that officially "don't count" in Washington, such as $4.00 gasoline, $5.00 milk and $3.00 bread. With rampant if covert support of immigrant labor, legal or otherwise, who are willing to work for less, without any benefits at all, let alone health insurance, thereby increasing the risk of job loss.

We could destroy OSHA, making on-the-job causes of illness and injury more likely. We could buy legislation that benefits pharmaceutical companies while making both medicine and health insurance unaffordable. We could destroy the economy of Main Street, making job loss more likely. The list is extensive, collectively making early default all but inevitable.

That issue addressed, our biggest worry becomes the solvency of the insurance companies. That problem can best be solved by requiring substitution of a "bigger and better" insurance company with deeper pockets.

Purchasing legislation and regulations (or the lack thereof) is the preferred method.

Roughly a quarter-century ago, when I was owner of a new and small consulting engineering firm in a Midwestern state, a law was passed requiring that operators of coal strip mines reclaim the messes they made. To ensure this might actually happen, the new law required coal mine operators to post reclamation performance bonds, payable to the state. So if the operators went bankrupt, the state could call the bonds, thereby obtaining funds for the state to hire and pay remediation contractors.

I never understood at the time why the small independent strip mine operators had so little interest in hiring a consulting engineer to design mining and reclamation operations so as to minimize reclamation expense, or even to provide honest estimates of expected reclamation expenses. Until, in an unguarded moment, one small operator explained Plan B.

At the time, only $250,000 in financial assets were required for formation of an insurance company, and once formed, no limits were placed on the value of insurance written. Same for performance bonds written to the government that granted the license and regulated.

 1  |  2  |  3  |  4  |  5