30.9.08

IT ALL SEEMS OBVIOUS NOW. Here's a passage from pages 118-119 of Rosenberg and Birdzell's How the West Grew Rich.

The development of marine insurance markets in Italy, Amsterdam, and London separated commercial risks from the risks posed by the perils of the sea and made it possible for merchants to venture increasingly large amounts of capital on the commercial outcome of a voyage without subjecting themselves to the less calculable uncertainties of the sea. The commercial risk was that the cargo might not bring prices as high as had been hoped for, so that the voyage might not be as profitable as expected, or might even result in a loss. But only rarely was there a commercial risk that the cargo might prove wholly worthless and produce a loss of the entire capital invested -- a risk decidedly present from storms, pirates, and the other hazards of the sea.

The division of risk between the perils of the sea and the perils of the market, with specialized insurers undertaking the former and shipowners the latter, converted an intrinsically hazardous business into one capable of drawing capital from relatively cautious and conservative merchants. Some such division of risk was essential to the development of maritime commerce. It is possible to think of other ways the risks might have been divided, such as marketing shares in the voyages themselves at Lloyd's instead of shares of the risk of loss from perils of the sea. But this would have required the underwriters at Lloyd's to familiarize themselves not simply with the risks of the sea, but also with the commercial risks involved in every line of trade conducted by sea. The division between specialists in maritime risks and specialists in market risks greatly facilitated the growth of maritime trade.

We thus take for granted the slicing and dicing of risks to ships, even if there no longer is a Lloyd's coffeehouse with a bell that rings to announce a sinking, and we understand foreign-exchange hedges against loss in the value of the cargo on delivery.

Because the book is a survey of the institutions that contributed to the prosperity of Europe and the former English colonies, it necessarily scants any survey of the controversies that must have accompanied the introduction of these new speculative instruments. I suspect there's some fascinating reading there: can anyone suggest a place to start?

But it places the current financial troubles in some perspective. There's a large market in private insurance for financial instruments, under the rubric of credit default swaps, and it has some people frightened.

As Congress wrestles with another bailout bill to try to contain the financial contagion, there's a potential killer bug out there whose next movement can't be predicted: the Credit Default Swap.

In just over a decade these privately traded derivatives contracts have ballooned from nothing into a $54.6 trillion market. CDS are the fastest-growing major type of financial derivatives. More important, they've played a critical role in the unfolding financial crisis. First, by ostensibly providing "insurance" on risky mortgage bonds, they encouraged and enabled reckless behavior during the housing bubble.

"If CDS had been taken out of play, companies would've said, 'I can't get this [risk] off my books,'" says Michael Greenberger, a University of Maryland law professor and former director of trading and markets at the Commodity Futures Trading Commission. "If they couldn't keep passing the risk down the line, those guys would've been stopped in their tracks. The ultimate assurance for issuing all this stuff was, 'It's insured.'"

I wonder if there isn't some ancient parchment complaining about those guys drinking strong coffee at Lloyd's encouraging reckless shipping during the South Sea bubble. (There's no such reference in Extraordinary Popular Delusions and the Madness of Crowds.) With 500 years of hindsight, the ability of captains to pass the maritime risk to Lloyds and some of the commercial risk to a foreign exchange speculator looks like a positive development. The insurers and the trading houses developed their own codes of conduct, and those were augmented by regulatory commissions with additional powers. One lesson the regulators and the industry ethics committees ought have learned is that transparency is a must. That structure is missing from the credit swap business.
And the fear of a CDS catastrophe still haunts the markets. For starters, nobody knows how federal intervention might ripple through this chain of contracts. And meanwhile, as we'll see, two fundamental aspects of the CDS market - that it is unregulated, and that almost nothing is disclosed publicly - may be about to change. That adds even more uncertainty to the equation.
The transactions themselves aren't anything complicated.
A CDS is just a contract: The "buyer" plunks down something that resembles a premium, and the "seller" agrees to make a specific payment if a particular event, such as a bond default, occurs.
The buyer puts sterling on the counter and the seller agrees to replace the hull if the ship sinks.
Used soberly, CDS offer concrete benefits: If you're holding bonds and you're worried that the issuer won't be able to pay, buying CDS should cover your loss. "CDS serve a very useful function of allowing financial markets to efficiently transfer credit risk," argues Sunil Hirani, the CEO of Creditex, one of a handful of marketplaces that trade the contracts.
That's exactly the Rosenberg-Birdzell formulation, only for a contingency more abstract than a ship foundering.
Because they're contracts rather than securities or insurance, CDS are easy to create: Often deals are done in a one-minute phone conversation or an instant message. Many technical aspects of CDS, such as the typical five-year term, have been standardized by the International Swaps and Derivatives Association (ISDA). That only accelerates the process.
No coffee, no coffehouse, no need to bring hull owners and underwriters to London. Less uncertainty, also, about whether an overdue ship has sunk or not. I have to wonder how economic historians 500 years from now will view the teething troubles we're having with these new institutions for dividing and transferring risk. The article even sees the parallel.
And as long as someone is willing to take the other side of the proposition, a CDS can cover just about anything, making it the Wall Street equivalent of those notorious Lloyds of London policies covering Liberace's hands and other esoterica. It has even become possible to purchase a CDS that would pay out if the U.S. government defaults. (Trust us when we say that if the government goes under, trying to collect will be the least of your worries.)
There is nothing notorious about insuring a pianist's hands. The problem an insurer faces, however, is of limiting membership in the club to reliable underwriters in a sound financial position. Again, there's nothing new.
When you put $10 on black 22, you're pretty sure the casino will pay off if you win. The CDS market offers no such assurance. One reason the market grew so quickly was that hedge funds poured in, sensing easy money. And not just big, well-established hedge funds but a lot of upstarts. So in some cases, giant financial institutions were counting on collecting money from institutions only slightly more solvent than your average minimart. The danger, of course, is that if a hedge fund suddenly has to pay off on a lot of CDS, it will simply go out of business. "People have been insuring risks that they can't insure," says Peter Schiff, the president of Euro Pacific Capital and author of Crash Proof, which predicted doom for Fannie and Freddie, among other things. "Let's say you're writing fire insurance policies, and every time you get the [premium], you spend it. You just assume that no houses are going to burn down. And all of a sudden there's a huge fire and they all burn down. What do you do? You just close up shop."
It's rules written in blood (the railroad version), or in red ink, again. We have prudent investor rules and reserve requirements and codes of ethics and the disinviting of careless underwiters to the coffeehouse to protect against such events. We have a 500 year head start on understanding these things.

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