The $2 Billion Dollar Loss and Insurable Interest

When JP Morgan announced that it had lost $2 billion by making risky market bets attention immediately focused on the Dodd-Frank banking bill and whether federally insured financial institutions should be allowed to make such bets. But the larger question is “Should any institution be allowed to make such bets?”

The language Wall Street uses obscures the financial activity that was actually taking place – JP Morgan lost the $2 billion by writing bond insurance. The company sold short term insurance policies that paid out money if the price of bundles of bonds dropped.

Wall Street uses obscure language – calling the transactions “Credit Default Swaps” instead of bond insurance – because historically we have regulated insurers to make sure they could pay off any claims and more importantly we only allowed insurance to be purchased on things people actually owned – the insurance buyer had to have “insurable interest” before they could buy the insurance.

Bond insurance can certainly make sense for a bond holder, just like home owners insurance makes sense for a homeowner. But the vast majority of the bond insurance that JP Morgan sold wasn’t bought by bond holders – it was bought by companies that did not own the bundle of bonds. They weren’t protecting their interest in their own holdings, they were speculating that something unfortunate would happen to the companies that issued the bonds, either self-inflicted or just from the ebb and flow of the economy. Essentially, the insurance buyers were betting on someone else’s misfortune.

Betting on other companies’ misfortunes was a significant cause of the Depression in 1929 and it’s something we rightly regulate. Since the 1930s we have greatly limited speculators’ ability to “short” stocks and bonds, to sell stocks and bonds they didn’t own in an attempt to drive down the price of the stock or bond. Bond insurance, or Credit Default Swaps, came into being in the late 1990s and took off in the 2000s – we now have about $7 of bond insurance for every $1 of corporate bonds. Credit Default Swaps are the new way of allowing speculators to get around the prohibition against betting on another company’s misfortune.

There is no real economic justification for the Credit Default Swaps – they don’t actually produce anything, they just move money from one company to another company with Wall Street taking a small cut. Defenders will argue that the bond insurance allows companies to protect themselves against downturns in the economy, and also makes it easier for companies to issue bonds. But there are already plenty of ways to hedge against downturns and companies were certainly able to issue bonds before the late nineties. The real reason that Wall Street likes complex financial instruments like the Credit Default Swaps is because their complexity makes it easier for clever gamblers to take the money of less clever gamblers, and every time a bet gets made Wall Street takes a little cut. But that is the topic for another day.

So this is the question we as a country need to answer – should we allow Credit Default Swaps to even exist in the regulated economy? We have had about 12 years of experience with Credit Default Swaps and in that time they helped cause a significant financial crisis. We have over a century of experience without them, and corporations somehow managed to issue bonds and protect themselves against downturns in the economy. So why not go back to the old way? Why not go back to only allowing insurance to be purchased on things you actually own? Our economy would be better for it.

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