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You'll Be Happy to Hear the Revolutionary State Has Seized Everything Except the Insurance Industry
Talk about markets in everything:
I became intrigued by an oddity that I came to think of as the end-of-the-world trade. The trade is the purchase of insurance against what would in effect be the failure of the modern capitalist system. It would take a cataclysm -- around a third of the leading investment-grade corporations in Europe or half those in North America going bankrupt and defaulting on their debt -- for the insurance to be paid out.
I asked one investment banker what might cause half of North America's top corporations to default. No ordinary economic recession or natural disaster short of an asteroid strike could do it: no hurricane, for example, and not even 'the big one', a catastrophic earthquake devastating California. All he could think of was 'a revolutionary Marxist government in Washington'. That's not a likely scenario, yet the cost of insuring against it had shot up ten-fold. Normally one can buy $10 million of end-of-the-world insurance for between two and three thousand dollars a year. By early last November, the prices quoted were between twenty and thirty thousand, and even then it was difficult to buy in quantity -- at least, said the banker, 'not from anyone you trusted'.
Via Ken MacLeod, who comments: "You can insure against the revolution? Who knew?"
Jesse Walker|5.14.08 @ 10:01AM|#
I'll save the answer to the obvious question for the comments.
From the article:
All this activity explains the attractiveness of the
end-of-the-world trade. The trade is the buying and selling of
protection on the safest, super-senior tranches of the
investment-grade indices. No one buys protection on these tranches
because they are looking for a big pay-out if capitalism crumbles:
if nothing else, they have no reason to expect that the institution
that sold them protection would survive the carnage and be able to
make the pay-out. Instead, they are looking to hedge their exposure
to movements in the credit market, especially in correlation.
Traders need to demonstrate they've done this before they're
allowed to book the profits on their deals, so from their viewpoint
it's worth buying protection, for example from 'monolines' (bond
insurers), even if the latter would almost certainly be insolvent
well before any pay-out on the protection was due.
robc|5.14.08 @ 10:10AM|#
Jesse,
That answers my obvious question, but leads to another. If no one
expects a payout, why is there a market for this at all, and how
can it be used as a hedge? If I was analyzing their positions, I
would consider that as zero value, and therefore not a hedge.
|5.14.08 @ 10:18AM|#
Put the insurance company on the Moon.
To clarify, the only folly in this is buying such insurance.
Selling it is a lovely idea. I'm going to sell insurance against
the occurrence of a robot takeover.
"You can insure against the revolution? Who knew?" Yes, you can.
With weapons.
|5.14.08 @ 10:18AM|#
"That's not a likely scenario"
Well, I'm not voting for Obama either, but I wouldn't consider his
victory unlikely.
Episiarch|5.14.08 @ 10:41AM|#
News flash: Jesse is also Richard Bachman and Stephen King is a liar. Jesse, The Running Man was great.
|5.14.08 @ 10:46AM|#
Jesse's "Theory of Moral Sentiments" could have gone a little deeper into off-shore radio stations.
|5.14.08 @ 10:47AM|#
So basically buyers are just looking to park their money somewhere. But since there's zero expectation that the policy could actually pay out, it's just another speculative market, as evidenced by the recent irrational run up in price. This bubble must burst and the 'end of the world market' will inevitably collapse. Therefore buying this insurance is a high-risk speculative play of the exact opposite nature from the exposure hedge they are ostensibly being purchased for.
|5.14.08 @ 10:51AM|#
it's just another speculative market, as evidenced by the
recent irrational run up in price.
It would only be a speculative market if the buyers had the right
to re-sell their policy. This seems to be simply a market that
capitalizes on irrationality and stupidity.
|5.14.08 @ 10:53AM|#
Back in 1998, I though of selling apocalypse insurance for Y2K. I was going to cover people for the end of the world caused by "Acts of God". Figuring that it was a) unlikely and b) if the end of the world came, I'd be long gone. I just couldn't figure out how to get through the regulatory hoops to legally do this.
|5.14.08 @ 10:54AM|#
And by Y2K, I mean the year 2000 and not the expected breakdown of global computing.
|5.14.08 @ 11:00AM|#
It would only be a speculative market if the buyers had the
right to re-sell their policy.
That's true. What makes you think they can't re-sell? Because that
would make even a ten-fold price run-up even more inexplicable.
gorgonzola\'s foil|5.14.08 @ 11:02AM|#
Someone has to buy the long tail to get it off the books, I get
it. Lloyds syndicates used to do this internally, and look what the
asbestos liability got them. Now, there's a market.
I'd be afraid of the counterparty risk, though. What keeps the
insurance underwriter from being 1/3 of the failed companies? Is it
covered by a Superfriends combination of Munich Re, Swiss Re and
Berkshire Hathaway?
MR|5.14.08 @ 11:04AM|#
Ummm, why cannot this (hypothetical?) insurer be based outside USA? Even this end-of-the-world marxist president in Washington is not the end of the world...
ktc2|5.14.08 @ 11:05AM|#
I'm lost. Why buy insurance that has zero chance of ever paying out? How is that in any sense a hedge against anything? You're just giving your money to someone in exchange for . . . nothing, ever.
|5.14.08 @ 11:07AM|#
What makes you think they can't re-sell?
Insurance is not usually tradeable. However, after scanning TFA
(it's very long), it appears that this is a form of derivative
trading and not true insurance, thus it is a tradeable
entity.
So it looks like you're right.
|5.14.08 @ 11:10AM|#
Ummm, why cannot this (hypothetical?) insurer be based
outside USA? Even this end-of-the-world marxist president in
Washington is not the end of the world...
The US economy is 20% of global GDP, so while it's not the end of
the world, the rest of the world is f-ed. Not to mention that the
largest multinationals are based in the US. The revolutionary
Marxist governments aren't going to be pleased with Goldman Sachs,
IBM, McDonalds, Coke, etc. Their foreign offices will still run,
but they're not exactly hydras, where cutting off their head will
have no negative effect.
|5.14.08 @ 11:19AM|#
Judging from Jesse's answer to the obvious question, this appears to be yet another form of accounting magic, insisted on by auditors in industries that deal with credit and trade confidences. It doesn't make sense to anyone but someone that deals in moving money to make money. If you're selling something other than confidence in the world economy, this makes absolutely no sense, but if the product you're selling is bets on trade deficits, government bonds and other intangibles, then you probably have to play this charade with your accounting group to get investors to believe in your product. In the end, its all a shell game.
NeonCat|5.14.08 @ 11:20AM|#
@ Pro Libertate
Those wouldn't be robots that run on old people's medicine, would
it? Strong robots with metal claws?
|5.14.08 @ 11:22AM|#
MP is correct. The use of the word "insurance" is a metaphor for
complex derivatives markets designed to serve as a hedge against
the default of very senior bond tranches.
They are available in different markets as well. For example, you
could purchase "insurance" against AAA securities backed by
residential mortgages on the RMBX index. I believe that in order
for this contract to pay off, something like 20-30% of all US
homeowners would have to default. Very unlikely, but according to
most banks' internal rules, all trades have to be hedged
appropriately, so there is a market.
|5.14.08 @ 11:24AM|#
Brian24,
I see. If that is correct, I retract my previous statement.
However, I still think this is a market created by accounting
rules.
|5.14.08 @ 11:41AM|#
That's true. What makes you think they can't re-sell?
Because that would make even a ten-fold price run-up even more
inexplicable.
The magnitude of the run-up is inexplicable, but there is a reason
for a significant increase. The value of these derivatives goes up
if their credit ratings go down. If the market perceives a
significant chance of major changes to credit ratings, then there
is value.
Example, let's say I get a derivative to hedge against default of
GE corporate bonds. GE is AAA rated and the chance of default is
close to zero. However, if GE is downgraded to AA because of
exposure in their finance division, the value of the default hedge
goes up, even if there's still a vanishingly small chance they'll
default.
That, in combination with a lack of liquidity, counterparty risk
and credit tightness is the reason the values have gone up so much.
A 10-fold increase seems to be far to high, but I don't have access
to these derivatives to short them, so I can't profit off of my
belief.
|5.14.08 @ 11:41AM|#
MP
RTFA I second your observation on its length. While it does confirm
that these are derivatives that can be bought and sold. The article
claims that the price spike is the result of a lack of liquidity.
If I understand correctly, this is due to relatively few
institutions being allowed to construct these types of CDOs.
So it looks like bean counter bullshit. Buying this "protection"
satisfies the accounting rules to book your profit. But this is
basically selling assets of no value for cash, made possible by
forbidding just about everybody from cashing in on the free
money.
But they are traded on an open market, so it will correct itself
eventually. The correction is just being delayed by regulation.
|5.14.08 @ 11:52AM|#
Mo
I understand what you are saying. However, your example is not apt.
Hedging against GE is a legitimate investment. Even though the
chances of its collapse are tiny, you have a reasonable expectation
the derivative would pay out in the unlikely event that it does.
Even though the derivatives are bought and sold valued on GEs
current perceived health without regard to impending default, there
is still some real asset backing it up.
The 'end of the world' derivatives are different, they are complete
fiat with absolutely nothing backing them up. Their only real value
is as a sort of fee to the accounting world. Sooner or later they
must necessarily go to zero. There's simply no there there.
Kolohe|5.14.08 @ 11:55AM|#
Peter Thiel, founder of paypal, has some related thoughts in the
full essay linked to by this
marginal revolution post.
He sorta of said the opposite: Asset prices will always represent a
slightly higher "expected value" than would be calculated with
perfect knowledge of the 'true' probabilities, because there are no
counterparties to the non-zero probability utter catastrophic
failure.
This is embodied when he says, to paraphrase, 'Bet on China to
succeed, because you won't be able to collect if it fails.'
T|5.14.08 @ 12:09PM|#
"You can insure against the revolution? Who knew?" Yes, you
can. With weapons.
No, that's just insuring you can participate meaningfully in the
debate.
Gahan|5.14.08 @ 12:35PM|#
I'll stick with my basement full of canned peaches and beef jerky, thank you very much.
Gahan|5.14.08 @ 12:38PM|#
Pro Libertate,
Does your robot policy cover diesel trucks and household appliances
that inexplicably come alive and start attacking people?
|5.14.08 @ 12:41PM|#
the price spike is the result of a lack of
liquidity
I would like to believe the lack of liquidity is due to a shortage
of suckers willing buyers; but that's probably not
it.
Taktix®|5.14.08 @ 1:20PM|#
Sign me up too, and I'll take the "involuntary servant of the machine overlords" rider, please...
Gahan|5.14.08 @ 1:28PM|#
How dare you try to gouge me when countries like Cuba provide free robot protection to their citizens. Socialized robot insurance for all!
|5.14.08 @ 1:33PM|#
Taktix®,
There is an umbrella policy as well--don't miss this opportunity to
protect your family.
Gahan,
That's a myth. Cuba is totally unprepared for the advent of the
machines. Japan, on the other hand, is too prepared, having fallen
victim to robot
geishas some years ago.
robc|5.14.08 @ 1:48PM|#
Pro Lib,
The robot takeover happened in 2000.
New
Zealanders wouldnt lie to me, would they?
|5.14.08 @ 1:57PM|#
New Zealand? What does New Zealand know about robots? Sheep, opposition to nukes, and lovely settings for fantasy movies, yes, but not robots.
|5.14.08 @ 3:15PM|#
The 'end of the world' derivatives are different, they are
complete fiat with absolutely nothing backing them up. Their only
real value is as a sort of fee to the accounting world. Sooner or
later they must necessarily go to zero. There's simply no there
there.
There's something backing it up, it's unlikely, but there's a
return (sorta). It's like the people that buy the S&P 500 = 900
calls. There's virtually zero chance it will happen, so it seems
like free money. Then one does hit and the contract sellers are
f-ed.
"Bet on China to succeed, because you won't be able to collect
if it fails."
That's a dumb, ahistorical statement. Japan was way bigger and
badder in the 80s, its economy failed in the 90s and those that bet
against Japan became rich men.
|5.14.08 @ 3:22PM|#
Via Ken MacLeod, who comments: "You can insure against the
revolution? Who knew?"
10$ says no one sells insurance against a free market
revolution.
|5.14.08 @ 3:32PM|#
10$ says no one sells insurance against a free market
revolution.
Sure they do, it's just called an out of the money put for the
Wilshire 5000.
|5.14.08 @ 4:12PM|#
$10 says no one sells insurance against a free market
revolution.
That's because you only insure against bad things happening, not
good things.
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