Those Damned Derivative Thingies

by Chris Clancy
by Chris Clancy
Recently by Chris Clancy: Around With Ludwig

This essay is a story about insurance, or rather, a story about a type of insurance policy which underwent a mutation. This mutation was not spontaneous – it was engineered. It was one of the biggest scams ever perpetrated.

Paradoxically, the problem was that it worked too well and just got too big.

I hope you stay with the story until its denouement. Maybe you’ll be gobsmacked. If it moves you to go out and start looking for suitable lamposts – then it’s understandable.

When a business makes a loan to another party it can insure against the risk of default. This would be prudent behaviour if the lender had concerns about the borrower not repaying everything which was due.

Insurance companies, like all industries, work to a set of fundamental principles. Two of their most fundamental principles are indemnity and insurable interest.

Indemnity simply means that no-one should "profit" from making an insurance claim. Instead, the money received should be enough to restore you financially to the position you were in before the reason for making the claim occurred.

Insurable interest means that you cannot insure something unless you have a legitimate interest in protecting yourself against something bad happening to that thing. So, for example, you can insure your car or the life of your spouse. You cannot, however, insure the car or the spouse of a complete stranger since your only incentive would be the hope that something bad happens to either or both. In fact, you would have a very strong motive for making sure that something bad actually does happen to either or both!

What has the above got to do with the present mess?

Everything unfortunately.

Understanding the gravity of the situation we are now in means getting to grips with the dreaded "D" word – and I don’t mean "Depression" – I mean "DERIVATIVES"! Few understand them. The following quote refers to Gordon Brown:

"He … made the extraordinary confession that as Chancellor he 'didn't know a lot about' sub-prime mortgages – a key banking practice that sparked the economic collapse."

Mention of the ‘D’ word is usually enough to turn most people off instantly – therefore in what follows I have attempted to keep it as brief and clear as I can and to avoid mentioning this heinous word. Instead I’ll refer to them as Gherkins, Sprouts and Bananas.

The current crisis was started by cheap money being kept cheap for too long. It found its way into the housing market where things escalated as a result of government encouragement for lenders to make bad loans. The lenders who made the bad loans didn’t care since they could sell them on to someone else.

The buyers of these loans didn’t care either since they knew the government would bail them out if they got into trouble. These loans were then securitised; in other words, they were divided up into securities (financial instruments) called "Gherkins" and then sold on to the financial industry.

The financial industry then employed very clever people to mix these securities up in all sorts of permutations and combinations. By the time they had finished splicing and dicing, mixing and matching a new generation of financial instrument had emerged – these were called "Sprouts."

Why did they do this?

It was done to hide the fact that many of these securities were based on bad loans. As such they could only attract a "junk" credit rating which made them more difficult to sell on. By combining them with good loans in incredibly complicated mathematical models, using all sorts of weird and wonderful statistical techniques, this new generation of financial instruments could all attract a triple-A credit rating. Obviously this made these things highly marketable.

Sprouts were sold in vast quantities all over the world. The buyers simply looked at the credit rating. They didn’t know how these things were constructed. They didn’t realize that the models were flawed – Austrian economics tells us again and again that predictions involving human action cannot be reduced to mathematical formulae. (If you’re into self-abuse and really want to put yourself through it go here for a simplified example of how to create a Sprout – and more).

Let’s return to the world of insurance.

Organizations which had purchased Sprouts in huge quantities wanted to reduce their risk. Companies like AIG, for example, offered them insurance policies. In return for regular monthly premiums they could insure against their Sprouts going bad. This was quite legitimate since they had an insurable interest – they owned what they were insuring – and would be rightly indemnified in the event of default.

What happened next was that the insurance policies themselves were then securitised and another generation of financial instruments emerged called "Bananas."

These things have been loosely described as "insurance policies." Nothing could be further from the truth! These things had nothing whatever to do with indemnity and insurable interest. The buyers of Bananas were given the mysterious title of "counterparties." Nobody actually knows who they are.

What was their incentive in purchasing Bananas?

Put simply, Bananas were a bet in which the die was loaded in favour of the gambler, or counterparty. They were betting on the failure of bad loans which were purchased and then re-packaged into Sprouts and then sold on! For those in on the scam there was simply no reason to buy Bananas unless they were confident that the sub-prime market would collapse – which it did. They then claimed on their "insurance" policies.

No. Don’t reach for the bottle just yet. You’ll need a clear head for what comes next. Because it actually gets worse.

Just to recap. The housing food chain spawned three types of financial life form – Gherkins (Mortgage Backed Securities), Sprouts (Collateralised Debt Obligations) and Bananas (Credit Default Swaps).

In this must-read article by James Lieber (which I hope you pass on to as many people as possible) he argues that it was Bananas which turned what should have been a recession into a depression – that the failure of the sub-prime market and its concomitant Gherkins and Sprouts by themselves would not have landed us where we are now.

Why?

Because the amount of money which is still out there waiting to be claimed on Bananas is mind-boggling!

How did it become so large?

The answer is the word "replication." One Sprout could be "insured" time and time again. This is why the thing became so large.

Lieber, writing in Jan. 2009, estimated that the Banana liability was in the region of $600 trillion. In fact, Ellen Brown, writing in Sep. 2008, put total trade in Gherkins, Sprouts and Bananas in excess of $1,000 trillion. The latter is called a quadzillion. If so then we’ve made it – not billions or trillions any more – now we’re into quadzillions!

And just where has all this bailout money paid to financial institutions gone? There’s no way of telling because the Fed’s not saying. How much has gone straight into the pockets of the counterparties, whoever or whatever they are?

I pray HR 1207 makes it all the way. Maybe it will yield up the truth about what has been going on – the fact that it didn’t just happen – it was quite deliberate. And let’s be clear, as Lieber points out in his article, it simply could not have been done without collusion between major players.

Is there a way out of this nightmare? Well, call me an optimist, but there must be. If people can devise a system whereby a tiny elite run the world on money created out of thin air, and get away with it, then surely we have the wit to devise a method of neutralising or cancelling these things – of evaporating them into thin air!

Then go after the counterparties who have already received money and prize every stinking penny from their filthy money-grubbing fingers.

This is no conspiracy theory – it’s fact. See here and here for two articles recently published on LRC – laugh or cry, it’s up to you – but we’ve all been conned, scammed, stiffed or any other word you can think of – yet again.

The greatest scam in history has littered the world with banana skins. There’s a lot more slipping and sliding to go before we emerge from this one – if we ever do – and in one piece at that!

July 6, 2009

Chris Clancy [send him mail] is Associate Professor of Financial Accounting at Zhongnan University of Economics and Law in Wuhan, Hubei Province, People's Republic of China.