Robert O’Harrow Jr. and Brady Dennis of the Washington Post penned a detailed account of how “credit default swaps” helped bring down the world economy. Monday’s installment deals with the genesis of the unholy instruments; Tuesday’s chapter covers the way AIG Financial Products applied them and undermined the global financial system.
Time’s Justin Fox puts part two in perspective. Highlights:
Insurance works financially when it protects people from smallish events that occur randomly-like fire, or burglary, or death. The business turns problematic when it gets into regional debacles like hurricanes and earthquakes, and completely untenable when it faces a global or even national disaster. That’s why property insurance policies often include “Act of God” clauses that give the insurer an out in case of earthquake or meteor strike or Rapture. It would have been interesting if AIG had tried to sell credit default swaps with such a clause-we’ll pay up unless credit markets totally fall apart. It didn’t, so it was essentially running a scam. In the situation that market participants most needed insurance against, AIG wouldn’t be able to provide it. At least not without a couple hundred billion in U.S. government aid.
It retrospect, it seems clear that buying credit default swaps allowed many lenders to believe that they could safely lower lending standards-because they’d outsourced the risk to somebody else. That rendered AIG’s historical risk models completely useless.
Why didn’t the authorities do something? They did. They made this entire catastrophe possible by rendering CDSs and similar con jobs invisible through Senator Phil Gramm’s Commodity Futures Modernization Act.
Image by Mike Licht. Download a copy here. Creative Commons license; credit Mike Licht, NotionsCapital.com
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