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.
Remember AIG? You should — you bought it, and you just gave it a Christmas gift, billions of tax dollars.
Justin Fox:
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.
The U.S. economy’s response? Credit meltdown and an effective unemployment rate of 12.5 percent. Swiss Banker Phil Gramm’s response? He keeps the deregulatory faith.
Image by Mike Licht. Download a copy here. Creative Commons license; credit Mike Licht, NotionsCapital.com
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NotionsCapital 
January 2, 2009 at 11:34 pm
Insurance. Infant life insurance is like taking candy from a baby. Many years ago I learned about the insurance industry, which is really an industry to take premiums to make the company money and then deny claims. They are investment firms, a la Lloyds of London which originated to insure ships sailing from London.
The fact that they joined the pack in drinking the free investment cool-aid should not be a surprise. And AIG got a huge bailout for its errors.
So now we and our children and grandchildren have bailed them out. The seat belt law never lowered our rates even though insurance companies made out like bandits. I wanted to tether cuts on premiums to the seat belt law. No way, they just made more money.
All I do now is pay my premium, but have now learned that every week insurance companies are required to tell ??? who is current on their insurance bill and who is not. I just read it in the paper and wonder who is going to get this information and how they’re going to use and distribute it.
Privacy, again. It seems they missed the target population – those who have no insurance and plan to stay that way. You missed the mark on that one.
One wonders what it means to be “insured.” Dee
January 3, 2009 at 12:25 pm
You have to admire an industry that has the gall to raise policyholders’ rates when insurance companies make investment mistakes.