Insure your neighbor's house and then burn it down--derivatives played a role in creating the Greek crisis

02/12/2010 1:32 pm EST

Focus: STOCKS

Jim Jubak

Founder and Editor, JubakPicks.com

Credit default swaps are not insurance.

The most common way to describe these derivatives is to say that they’re a way to insure bonds and other financial instruments against default. I’ve used that explanation myself over and over again.

But as James Rickards explains in a column in today’s Financial Times, while these derivatives may be a way to insure against the danger of default, they very much aren’t insurance in one crucial way.

And it’s that difference that has helped turn the Greek budget “problem” into the Greek budget “crisis.”

It turns out while we’ve all laughed at Greek Prime Minister George Papandreou’s attempt to blame his country’s troubles on speculators, he had a point.

Okay, so how are credit default swaps different from insurance? The most critical difference is that while insurance regulators say you can’t buy fire insurance on your neighbor’s house—and then burn it down to collect—you can in effect do exactly that in the credit default swaps market.

In a credit default swap somebody sells protection against a default and collects a premium in return. The sellers, Rickards notes, are usually big institutional investors such as pension funds that have the collateral to put up to guarantee payment in case of a default.

The buyer on the other end of the swap is frequently another big institution looking to lay off risk or, and this is the crucial point, a hedge fund or some other relatively short-term trader hoping to make a quick profit if the odds of a default start to rise.

Think about what happens in a situation like the ongoing Greek crisis. As the odds of a default increase, the value of protection against a default rises. The buyers of that protection wind up holding the end of the swap that climbs in value every time the situation gets worse.

The seller of that protection winds up on the losing side of the swap. At best as the odds of a default rise, sellers of protection are required to put up more collateral against the possibility of a default. (Makes sense, right? More chance of a default. More collateral against a default). At worst, the actual asset that underlies the derivative, say, Greek government bonds or bonds of Greek banks, goes into default and the seller of protection has to cough up the cash.

Do you see the inherent problem in this set up?

Since the buyer of protection makes money as the odds of a default rise, buyers have an interest in seeing a “problem” turn into a “panic.”

Not all buyers of protection stand to profit as odds of a default rise. Some buyers actually own the underlying asset—Greek government bonds, for example, and they lose money when that asset falls in price as the odds of a default rise. For these buyers, a credit default swap indeed operates pretty much like insurance.

But not all buyers of protection against default by the Greek government actually own the underlying asset. They don’t own bonds that go down in price as the odds of default rise, writes Rickards. Instead the worse the situation seems, the more they profit.

The insurance industry recognizes this problem, which is why buyers of insurance are required to have an insurable interest. You can’t take out fire insurance on your neighbor’s house, for example, because you don’t have an insurable interest in that house. Buying insurance when you don’t have a stake in the underlying asset creates a perverse incentive, the insurance rules recognize. That insurance would actually give you an incentive to burn down your neighbor’s house.

Rickards may not be the most unbiased of observers. He is former general counsel of Long-Term Capital Management. Speculators of the kind he is calling out now had a role in the demise of Long-Term Capital as a result of $4.8 billion in losses during the 1998 Russian financial crisis. And there is no doubt that in the current situation Greece bears the bulk of the fault for the core budget problem: The country has cooked its books and mis-managed its finances for years.

But he still makes a very good point: the current structure of the derivatives market and the current minimal regulation of that market give some big money players huge incentives to turn problems into panics.

Remember that the next time some talking head tells you that what is actually a manageable problem means the end of the world.

Your panic could mean his profit.

Related Articles on STOCKS