Remember in Hamlet when King Claudius discovers Laertes has been buying naked CDS protection on Danish government bonds? Polonius, the royal treasurer, fears it will increase funding costs and bring on a fiscal crisis. The king laughs off the threat with the famous line, “There's such divinity doth hedge a king, that treason can but peep to what it would, acts little of his will.”
Few modern CEOs or heads of state have demonstrated the same wisdom and courage. Instead we are likely to hear less poetic line, “It’s like buying fire insurance on your neighbor’s house!”
To suffer the slings and arrows
Actually it’s not like buying insurance. The distinction between hedging (including buying covered CDS protection) and insurance is Finance 101 material. You buy insurance on physical assets, when you buy fire insurance you are betting against a physical house. You hedge against mismanagement of physical assets. You don’t short a country or a company, you short its management. You believe the physical assets would be worth more with different people in charge. It’s easy to see why the people currently in charge like to pretend you’re insulting the country or company, rather than themselves. What’s a bit harder to see is why the pretense resonates so widely.
Let’s start with pure insurance. There is a physical risk, that exists before the insurance contract is written: a building may be destroyed, an automobile may crash, a person may have a heart attack. People exposed to the risk all contribute to a pool which is used to compensate the ones hit by the risk.
CDS are entirely different. Two people make a bet, creating a new risk that did not exist before the contract was written. It is a paper risk. The bet is not that physical assets will be destroyed, but that they will pass out of one set of hands to another: a company will default, transferring control of company assets to a bankruptcy court and rearranging claims of stakeholders. There is no pool, the counterparties make daily payments to each other as the risk of bankruptcy moves up and down.
What’s in a name?
Before discussing why these things make such a difference, I should point out that not everything insurance companies sell is pure insurance, and not all CDS are free of insurance components. A mutual insurance company is the closest to the pure insurance definition, for-profit companies also add a layer of reinsurance, a financial contract more like a hedge than insurance. However due to regulations that allow companies to raise rates after a disaster to recoup losses, and prevent competitors from undercutting them, for-profit insurance companies can act a lot like mutual insurance companies.
What we call “health insurance” in the US has become almost completely divorced from insurance. For tax reasons, people are encouraged to run all medical expenses, including routine care, through the “insurance” wrapper. There’s a lot more prepaid service than risk-sharing involved. With health insurance reform, companies will be prohibited from charging on the basis of risk, and customers will be required to buy, which makes it much more like a tax than insurance of any sort.
On the CDS side, we know that some protection sellers did not post mark-to-market collateral (AIG being the best known). That meant they had to reserve a pool of collateral for payments. Counterparties did not require this pool to be segregated due to AIG’s AAA rating but it still gave the AIG swaps some insurance features.
In the second half of the 1990s, insurance products competed with CDS. They lost for a number of reasons. The CDS had standardized terms and documentation, and could be traded. Mark-to-market collateral presented less risk and required less capital than forcing protection sellers to keep reserves. Probably most important, CDS paid off seamlessly while insurance contracts too often led to lawsuits and negotiated partial payments, too late and uncertain for financial purposes. The point is that CDS and insurance are different, and for credit protection CDS won out in the market (insurance still dominates the residential fire market).
To forfeit his ungodly gains
The first difference between insurance and hedging is insurance is negative sum. Since the present value of the total claims paid from the pool must be less than the premiums paid in, due to overhead expenses and (sometimes) profit, it only makes sense to buy if it offsets a risk you already have. If you “buy fire insurance on your neighbor’s house,” it’s presumably because you expect a profit. If that’s because you plan arson, it’s clearly against public interest. But even if it’s only because you know your neighbor is at greater risk than the insurance company thinks, it’s still antisocial. You should warn of the danger, not attempt to profit from it. In any case, you shouldn’t extract profit from a pool of money that is meant to help victims. For this reason, the law requires an “insurable interest” to collect on an insurance policy.
On the other hand, both parties to a swap often think they have positive expected value. There’s no suspicion of intended crime, it’s just a difference of opinion (or possibly time horizon, risk preference, numeraire or other factor that makes a zero-sum transaction positive expected value to both sides). In other cases, one or both sides is hedging a risk.
CDS are written on public financial events that affect all portfolios in the market. You need not own the reference bond to have an interest that is hedged with a CDS. It’s hard to see how anyone can have a large financial interest in a house they don’t own, but it’s easy to see how someone other than a bondholder can be hurt by a default.
Most important, profit to the protection buyer does not come from a pool of money reserved for victims. It comes from a willing counterparty that wanted the bet. There’s no duty for the protection buyer to warn anyone, and even if there were, the only credible warning is to buy the CDS.
Nothing comes amiss, so money comes withal
The second difference is the social interest against undercharging for insurance. The premiums are used to build a pool to compensate for real, physical damage. That can only be done with real, physical money. Undercharging means the pool will be insufficient. With CDS mark-to-market collateral, there’s no expectation of a pool of money to compensate for damage, only daily payments. If one side cannot make the payments, the contract terminates, generally with at most a small loss, which concerns only one counterparty and no victims.
Another reason to discourage underpricing is that physical risk generally has negative externalities. Too-cheap insurance encourages too much physical risk, because insuring it is cheaper than preventing it. There are too many accidents, disasters and emergencies. The direct owners are compensated by insurance, but the community may not recover the costs of rescue and repair, nor the damage to bystanders and neighbors; and no one can recover the people killed. For this reason we have regulations forcing the price of insurance up, and laws requiring people to buy it.
On the other hand, we find all kinds of government subsidies pushing down the price of financial risk. We have loan and deposit guarantees, below-market funding and tax incentives to take financial risk. These spring from the belief that people take too little financial risk, there is not enough innovation, daring and entrepreneurship. When a new idea or new business takes off, the owner and the broader community both benefit.
Paper risk often substitutes for physical risk, with positive as opposed to negative externalities. Suppose a lot of people believe in home nuclear reactors, and a lot of other people disagree. If the first group builds millions of reactors we have real, physical losses if they’re wrong: wasted real assets and (possibly) uninhabitable ex-residential areas. If instead the people who disagree are allowed to short stocks, all the pro-nuclear people can get the financial exposure they want from a single small company. If the technology fails, the economic losses to its fans are the same, but the net damage to society is far less. If the technology succeeds, the short-sellers lose, but short-sellers don’t prevent homes from getting nuclear reactors.
Two households, both alike in dignity
Here is the proper analogy to buying naked CDS protection. Your neighbor in the suburbs is an older widow whose children have left home. She no longer needs all the room, nor can she maintain the house, climb the stairs nor pay the high property taxes to support schools she doesn’t use. She would like to sell the house and move to a no-maintenance condo in the city, near her children and with good access to shops and services without having to drive. Unfortunately, she thinks her house is worth far more than the best offer she can get, which is $400,000 from a young family.
You would like the transaction to go through, both because you care about your neighbor and because you would like a young family to come in and maintain the house and participate in the community. You think $400,000 is actually a generous price.
You suggest that she sell the house for $400,000, and also that she buy a virtual copy of her house from you for $400,000. That virtual house is really a contract, in two years you will get a professional appraiser to estimate the value of her house, if it is greater than $400,000 you will pay her the difference; if it is less than $400,000 she will pay you the difference. This allows her to sell the house and move, but get all the profit from staying if she is correct that the house is worth more than $400,000. If the house is worth less than $400,000, she still gains from moving, and the money she pays to you is money she would have lost anyway by keeping the house.
Note that you are not betting against the physical house, if it burns down fire insurance will cover the loss and make no difference to your contract. You are betting that the house is more valuable to the young family than to your neighbor. You want to change the management of the assets, not the assets themselves.
In a rational world, your neighbor would thank you for the offer as it allows her to have her cake and eat it too. Everyone would agree you have done a public-spirited thing. At worst, she would decline your offer with thanks.
In the real world, she will accuse you of pushing down the value of her house by offering to sell virtual copies for $400,000. She will claim you are the reason she can’t get full value for her house, even though you are offering her precisely that opportunity. The community will be outraged that she can’t move, and you will be blamed for the deterioration in the house she cannot maintain, and the revenue shortfall to the school district for the property taxes she cannot pay; not to mention the unfortunate young family cooped up in a small co-op with bad neighborhood schools. It will be your fault she doesn’t see her children often, that she gets in a car accident because her vision is deteriorating but she must drive to shop, and for the danger to her health because she is 30 miles from a hospital instead of 30 blocks. And everyone else disappointed by the market value of their houses will join in the chorus against you. And no doubt someone will say, “it’s like buying fire insurance on your neighbor’s house.”
I leave you find final words of wisdom from Hamlet, “Either a borrower or a lender be, but ne’er trade CDS, ‘tis better to be vile, than vile esteemed.”
About the author: Aaron Brown is risk manager at AQR Capital Management and author of The Poker Face of Wall Street and A World of Chance: Betting on Religion, Games, Wall Street (with Reuven and Gabrielle Brenner). He also is a columnist for Wilmott Magazine, and writes for a lot of finance and poker periodicals; as well as teaches classes and speaks at conferences. Mr. Brown serves on the Editorial Board of GARP and is a member of the National Book Critics Circle.
Few modern CEOs or heads of state have demonstrated the same wisdom and courage. Instead we are likely to hear less poetic line, “It’s like buying fire insurance on your neighbor’s house!”
To suffer the slings and arrows
Actually it’s not like buying insurance. The distinction between hedging (including buying covered CDS protection) and insurance is Finance 101 material. You buy insurance on physical assets, when you buy fire insurance you are betting against a physical house. You hedge against mismanagement of physical assets. You don’t short a country or a company, you short its management. You believe the physical assets would be worth more with different people in charge. It’s easy to see why the people currently in charge like to pretend you’re insulting the country or company, rather than themselves. What’s a bit harder to see is why the pretense resonates so widely.
Let’s start with pure insurance. There is a physical risk, that exists before the insurance contract is written: a building may be destroyed, an automobile may crash, a person may have a heart attack. People exposed to the risk all contribute to a pool which is used to compensate the ones hit by the risk.
CDS are entirely different. Two people make a bet, creating a new risk that did not exist before the contract was written. It is a paper risk. The bet is not that physical assets will be destroyed, but that they will pass out of one set of hands to another: a company will default, transferring control of company assets to a bankruptcy court and rearranging claims of stakeholders. There is no pool, the counterparties make daily payments to each other as the risk of bankruptcy moves up and down.
What’s in a name?
Before discussing why these things make such a difference, I should point out that not everything insurance companies sell is pure insurance, and not all CDS are free of insurance components. A mutual insurance company is the closest to the pure insurance definition, for-profit companies also add a layer of reinsurance, a financial contract more like a hedge than insurance. However due to regulations that allow companies to raise rates after a disaster to recoup losses, and prevent competitors from undercutting them, for-profit insurance companies can act a lot like mutual insurance companies.
What we call “health insurance” in the US has become almost completely divorced from insurance. For tax reasons, people are encouraged to run all medical expenses, including routine care, through the “insurance” wrapper. There’s a lot more prepaid service than risk-sharing involved. With health insurance reform, companies will be prohibited from charging on the basis of risk, and customers will be required to buy, which makes it much more like a tax than insurance of any sort.
On the CDS side, we know that some protection sellers did not post mark-to-market collateral (AIG being the best known). That meant they had to reserve a pool of collateral for payments. Counterparties did not require this pool to be segregated due to AIG’s AAA rating but it still gave the AIG swaps some insurance features.
In the second half of the 1990s, insurance products competed with CDS. They lost for a number of reasons. The CDS had standardized terms and documentation, and could be traded. Mark-to-market collateral presented less risk and required less capital than forcing protection sellers to keep reserves. Probably most important, CDS paid off seamlessly while insurance contracts too often led to lawsuits and negotiated partial payments, too late and uncertain for financial purposes. The point is that CDS and insurance are different, and for credit protection CDS won out in the market (insurance still dominates the residential fire market).
To forfeit his ungodly gains
The first difference between insurance and hedging is insurance is negative sum. Since the present value of the total claims paid from the pool must be less than the premiums paid in, due to overhead expenses and (sometimes) profit, it only makes sense to buy if it offsets a risk you already have. If you “buy fire insurance on your neighbor’s house,” it’s presumably because you expect a profit. If that’s because you plan arson, it’s clearly against public interest. But even if it’s only because you know your neighbor is at greater risk than the insurance company thinks, it’s still antisocial. You should warn of the danger, not attempt to profit from it. In any case, you shouldn’t extract profit from a pool of money that is meant to help victims. For this reason, the law requires an “insurable interest” to collect on an insurance policy.
On the other hand, both parties to a swap often think they have positive expected value. There’s no suspicion of intended crime, it’s just a difference of opinion (or possibly time horizon, risk preference, numeraire or other factor that makes a zero-sum transaction positive expected value to both sides). In other cases, one or both sides is hedging a risk.
CDS are written on public financial events that affect all portfolios in the market. You need not own the reference bond to have an interest that is hedged with a CDS. It’s hard to see how anyone can have a large financial interest in a house they don’t own, but it’s easy to see how someone other than a bondholder can be hurt by a default.
Most important, profit to the protection buyer does not come from a pool of money reserved for victims. It comes from a willing counterparty that wanted the bet. There’s no duty for the protection buyer to warn anyone, and even if there were, the only credible warning is to buy the CDS.
Nothing comes amiss, so money comes withal
The second difference is the social interest against undercharging for insurance. The premiums are used to build a pool to compensate for real, physical damage. That can only be done with real, physical money. Undercharging means the pool will be insufficient. With CDS mark-to-market collateral, there’s no expectation of a pool of money to compensate for damage, only daily payments. If one side cannot make the payments, the contract terminates, generally with at most a small loss, which concerns only one counterparty and no victims.
Another reason to discourage underpricing is that physical risk generally has negative externalities. Too-cheap insurance encourages too much physical risk, because insuring it is cheaper than preventing it. There are too many accidents, disasters and emergencies. The direct owners are compensated by insurance, but the community may not recover the costs of rescue and repair, nor the damage to bystanders and neighbors; and no one can recover the people killed. For this reason we have regulations forcing the price of insurance up, and laws requiring people to buy it.
On the other hand, we find all kinds of government subsidies pushing down the price of financial risk. We have loan and deposit guarantees, below-market funding and tax incentives to take financial risk. These spring from the belief that people take too little financial risk, there is not enough innovation, daring and entrepreneurship. When a new idea or new business takes off, the owner and the broader community both benefit.
Paper risk often substitutes for physical risk, with positive as opposed to negative externalities. Suppose a lot of people believe in home nuclear reactors, and a lot of other people disagree. If the first group builds millions of reactors we have real, physical losses if they’re wrong: wasted real assets and (possibly) uninhabitable ex-residential areas. If instead the people who disagree are allowed to short stocks, all the pro-nuclear people can get the financial exposure they want from a single small company. If the technology fails, the economic losses to its fans are the same, but the net damage to society is far less. If the technology succeeds, the short-sellers lose, but short-sellers don’t prevent homes from getting nuclear reactors.
Two households, both alike in dignity
Here is the proper analogy to buying naked CDS protection. Your neighbor in the suburbs is an older widow whose children have left home. She no longer needs all the room, nor can she maintain the house, climb the stairs nor pay the high property taxes to support schools she doesn’t use. She would like to sell the house and move to a no-maintenance condo in the city, near her children and with good access to shops and services without having to drive. Unfortunately, she thinks her house is worth far more than the best offer she can get, which is $400,000 from a young family.
You would like the transaction to go through, both because you care about your neighbor and because you would like a young family to come in and maintain the house and participate in the community. You think $400,000 is actually a generous price.
You suggest that she sell the house for $400,000, and also that she buy a virtual copy of her house from you for $400,000. That virtual house is really a contract, in two years you will get a professional appraiser to estimate the value of her house, if it is greater than $400,000 you will pay her the difference; if it is less than $400,000 she will pay you the difference. This allows her to sell the house and move, but get all the profit from staying if she is correct that the house is worth more than $400,000. If the house is worth less than $400,000, she still gains from moving, and the money she pays to you is money she would have lost anyway by keeping the house.
Note that you are not betting against the physical house, if it burns down fire insurance will cover the loss and make no difference to your contract. You are betting that the house is more valuable to the young family than to your neighbor. You want to change the management of the assets, not the assets themselves.
In a rational world, your neighbor would thank you for the offer as it allows her to have her cake and eat it too. Everyone would agree you have done a public-spirited thing. At worst, she would decline your offer with thanks.
In the real world, she will accuse you of pushing down the value of her house by offering to sell virtual copies for $400,000. She will claim you are the reason she can’t get full value for her house, even though you are offering her precisely that opportunity. The community will be outraged that she can’t move, and you will be blamed for the deterioration in the house she cannot maintain, and the revenue shortfall to the school district for the property taxes she cannot pay; not to mention the unfortunate young family cooped up in a small co-op with bad neighborhood schools. It will be your fault she doesn’t see her children often, that she gets in a car accident because her vision is deteriorating but she must drive to shop, and for the danger to her health because she is 30 miles from a hospital instead of 30 blocks. And everyone else disappointed by the market value of their houses will join in the chorus against you. And no doubt someone will say, “it’s like buying fire insurance on your neighbor’s house.”
I leave you find final words of wisdom from Hamlet, “Either a borrower or a lender be, but ne’er trade CDS, ‘tis better to be vile, than vile esteemed.”
About the author: Aaron Brown is risk manager at AQR Capital Management and author of The Poker Face of Wall Street and A World of Chance: Betting on Religion, Games, Wall Street (with Reuven and Gabrielle Brenner). He also is a columnist for Wilmott Magazine, and writes for a lot of finance and poker periodicals; as well as teaches classes and speaks at conferences. Mr. Brown serves on the Editorial Board of GARP and is a member of the National Book Critics Circle.