The importance of language--and its abuse: when "swaps" really mean "insurance"
Saturday, May 29, 2010 at 12:07AM 
A simple but compelling observation by Floyd Norris in the NYT: "swaps" used to mean swaps, but then they were expanded to include protections that were tantamount to insurance:
As it happened, however, clever people on Wall Street followed the prescription laid down by Humpty Dumpty in Lewis Carroll’s “Through the Looking Glass:”
“When I use a word,” Humpty Dumpty said, in rather a scornful tone, “it means just what I choose it to mean — neither more nor less.”
When Alice protested, Humpty Dumpty replied that the issue was “which is to be master — that’s all.”
The word here is “swap.” It used to mean, well, a swap. In a currency swap, one party will win if one currency rises against another and lose if the opposite happens.
Credit-default swaps are, in reality, insurance. The buyer of the insurance gets paid if the subject of the swap cannot meet its obligations. The seller of the swap gets a continuing payment from the buyer until the insurance expires. Sort of like an insurance premium, you might say.
But the people who dreamed up credit-default swaps did not like the word insurance. It smacked of regulation and of reserves that insurance companies must set aside in case there were claims. So they called the new thing a swap.
In the antiregulatory atmosphere of the times, they got away with it. As Humpty would have understood, Wall Street was master. Because swaps were unregulated, calling insurance a swap meant those who traded in them could make whatever decisions they wished.
That decision, perhaps more than anything else, enabled the American International Group to go broke — or, more precisely, to fail into the hands of the American government. Had it been forced to set aside reserves, A.I.G. would have stopped selling swaps a lot sooner than it did.
The decision that swaps were not insurance meant that anyone could buy or sell them — or at least anyone who could find a counterparty.
Had credit-default swaps been classified as insurance, the concept of “insurable interest” might have been applied. That concept says that you cannot buy insurance on my life, or on my house, unless you have an insurable interest.
Meaning, you have to have skin in the game to ensure your reasonably non-self-destructive behavior.
Pretty sensible and a nice explanation that I've missed up to now. Simple works.
I will admit that I knew the swaps in question functioned like insurance; that's how I usually explained them--in rudimentary fashion. What I was missing was the knowledge that expanded function purposefully leveraged a rule-set gap. It makes the achieved abuse a lot easier to understand.
Reader Comments (4)
Switching names to avoid regulation should be considered fraud.
I was working on wall street as a software engineer in the years leading up to the crash. The last project I worked on involved CDS's. When I started on the project the group manager sat me down and explained what a CDS was, and when he finished, I said "oh, its insurance". He responded sternly, "no, thats covered by different regulations, dont call it that".
You can smell a crash coming in New York. The dot-com crash was preceded by a lot of bullshit - when you start having conversations with people who have idea what they are doing, making bank on ideas that simply aren't feasible long term. The housing crash was preceded by house prices completely out of line with incomes and the rental market, and conversations with people telling you the housing market never goes down. The financial crash was preceded by conversations like the one above.
Its all about the level of bullshit chatter. As my bullshit antenna goes berserk, its time to get out of the market.
Anyone remember Dow 40K?
"They" were using 'swaps' to cover toxic sub-prime mortgage paper
risk. .I learned how bad it was.
When my auto mechanic told me he was also Mortgage Broker,
( He said they don't confirm income and sub-prime Mortgages were easy to resell at a nice profit.)
this alleged connection between the Federal Reserve and my
auto mechanic, no matter how distant, caused the hairs on my neck to stand up and
my head to throb.
Maybe it was the oil fumes from the auto garage, but I don't think so.
Gerald
Anthropologist
Credit that is too easy to get is always a problem, and I am convinced that the Federal reserve is motivated by interests other than price stability and an employment target. Incidentally, Volcker was behind the painful but necessary short term rate hikes in the 80's...which made saving worth it, and I agree, with a stabilization in the growth of government, had a huge effect on the 90's boom.
Bad insurance is also a huge problem!...which leads to "too big to fail," the worst "government backed," meaning us, insurance ever devised!
I agree with "insurable interest," but these CDO's are one symptom of a greater disease: the delusion that money brings prosperity....no...they're just pieces of paper!