The Hindu Business Line : CDS: Insuring neighbour’s house

In Credit Default Swap, there is a distinct possibility of the insurer being hamstrung in the absence of a direct interface with the reference entity.

S. Murlidharan

The irrepressible Warren Buffet described Credit Default Swap (CDS) as financial weapons of mass destruction after it had brought the formidable American insurance giant AIG on its knees, necessitating a huge government bailout. CDS conceptually is a simple Over the Counter (OTC) contract between a party and counterparty against bad debts in our lingo and against Non-Performing Assets (NPA) in the American.

In other words, it is insurance against a financial default. There is nothing wrong in this except that the reference entity, that is, the borrower himself, is not in the picture unlike in the case of a bank guarantee or its variant Letter of Credit (LC) even though it is his financial health that is being speculated upon.

Thus Lehman Brothers holding bonds of Citibank would take insurance against default by Citibank, known as reference entity, that is, the entity whose financial health is the subject of intense scrutiny by the buyer of the insurance product Lehman Brothers and its seller AIG.

Prescribing without seeing

This practice smacks of a doctor writing a prescription without seeing the patient, going strictly by the symptoms and hearsay. In the event, its efficacy may be suspect. A company seeking loan from another and providing a bank guarantee as comfort to the lender, bares itself before the bank, laying down financial and other details that are relevant and demanded. Likewise, a rating agency pores over the information provided by the company whose instrument is being rated.

But a CDS is bought behind the back, so to speak, of the reference entity. Even though there is nothing immoral in this, there is a distinct possibility of the insurer being hamstrung in the absence of a direct interface with the reference entity.

Many in the know say that AIG committed the sin of treating CDS like any other insurance product, whereas it is one thing to insure a house but quite another to insure the mortgage on the house given the fact that while a house is likely to have the same set of risk factors, each mortgage borrower is unique.

In the event, its examination of mortgage-backed securities was at best perfunctory, vicarious and slipshod with an eye on premium alone in a milieu where house prices were soaring, lulling it into complacency.

Altar of greed

To be sure, most of the financial products including the much vilified derivatives have had a noble origin but started going off at a tangent at the altar of greed. This happened to CDS too. From a purely hedging tool, it soon became a speculative one so much so that one could take an insurance on the financial health of another even though he had no exposure whatsoever, in a manner of one taking insurance on the house of his neighbour.

One of the fundamental tenets of insurance is insurable interest which alas was given a go-by in the overarching desire to earn hefty fees on bets placed about the financial health of a reference entity.

The readiness of insurers to insure even in the absence of insurable interest encouraged brinkmanship though market enthusiasts rationalised it as a right step in ‘discovery’ process — this time round discovery of the financial health of a reference entity.

CDS as a speculative tool, ironically, fetched dollops of money for the buyer of insurance without insurable interest on default by the reference entity. And to the insurance company limitless premia.

Soon the insurance product became transferable not through assignment but in the marketplace — the original insured (without insurable interest) who had paid premium to the insurance company hawked his insurance cover to another, once again without insurance interest, when the reference entity’s woes increased warranting a greater premium. The calculation was simple. With the reference entity in a bad shape, fresh insurance premium would be much higher. Why not enter into a win-win deal?

Indian Scenario

The AIG fiasco on the back of its mindless hawking of CDS should make any one go slow on such adventurism. One hopes our Reserve Bank of India eschews the urge to be among the Joneses. There are reports that it is keen on ushering in CDS. Probably, the foreign insurance companies are itching for action on this exciting if potentially dangerous arena.

It would be advisedly better to restrict CDS only for hedging. Placing a bet on a reference entity’s financial health and squeezing some money from an insurance company is obscene to say the least.

If at all an appraisal of a reference entity is to be done, let it be done transparently and directly because in the absence of insurable interest there is every danger of one setting fire to neighbour’s house smacking of a self-fulfilling prophecy.

For, in the speculative market for CDS there is a vested interest in the downfall of the reference entity for some thus encouraging them to actually engineer the downfall of the reference entity, especially if the huge stakes warrant such sadism.

(The author is a Delhi-based chartered accountant.)

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