CDS, CDOs and arsonists

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The CDS-market is basically an insurance market. Insurance has to calculate risk probabilities on a basis that can be objectively reproduced. However, an insurance company would not underwrite a policy for an event that may be influenced by the policy holder or at least would not concentrate large parts of its business in such policies as long as it cannot be diversified away, as for example in car insurance (most claims are accidents and only a few might have a fraudulent background) or there are strong incentives not to manipulate the payout (such as in life insurance).

Another way to insure risks that may be influenced is to underwrite charging high premiums, as happens with director’s liability or terrorism policies. This may dissuade people in defrauding their insurance because the gain achieved through fraud must be proportionally much higher.
CDS, on the other hand, may be manipulated quite easily over OTC markets and also by a third party which is the respective company subject of the CDS protection. Premiums are not high enough to be dissuasive and diversification is also limited.

Yet a step further is insurance on CDOs either through a CDS or monoline. CDOs pose an additional problem for insurance protection due to a basic flaw in their structure. They are not so complex instruments as is always said, but their problem lies within the fact that no one knows exactly what is packaged into them. One does not know whether one has sufficiently diversified away any risk, because policies are underwritten by others, i.e. one just gets the repackaged mortgages or loans and has to believe. Though, insurance, or investments in general, should not be a matter of faith but of verifiable statistics.

Regulation of risk management should therefore start where it is supposed to start: not with capital requirements based on complex valuation and risk management tools, but with the obligation to see whether risk management is actually possible for certain areas. Would you be able to manage the risk of underwriting fire insurance policies to an arsonist?

Good examples of a new generation o transparent investments are the cat-bond structures that have been issued this year. Collateral is marked-to-market daily and there are to-up obligations for swap counterparties. Something that should lead the way in other areas of securitisation.

http://www.hedgefund-lawyer.com/