Tuesday, March 10, 2009

Insuring against the end of the world

A fascinating development ...

Credit protection madness - Paul Krugman - NYTimes.com

Marketwatch reports:

The cost of buying protection against the risk that the United States will default on its mounting debt has surged in the past months, outpacing the rise in corporate-credit costs, now that the government has absorbed more private-sector debt...

... the people buying these contracts are crazy. A world in which the US government defaults would be a world in chaos; how likely is it that these contracts would be honored?..

The fundamentals are insane, yet "serious" people are offering this product. The comments on the post are quite good, particularly this one by "TC":

The price of CDS on the US may not necessarily be driven by outright purchases of CDS on the US. Rather, these contracts are often used as part of more complex arbitrage strategies. This could cause the price of a CDS contract to deviate from theoretical fair value by a significant amount...

So this development is fascinating because ...

  • In the esoteric world of finance 2.0 there's an angle from which this "makes sense" -- probably the same angle used by AIG's wizards in 2007.
  • The people who are selling this know they'll never have to pay out -- because if the US collapsed we'd be using seeds as currency.
  • There exist buyers who are either speculators betting on delusional customers or currently delusional customers.

So it's a bit of a mini-review of the past year in one news report.


chrismealy said...

I can understand selling this insurance, but who the hell is buying it? What could they possibly do with it that would make money?

There's gotta be a scam here, right?

JGF said...

Buyers may assume they'll find a greater fool to sell to. The gamble can work, to a point.