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Saturday
Nov052011

Burning Down the House

The social outcomes of free-market capitalism heavily depend on the alignment of incentives between individual market players and the greater good: people, communities, society, and tomorrow's generations. One of the root causes of the current financial crisis can be found in a massive disalignment of these incentives.

My co-founder recently pointed me to a spot-on explanation of the destructive nature of credit default swaps, found in the book "The Big Short" by Michael Lewis. The analogy is extremely simple and powerful. Credit default swaps create an incentive to burn down your neighbor's house.

Credit default swaps and fire insurance

A credit default swap (CDS) is an insurance product. It protects the buyer against the risk of an adverse event such as a default, a bankruptcy, or a downgrade. That in itself is not a bad idea. Just like insurance in general is not a bad idea. Fire insurance, for instance, makes a ton of sense.

The problem arises when CDSs become naked, meaning that they do not require ownership of the underlying asset from the buyer. That is like buying fire insurance for your neighbor's house — and there are two very good reasons why an insurance company will never sell you fire insurance for your neighbor's house:

  1. Lack of ownership. If you do not own the asset, you do not care for it. Put differently, you would not mind if the house burnt down. Nothing in that house belongs to you. The only thing you know is that if it burns down, you get a huge amount of cash from the insurance company. That creates an incentive for you to do everything in your power to let that house go down in flames — or, at the very least, do nothing to prevent it from burning.

  2. Enabling leverage. Allowing the sales of insurance for other people's assets enable buyers to bet on the occurance of the insured adverse event and use the insurance policy as a highly leveraged investment — which yields higher returns the faster the adverse event happens. Now imagine that every single person in your street had a fire insurance policy on your house. Would you still trust your neighbors?

It is not like this was a big secret. Most people who know what they are talking about insist that CDSs are one of the most toxic derivatives ever conceived. The European Union is about to ban naked CDSs permanently. But why hasn't this happened earlier? The disalignment of incentives could not be more explicit than with CDSs.

Want to earn money burning down your neighbor's house?

What if that house… was Greece?

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References (2)

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    Burning Down the House - Thoughts on Technology and Innovation - Deviant Bits
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    Response: Maxx Test 300
    Burning Down the House - Thoughts on Technology and Innovation - Deviant Bits

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