I was recently struck by the similarity between two economic phenomena – health care insurance and credit default swaps. Or more accurately, the similarity in how they don’t work how they’re designed to.
From the New York Mag on Goldman Sachs and CDS’s:
As it happened, Goldman Sachs was AIG’s biggest banking client, having bought $20 billion in credit-default swaps from the insurer back in 2005. The swaps were meant to offset some real-estate investments Goldman had made, specifically a bunch of mortgage bonds it had on its books. The idea was simple: If the value of the mortgage bonds went down, the value of Goldman’s AIG swaps went up, assuring Goldman was safe from all-out losses on what it feared was an upcoming collapse in real estate. In reality, this was nothing like insurance and much more like an old-fashioned hedge.
By that weekend in September, Goldman Sachs had collected $7.5 billion from its AIG credit-default swaps but had an additional $13 billion at risk—money AIG could no longer pay. In an age in which we’ve become numb to such astronomical figures, it’s easy to forget that $13 billion was a loss that could have destroyed Goldman at that moment.
From the LA Times:
Blue Cross of California encouraged employees through performance evaluations to cancel the health insurance policies of individuals with expensive illnesses, Rep. Bart Stupak (D-Mich.) charged at the start of a congressional hearing today on the controversial practice known as rescission.
MR already made key points, but I think one thing is worth pointing out.
In financial engineering – because of agency, liquidity, contractual, or statistical self-deception, a device which is supposed to protect you from disaster ceases to operate correctly in disastrous environments.
In comparison, imagine if seat-belts worked fine at low speeds, but ceased to work at high speeds. What point is there then?