Monday, May 24, 2010

Sinking Seaworthy Ships

On March 9th, The Chairman of the CFTC said the following about credit default swaps:

Keynote Address of CFTC Chairman Gary Gensler - OTC Derivatives Markets Conference

"At the height of the crisis in the fall of 2008, stock prices, particularly of financial companies, were in a free fall. Some observers believe that CDS figured into that decline. They contend that, as buyers of credit default swaps had an incentive to see a company fail, they may have engaged in market activity to help undermine an underlying company's prospects. This analysis has led some observers to suggest that credit default swap trading should be restricted or even prohibited when the protection buyer does not have an underlying interest.

Though credit default swaps have existed for only a relatively short period of time, the debate they evoke has parallels to debates as far back as 18th Century England over insurance and the role of speculators. English insurance underwriters in the 1700s often sold insurance on ships to individuals who did not own the vessels or their cargo. The practice was said to create an incentive to buy protection and then seek to destroy the insured property. It should come as no surprise that seaworthy ships began sinking. In 1746, the English Parliament enacted the Statute of George II, which recognized that 'a mischievous kind of gaming or wagering' had caused 'great numbers of ships, with their cargoes, [to] have . . . been fraudulently lost and destroyed.' The statute established that protection for shipping risks not supported by an interest in the underlying vessel would be 'null and void to all intents and purposes.'


For a time, however, it remained legal to buy insurance on another person’s life in England. It took another 28 years and a new king, King George III, before Parliament banned insuring a life without an insurable interest."


History does seem to repeat in finance. The names of the products may change but the effect is the same.

From John Kenneth Galbraith's bookA Short History of Financial Euphoria:

"The rule is that financial operations do not lend themselves to innovation. What is recurrently so described and celebrated is, without exception, a small variation on an established design, one that owes its distinctive character to the aforementioned brevity of financial memory*. The world of finance hails the invention of the wheel over and over again, often in a slightly more unstable version." - John Kenneth Galbraith

The problems we face in finance today have parallels that go back a long way.

Adam

* More from the same book: "...for practical purposes, the financial memory should be assumed to last, at a maximum, no more than 20 years. This is normally the time it takes for the recollection of one disaster to be erased and for some variant on previous dementia to come forward to capture the financial mind. It is also the time generally required for a new generation to enter the scene, impressed, as had been its predecessors, with its own innovative genius." - John Kenneth Galbraith

CFTC Chairman Keynote Address

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