Imagine that you take out a $10,000 life insurance on me for, say, $10 a month. (No, I don't know what the actual insurance quotes would be. I'm just picking an easy number for this example.) Now let's say that 99 of your friends also take out that same policy on me. So here we have a hundred people betting that I'm going to die. (Let me tell you, you're one sick bunch.) As long as I'm alive, insurance company is collecting a thousand bucks of easy money a month. (I get nothing except 100 invitations to poisoned dinners.) All is well until that fateful day when I kick the bucket ... which breaks my big toe, which causes an infection, which kills me. Happy now?
I'd like to think that the insurance company would be very sad about my death. But the fact is that they now have to pay out $1 million. Truly a sad moment. And, unless that company was able to collect on me for more than 1000 months, their sadness will amount to a major depression (which is worth a bucket of tears in today's economy though not the same bucket that caused my demise.)
So what can our poor insurance company do while I'm an absolute perfect picture of human perfection and longevity? ::: cough cough ::: They talk to another company and say, "We will pay you $500 a month. If our client dies, you will pay us $1 million." The second company looks me over and enthusiastically agrees that I am an absolute perfect picture of human perfection and longevity. (Did I mention of modesty too?) Since they believe they can make money in this deal, our second company agrees to the terms.
This is basically what happened in the investment community. In the beginning, it was like one person buying a life insurance on another. But because covering investment risk isn't called "insurance", this arrangement wasn't subject to any regulatory oversight. With economic times being good, this risk protection -- known as credit default swap (CDS) -- was quite profitable. This led to investment companies to start using CDS more as an investment tool and less as financial protection. One business would buy "insurance" from another company, who buy the same from a third company, who do the same with the fourth and so on. Soon, we had the same scenario as the one where 99 of your friends took out insurance on me. And then ... that bucket got in my way.
So that's what happened. I unexpectedly died and started the entire credit crisis. Like a row of falling dominoes, one company failed to pay out on its "insurance" policy, which caused the next company to not be able to pay out, and so on. Sorry about that. Oh well. The nice thing about being dead is that I don't have to worry about any expenses now ... or buckets.
1 comment:
Nice post. I guess that's the way insurance company works. Insured people then insured their company to another and so goes on. You're chance or assurance now to claim the benefits afterward is small or limited, and worst if you can't even get back what you had insured because the insurance companies would suffer bankruptcy.
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