Newsworthy Math

What Was Wrought

CDO’s (collateralized debt obligations), see this for my introduction to these, depend on underpriced low grade debt. If I can get a 20% discount on debt that has a 10% chance of defaulting, then I should just buy this all day. All I need is enough risky debt (and some confidence in these percentages, but that’s a story for another day). But as CDOs became more and more popular low grade debt was getting used up. Even worse, as demand for it grew its price rose. CDOs were changing the entire ecosystem of low grade debt. There wasn’t enough of it and it was too pricey. There was no profit left. What to do?

One compelling answer was to simply issue more of it. Brokers could persuade people to take on deceptively structured mortgages, that could only get paid back if house prices rose forever. Lousy business plans were funded by people whose sole investment in the debt was they commission they got for issuing it. Dogs were being offered credit cards. These guys made the Glengarry Glenross salesmen seem like saints.

But there’s only so much new low grade debt that this can create and only so low you can go. Enough of it was issued to ruin the economic lives of people who thought they were just buying a house, but not enough to feed the maw.

Alchemy

What there was plenty of was collateralized debt. Some was graded AAA, some graded B. Why not buy these crappy debts and create CDOs? So, we start with $100 of debt that someone was misled into borrowing. We structure that to create $60 worth of grade B debt. Get enough of that and you can create another CDO, with $50 worth of single B tranches, and so on. $100 of crappy debt turns into $300 worth of crappy debt. (I’m making up all these numbers, but the principle is correct.) These were the synthetic CDOs. George Soros (that vicious communist) says pretty much that in April 23rd’s Financial Times.

So why was so much money lost? Why were trillions of dollars needed to prevent an economic meltdown?  It wasn’t because people took out trillions of dollars of mortgages they couldn’t afford. It happened because people got paid, and very well paid, for turning $100 worth of debt into $300 of debt. So they did it again, and again. What did they have to lose?

The life insurance business is very good at calculating the probability of you dying within the next year. It’s one of these things that we’ve being doing so long that we’re pretty good at it.

Given your circumstances, they can produce a curve showing the probability of you dying at any given year from then on.

Here is an hypothetical curve of life expectancy at birth. Babies have a higher risk of dying than older children, then it pretty much rises (though far more complexly than the curve below suggests).

Given your circumstances

Your circumstances, the things that shape your probable mortality curve, are complex. Your sex, your ethnic mixture, your behavior, your age, (not always a negative, in Mediaeval Venice insurance for a 20 year old cost the same as that for a 40 year old, the 40 year old having proved himself immune to the prevailing diseases). These, and  many other dimensions, contribute to the shape of your mortality curve. Think of it as eHarmony calculating your annualized compatibility with death.

If the insurance companies can calculate these curves accurately enough, can sell enough insurance to even out the risks, and have enough capital behind them that they can survive a temporary run of bad luck, then they can charge a little bit above the real risk, and make a tidy, reliable profit. Paying over the odds can be well worth it for the individual, given the effect of catastrophe, and this can be a perfectly reasonable business. That’s what most of AIG did, and did well.

Insurance companies also have a get out of jail free card: the Act of God. Mortality curves can only take so much into account. If the earth’s crust splits, if a meteor strikes and makes half the planet uninhabitable, if the zombie epidemic finally erupts, or if the river floods (different insurance contracts are more or less inclusive in what they count as Acts of God), then all bets are off.

What Insurance Is

Insurance is a way of sharing risk. If we each have a one in a thousand chance of our house burning down, and we all pay two thousandths of the value of our house, then all things being equal, the people whose houses burn down will be paid back, and there’ll be some money left over as recompense to the people who set up the deal.

But insurance can’t reduce risk, it can only share it. And probabilities can only be calculated based on an enormous number of assumptions. The reliability of these assumptions is up for grabs. In the financial world the invisibility of these assumptions can have dire consequences. I shall take this up again in an overdue discussion of Credit Default Swaps.