In our insurance-minded society, it’s hard to imagine going without it. It never used to be the case. It’s something of a modern invention. If you go back in time you find that the further back you go the less prevalent the idea of insurance was. Certainly no one thought of it during medieval times. If your hut burned down, or your hay cart caught on fire, you were just out of luck. You couldn’t call Allstate or Farmer’s Insurance to bail you out. Of course, having insurance sets our minds at ease some; we don’t consider so much the possibility of a catastrophic loss. We just figure if something really bad happens, we’re covered.
In some ways the idea of insurance has been taken to the extreme. We insure against everything now. We don’t want to be caught shorthanded. Now, living a life without risk isn’t just a privilege, but it’s our right. Or so we think. We even insure our investments now. But something happens to your mindset when you insure everything; you entirely disregard risk as though it’s not even there. Guarding against risk by paying for it is kind of a new idea. But you can’t eliminate risk altogether. And sometimes in an effort to minimize risk you actually make it worse. But the prime attraction of insurance is that risk isn’t eliminated, but spread out across a large body of clients. And, unfortunately, in a certain way insurance has made us a bit overconfident; we think that, even though risk has been mitigated somewhat, we’ve eliminated it altogether.
This whole idea is partly what led to the housing crisis of 2008. The idea of credit default swaps was born as a way to insure against default on CDOs (a collection of Mortgage-backed securities—bonds—an investment vehicle), and especially on high-risk CDOs involving the now infamous “sub-prime mortgages”. Those who created the CDOs in the first place deemed them safe—even on the riskiest pool of mortgages—simply because these mortgage bonds were pooled together. In a way, by pooling these together, it was a type of insurance against the risk of loan default. So, now CDSs (Credit Default Swaps) were created for a select few who had little faith in these CDOs to insure them from the downside risk if one of them should fail. Which almost no one thought could ever happen. In a way, it was a kind of insurance on your insurance. And if some people need to insure their insurance, then maybe the first insurance isn’t so good. Or put another way: if some are insuring their investments, then maybe they’re a bit too risky. But this isn’t the worst of it. When you involve the implementation of mortgages with adjustable rates, of which a large number are set to increase at the same time, it’s a powder keg waiting to happen. Those select few who saw the mortgage bonds imploding and bought the CDSs won big, but the rest of the public were in for a world of hurt.
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To be honest, looking at all this in retrospect boggles the mind. I mean, what were they thinking? When you look at this now you think, “Oh yeah. What could possibly go wrong in that scenario?” <sarcasm intended> I guess I look at it this way: if the world economy had gone down, even those who bet against the housing market would have gone bust. But the bottom line is that you can’t insure against everything. And sometimes you’re taking insurance past the point of the purpose it was intended to serve.
Wang, Dan. (May 12, 2014). Collateralized debt obligations and credit default swaps. Retrieved from http://danwang.co/collateralized-debt-obligations-and-credit-default-swaps/