There’s no real mystery to effective financial regulation – it comes down to a few simple principles. One of those principles is based on the concept of Insurable Interest, the idea that you can only buy insurance on something if you have an economic interest in it. As an example, you can buy fire insurance on your house, because you suffer financially if it burns down, but you cannot buy fire insurance on your neighbor’s house – it doesn’t cost you anything if his or her house burns down.
The idea of Insurable Interest isn’t something financial regulators came up with in the 1930s when we were creating our financial regulatory system. It dates back hundreds of years, to English Common Law – its been part of our history since the founding of our country. It’s a pretty simple concept that most people intuitively understand and is the basis of our laws regulating the issuance of insurance.
In almost every case, insurance is regulated by some level of government, to guarantee that the entity selling an insurance policy has the ability to pay any claims and that insurable interest exists. Wall Street, however, managed to avoid regulatory oversight for a kind of insurance on bonds, called Credit Default Swaps. Because Credit Default Swaps weren’t regulated the concept of insurable interest wasn’t applied – anyone could buy insurance on a bond, whether they owned it or not. Further, there was no oversight body insuring the insurance issuer could actually pay off the claims on the insurance it had issued.
Credit Default Swaps were a tiny bit of activity on Wall Street in the 1990s. However beginning in 2003 the Credit Default Swap activity exploded. At the height of the bubble, there were over $35 trillion in Credit Default Swaps outstanding. Depending on what was being counted, the corporate bond market at that time was only $8 to $14 trillion. So there was $2 to $4 of insurance for $1 dollar of bond outstanding. Credit Default Swaps had stopped being a form of insurance and instead had become a way of gambling.
Much of this bond insurance was issued by a very old insurance company, the American International Group, or AIG. When the financial crisis hit, the federal government stepped in to essentially guarantee the bond insurance policies that AIG had issued to other Wall Street financial institutions, even though those institutions rarely owned the bonds they had bought the insurance on. To keep AIG solvent, to keep it from being forced out of business, the federal government under President Bush invested $180 billion in AIG. This was the single biggest outlay of the $700 billion that the government used to help support our economy and avoid a depression. All because we let Wall Street avoid a very simple concept that we had followed literally since the founding of our country – you can’t buy insurance on something you don’t own.