I just spotted the next global "black swan" -- but I think it
actually looks like a giant Pteranodon. I'm talking about so-called
The Lowdown on "Death Derivatives"
After betting trillions on everything from
to mortgages that never should have been issued in the first place,
the big banks are back and they're betting on death -- yours and
It seems that Goldman Sachs Group Inc. (GS), JPMorgan Chase
& Co. (JPM), Deutsche Bank AG (
) and others now want to help securitize "longevity risk" through a
newly created derivatives market.
I don't know whether to laugh or cry.
Here's the deal. The banks want to collect billions in fees from
pension funds and other institutions by issuing insurance that will
manage the risks associated with living longer than the financial
planners planned. What Wall Street is proposing is to package up
the fees from these instruments into bonds that are then
securitized and sold to investors via a secondary marketplace the
banks themselves will effectively create -- a "death derivatives"
You might think this is farfetched, but the idea is actually far
enough along that several financial institutions have already
created mortality-rate indices that will be used to price and trade
these death instruments. For example, David Blake, director of the
pensions institute at the London-based Cass Business School, helped
JPMorgan and Credit Suisse Group AG (
) develop mortality indices for the United States, Germany, the
Netherlands and Wales in 2007.
He told Bloomberg
that this is to help buyers and sellers price derivatives more
accurately and to boost confidence to create a more liquid market.
In my mind's eye, I can see and hear the nightly business news
report that would result:
"The Dow Jones Industrial Average fell 200 points in trading
today, while the death-note index spiked another 53 points on
news that the nation's new healthcare plan failed to prevent
market-related heart attacks."
Or how about this one:
"In an effort to maintain profitability and meet future
liabilities, the Dewey, Cheatem and Howe Insurance Co. late today
bumped off another class of policyholders. This continues a
recent trend that began due to pressure from some of Wall
Street's leading investment banks."
The conspiracy theorists are going to go nuts.
While I can understand the desire these companies have to offset
the financial risks of living longer, we need to take a step back
here and remember that
we've been down this path before
. And that "path" abruptly ended at a sheer cliff.
Right now, the worldwide derivatives market is valued between a
"conservative" $600 trillion and a potential peak of $1.5
quadrillion dollars, according to the latest research -- but nobody
knows for sure because so much of the market is totally unregulated
even at this stage of the game.
You'd think global regulators would have figured out that these
things are bad news. But that's not the case at all. As a result
... well, here we go again.
The bottom line: There literally isn't enough money on the
planet to bail out this market if or (more accurately) when it goes
bad. And the last thing we need is more self-dealing derivatives
and yet another set of financial instruments banks can "trade"
amongst themselves -- with very little, if any, oversight. I find
it particularly troubling that these instruments are being designed
from the get-go to be traded off bank balance sheets, meaning there
will be virtually no capital-reserve requirements.
Talk about playing with fire.
The Death-Derivatives Dilemma
What's happened here actually is very simple. Thanks to better
medicine, better diets and simple science, people are living longer
and the companies that are responsible for pension plans and
insurance payouts didn't plan for this. So they've got hefty future
payments to make up.
Every year of additional life expectancy typically adds as much
as 4% to future pension requirements, according to Dutch insurer
Aegon NV (
). Aegon said last week that money set aside to cover policyholders
in the Netherlands, who are living longer than expected, resulted
in a 12% hit to its first-quarter profits.
Enter death derivatives. With these new instruments, if retirees
die sooner than expected, the investors who buy the "death notes"
profit. If those retirees live longer, investors will have to cough
up the additional money needed to pay them off. In the meantime,
they're holding "bonds," for lack of a better term, that pay 5% to
8% a year for 20 years.
But here's the thing: Insurance companies have to meet reserve
requirements and the money that funds their policies has to come
from somewhere. This is why these types of companies "reserve" a
portion of their policy premiums and overall earnings against
future capital needs.
I call this the "death-note dilemma," and it is actually quite a
fine line. If these companies put too much money into reserves,
they blow their quarterly or annual earnings -- and investors don't
like that. If they put too little into their reserves -- and end up
being "underfunded" -- their policyholders won't have the money
available to them when they need and expect it.
Enter Wall Street. By taking the "death notes" into the
financial markets, the companies now shunt risk to the rest of us,
while placing bets that have nothing to do with stocks, bonds or
even national debt. In other words, instead of trading risks
between the pension fund and its pensioners, these notes allow
investors to speculate on individuals over whom they have no vested
economic interest in keeping alive.
This is like buying fire insurance on your neighbor's house.
Instead of safeguarding that property -- as you would your own --
you have every incentive to burn it down so that you might collect
What's more, by creating vehicles outside the system that are
self-priced and self-regulated, there are no capital requirements,
no regulated exchanges, and almost no laws capable of restraining
(or even assessing) the risks being taken - that is, until the very
same companies that stand to collect billions in fees by selling
these things for the next 20 years blow up and the rest of us have
to bail them out ... again.
Even at the government's pathetically understated and completely
manipulated 2.9% core inflation rate, $17 trillion turns into $30
trillion in 20 years. At the more realistic 9% rate that we're all
feeling in our wallets right now, that same $17 trillion turns into
$95.27 trillion within the very same time frame.
And once a pension fund or other financial institution purchases
one of these ticking financial time bombs, they're on the hook for
an instrument that they can't adequately value, probably can't sell
and, at a time of crisis, almost assuredly won't be able to unwind.
That makes the so-called "counterparty risk" even riskier.
The industry and the banks maintain the risks are somehow low or
manageable because insurance companies don't go bust. But they do
-- the collapses of American International Group Inc. (
) and Lehman Bros. Holdings Inc. are tangible evidence of that
How to Solve the Death-Derivatives Dilemma
So now what? The way I see it, regulators the world over need to
act -- and quickly. The very same companies that have already taken
the world on a white-knuckle ride that it neither signed up for nor
deserved will do it again.
The solution is actually very simple. Instead of trying to
regulate entities or markets, the powers that be need to regulate
businesses by function. In this case, it doesn't matter if you call
the "death note" a swap, a policy, an option, a bond or a kumquat.
If the payout is based on the probability of some event occurring,
that's insurance by any other name and it needs to be regulated as
such -- with the appropriate level of reserves to back it up.
Absent that, these Wall Street "players" (and I imbue that term
with all the scorn that is warranted) will once again gorge
themselves, gambling on conditions they can't quantify by using
self-created instruments that have no transparently determinable
economic value and no clearly defined risks ... but for which the
entire global economy has been conscripted without its
That's one bet I don't want to make based simply on my own
mortality. And it's sure as hell a bet I don't want somebody making
on me in the name of profits.
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