'Death Derivatives': Wall Street's Latest Ill-Advised Maneuver

Keith Fitz-Gerald submits:

I just spotted the next global "black swan" -- but I think it actually looks like a giant Pteranodon. I'm talking about so-called "death derivatives."

The Lowdown on "Death Derivatives"

After betting trillions on everything from liar loans 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 mine.

It seems that Goldman Sachs Group Inc. (GS), JPMorgan Chase & Co. (JPM), Deutsche Bank AG ( DB ) 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" market.

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 ( CS ) 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:

Or how about this one:

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 ( AEG ). 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 your payout.

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. ( AIG ) and Lehman Bros. Holdings Inc. are tangible evidence of that reality.

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 knowledge.

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.

Disclosure: None

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

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