Perverse Incentives

After a break of more than a month during which the market whipped me around like a parent of the old used to whip an errant child, I have decided to start my daily musings in the hope that the bad luck of the month of March will end and I will revert to making money the way I used to when I wrote this note on a daily basis. Superstitious yes, but then I have exhausted all other rational ways of making money from this market and I am willing to try anything including subjecting myself to the torture of writing this daily and of course you to the even worse torture of reading it.

Let me start by saying that I went short yesterday when Nifty broke below 5280 levels. I will cut my short position and go long only above 5388 levels on Nifty futures. Having got this boring part out of the way I want to talk about how much I admire the US. While there is a lot to appreciate about he US, the use of Credit Default Swaps (CDS)by their large investment banks is something that makes me almost want to look up to them in awe. CDS allows the buyer to essentially bet on a binary event-like whether a company restructures/defaults its debt or not. The payoff naturally is if the outcome of that binary event is bad.

It is essentially like purchasing an insurance against a potentially bad outcome. Having said this, creating this product is not where their ingenuity lay. Allowing anybody to buy the CDS (insurance) even if they did not hold any of the insured assets was what made US so good. This allowed anybody to bet on any outcome. This free for all is what caused an explosion in volumes and a resultant increase in employment opportunities and eventually the countries GDP. But what stops me from actually bowing down to them in complete and utter devotion is the fact that they have not taken this concept of CDS to its logical conclusion.

I fail to understand what is it that prevents them from actually allowing individuals to buy insurance from insurance companies on assets owned by somebody else. For eg I should be allowed to buy fire insurance on my neighbors house. Or a life insurance on my colleague. OR anything that catches my fancy. Just imagine the sudden explosion of business that the insurance companies will have. In one swell stroke US can take care of GDP growth numbers and employment numbers. Wait, you say that doing this will create a perverse incentive? An incentive for me to buy fire insurance on my neighbors house and then actually torch it myself or to buy a life insurance on my neighbor and to kill him later? Well perverse incentives have not prevented CDSs from being sold to people who do not own the underlying asset. So why not here? Are we to say that companies are any more ethical than the people who work in them? And why worry? If this perverse incentive causes an explosion of claims and some insurance company comes under financial strain, then we can always rely on BIG BEN to use the world's greatest invention-the printing press- and save the day.

So heres hoping that the world of insurance will also be opened to a free for all like the world of corporate bonds and housing mortgages. This will dramatically solve a lot of problems for the near future. Employment numbers will look better, markets will move up and bonuses and salaries will jump (specially for we financial market types) Until this utopian dream of mine comes to fruition, I will have to continue to write this note and remind you that I remain short on the Nifty until 5388 is taken out.