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Credit default swaps have been a major element in the ongoing financial crisis. That doesn’t mean it’s necessarily easy to understand just what the problem is with them. I’ve taken a crack at it in the past, but more recently I heard an analogy that makes the entire situation a lot easier to visualize.

I heard the analogy during a radio interview with Doug Noland, a mutual fund manager who’s been writing dire weekly analyses of the credit market for years. It went something like the following.

Imagine a city near a river that is prone to the occasional flood. At some point, an enterprising citizen gets into the business of writing flood insurance, collecting premiums from insurees in exchange for a promise to pay back the insurees should a flood do any damage to their properties.

Now, imagine that there is an unusually long drought and the river goes a long time without experiencing a flood. Other enterprising types begin to notice that the flood insurer has for years been collecting all this money for doing absolutely nothing. A flood hasn’t taken place for ages — maybe climate patterns have changed so that the river doesn’t flood any more. And even if it does flood at some point, they will probably be retired by then. They want in to the easy money flood insurance game too.

So they start writing flood insurance, but in order to gain some market share, they lower the premiums to attract new business away from the original insurer. The lower cost of insurance encourages more people to build houses next to the river, assuming that if it ever does flood again, they will be reimbursed for their losses.

As the years go on and still no flood comes, more and more people enter the flood insurance business, driving the cost of flood insurance to ridiculously low levels. It costs so little to insure against disaster that eventually the entire city gets relocated to the shoreline.

Everyone’s seemingly a winner. The insurers are making a lot of money and the citizens get to feel safe and secure in their riverfront properties. Until the flood comes. Then the entire city is wiped out and it becomes clear that the insurers simply don’t have enough money to reimburse the insurees for all of their losses.

Credit default swaps are basically insurance against a borrower not paying back a loan. If the borrower defaults, the insuree is made whole by the issuer of the credit default swap. Writing credit swaps was easy money in flush economic times and everyone jumped on board — just like being a flood insurer was great as long as the drought went on. Since lenders felt protected against borrower defaults by all that insurance they bought, they made many more loans than they otherwise would have. This vast increase in lending is akin to the buildup of riverfront property. And the mass deft defaults underway are obviously analogous to the flood.

There are a couple of ways in which the credit insurance situation risks are even more self-reinforcing than those for flood insurance. In the modern age we have the credit ratings agencies that declared all that subprime mortgage-backed debt to be safe and sound. Perhaps we could insert the ratings agencies into the analogy by saying that we have a well-respected weatherman study the data and determine that because a flood has not happened for so long, flooding should no longer be considered a risk. (Maybe our allegorical weather expert created a model based on 20 years’ worth of data, not realizing that the last big flood took place 21 years ago). The weatherman’s soothing predictions would encourage even more people to get into the flood insurance business and collect that free money.

Noland points out an even bigger difference: in the river city scenario, the amount of property built on the shoreline by overly confident insurees does not influence the probability of a flood. But all the extra lending undertaken by overconfident credit insurees — think subprime mortgages here — actually increased the chance of future defaults even as the price of insuring against default plummeted.

Noland’s analogy ends when the flood takes place. Now that we’ve seen the real-life version in the credit markets, we can go back and complete the story for our fictional river city: the citizens (whether they built on the river or not) are taxed to repair the buildings, the flood insurers are bailed out, and everyone inexplicably continues to believe the weatherman.

— RICH TOSCANO

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