Washblog

"Risk" we'll define as the probability that an entity will default on its obligations. We'll define "rating" - as in "credit rating" - as the probability that an entity's balance sheet will protect it from default - so it's the opposite of risk. How can rating and risk be traded? Do you really want to know? Anyway, the main vehicle for making a pure risk/rating trade is the Credit Default Swap (CDS).  

Credit Default Swaps sunk AIG. AIG was a huge insurance company made up of what were presumably independent units. The problem, however, is that obviously these units were anything but independent. AIG's owning so many prosperous units gave it a AAA "rating". But in the new world, AIG was able to sell that AAA rating for cash to Goldman Sachs and the like through the Credit Default Swaps market.

As long as the CDS market exists, anything that adds to a parent company's credit rating becomes something - this "rating" - they can and do sell - inter-state and internationally. The default swaps market means that a unit of a corporation is no longer a local business. It's a piece of a portfolio of risk/rating assets in which the parent company trades interests worldwide on a daily basis.

This is very different from selling stocks or bonds. Stocks and bonds affect the individual units individually because they are obligations of those individual units. CDS are different. CDS allow a parent company to trade the risk and rating of subsidiaries without adding an obligation to those subsidiaries. With CDS there is functionally no way to keep the parent company from bringing a subsidiary into interstate commerce. The new world has made risk and rating fungible commodities. These commodities are listed and traded on exchanges. As long as the subsidiaries contributes money and statistical safety to the parent company, they are offering a commodity for interstate commerce whether they mean to or not.

And this has material effects on local insurance companies. They use banks for money management and investment advice. These days, a local insurance company's parent company can sell its banker an instrument that will make the bank rich if the local insurance company fails - exactly what happened to AIG's units that are now up for sale.

Now let's talk about the Cayman Islands. A typical insurance company has an alarming number of assets domiciled in tax havens. That didn't used to be a problem, because they were individual deals. The insurance company had a relationship with a foreign entity and that did not represent interstate commerce. The trouble is that now those foreign countries have essentially become international and, yes, inter-state markets.

But these are largely "OTC" markets. What this means is that, as we saw with AIG, America's insurance companies are a big part of the unregulated "shadow banking system". Now, maybe McKenna has no problem with shining light into those shadows, but I'll bet the insurance companies do.