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. (NYSE: GS), JPMorgan Chase & Co. (NYSE: JPM), Deutsche Bank AG (NYSE: 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 (NYSE ADR: 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:
"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 (NYSE ADR: 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. (NYSE: AIG) and Lehman Bros. Holdings Inc. (PINK: LEHMQ) 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 act 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 cumquat.
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.
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News and Related Story Links:
- Bloomberg:
Death Derivatives Emerge From Pension Risks of Living Too Long - The Atlantic:
Death Derivatives: Has Wall Street Finally Gone Too Far? - New York Times:
Wall Street Pursues Profit in Bundles of Life Insurance - Money Morning:
When it Comes to Naming Wall Street's Worst Invention Ever, Credit Default Swaps Continue to Fill the Bill - Money Morning:
Here's Why It's Time to Ban Credit Default Swaps. - Cass Business School:
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About the Author
Keith is a seasoned market analyst and professional trader with more than 37 years of global experience. He is one of very few experts to correctly see both the dot.bomb crisis and the ongoing financial crisis coming ahead of time - and one of even fewer to help millions of investors around the world successfully navigate them both. Forbes hailed him as a "Market Visionary." He is a regular on FOX Business News and Yahoo! Finance, and his observations have been featured in Bloomberg, The Wall Street Journal, WIRED, and MarketWatch. Keith previously led The Money Map Report, Money Map's flagship newsletter, as Chief Investment Strategist, from 20007 to 2020. Keith holds a BS in management and finance from Skidmore College and an MS in international finance (with a focus on Japanese business science) from Chaminade University. He regularly travels the world in search of investment opportunities others don't yet see or understand.
It could be better than you make it out to be. Derivatives are a zero sum game. Somebody's gotta win and somebody's gotta lose. A pension fund that buys longevity bonds will win if people live longer than expected; however, those winnings are simply to cover the "loss" of having to pay pensions for longer than you expected. But if people don't live longer than expected, they are only out the fees paid for owning the derivative. So this is not a bet that will cause insurance companies to croak. It's actually making them safer.
So the question is who is on the other side of this bet? And how are they going to come up with the funds should people live longer than expected. And why would that not be pure speculation? If the counter parties are large institutions, this would be a problem because small changes in mortality can have huge impacts on its balance sheet. It would only work if those counter-parties somehow profit when people more rapidly than expected. Unfortunately, I can't think of a natural counter-party for this type of risk.
Not surprised but still deserves a "Wow".
So, do you think any regulation of the markets would be necessary if Government has not consistently proven to be the bail out king…if moral hazard was allowed to play a role and inflict the pain on these financial (or should I say Gambling) institutions that they should have felt would they even consider building these houses of cards?
I understand the pension side of this but do you think they will look at betting on whole life insurance policies too?
Holy Cow! I can't believe that there are zero responses! Are people that detached from what's going on? I'm beyond concerned for the future of our country.
I'll short American Death & long African, essentailly betting that Americans will live too long & Africans die too quickly.
Futurists have predicted that there are people alive today who will be alive 2,000 years from today. I have been following the advances in genetic medicine. When geneticists overcome a single challenge of extending the ends of the DNA strands, and I believe that they are very close, those futurists' predictions will all come true. Because such an advance in human longevity seems unlikely, to the uninitiated who have not followed these advances in DNA medicine, these new derivatives will have the issuers caught with their pants down, and the taxpayer will end up holding the bag again.
You've hit it on the head: it's insurance, and there should be reserves to cover losses. There is already a reinsurance marketplace, and we don't need this.
However, if there are people who want to do this stuff, and they may go broke, or cause others to go broke, then let them. Just keep them out of the government-supported universe of banks and insurance companies. And if they go broke, so be it. And if someone else invests in them, and loses money, that's fine, too, but we don't allow our government-supported/insured/subsidized banks and industries do that.
Goldman Sachs and their ilk need to either stop doing things like this, or get off the public dole and do it on their own dime. Divest their FDIC-insured commercial banking business, so that if they go broke it's none of our business.
600 Trillionj????? who does your RESEARCH??
So when it starts to unravel down the road, when morals are likely to be worse than they are now it will be profitable to 'get rid' of the problem. I wonder what tool they will use? GMOs perhaps.
Best bet would be to give control of death derivitives to J.P. Morgan, Goldman Sachs, HSBC, Citibank and Wall St….look at how they manipulate the silver, gold, oil and other commodities markets..hate to see them miss out on a bit of 'extra' revenue…the boss would be upset (don't upset the Rockerfellers). Don't think their morals are likely to get worse…that is not possible.
Thanks for this piece, Keith. You are a man of many parts.
The article makes me very angry and fills me with frustration. I live in Australia and am too far from the action to have any effect on outcomes. We rely on the good old American common sense and values of what is right. Please bring these values to bear on the Vampire Squids.
I think derivaties should be regulated otherwise in a few years time we are going to be in a mess again.All the greedy bankers care about are big profits they dont care about the ordinary guy in the street who are suffering because of there gambling.
This is why Trump is being brought in by the Vatican – his job is to make the 2008 crash look like storm in a tea cup! – this guy is being sent in by the Illuminati to release a 2008style megazilla Financial Tsunami – goodbuy first world USA, welcome third world USA.