"Anonymous: I am a new respondent but have read the column for a long time. I believe that you are a natural born teacher turned columnist. Would you please explain at greater length and in more detail the last three paragraphs of today's column. The nest shoe to drop you call credit default swaps but I would like a more detail understanding and how they could trigger a financial chain reaction.
Steven Pearlstein: This is a hard one, and I worked long and hard on those three paragraphs last night. Let's just say there is this huge financial market you don't even know about where banks and hedge funds and big investors make bets with each other, in the form of contracts: A pays B $100 to "insure" that $10,000 worth of junk bonds at Company C don't default. If they do default, then B pays A $10,000. Now what makes this interesting is that A doesn't actually have to hold the junk bond (or the CDO, or the syndicated bank loan, or the municipal bond, all of which can be the subject of credit default swaps). It can buy the insurance, or place the bet, whether it owns it or not. Which is why the market is so big, because there can be, theoretically, an infinite number of insurance policies on every bond or loan."
Office memorandum, Walter Neff to
Barton Keyes, Claims Manager. Los
Angeles, July 16th, 1938. Dear Keyes:
I suppose you'll call this a
confession when you hear it. I don't
like the word confession. I just
want to set you right about one thing
you couldn't see, because it was
smack up against your nose. You think
you're such a hot potato as a claims
manager, such a wolf on a phoney
claim. Well, maybe you are, Keyes,
but let's take a look at this
Dietrichson claim, Accident and Double
Indemnity. You were pretty good in
there for a while, all right. You
said it wasn't an accident. Check.
You said it wasn't suicide. Check.
You said it was murder. Check and
double check. You thought you had it
cold, all wrapped up in tissue paper,
with pink ribbons around it. It was
perfect, except that it wasn't,
because you made a mistake, just one
tiny little mistake. When it came to
picking the killer, you picked the
wrong guy, if you know what I mean.
Want to know who killed Dietrichson?
Hold tight to that cheap cigar of
yours, Keyes. I killed Dietrichson.
Me, Walter Neff, insurance agent, 35
years old, unmarried, no visible
(He glances down at
his wounded shoulder)
Until a little while ago, that is.
After bond fund giant Pimco's Bill Gross gave a back-of-the-envelope estimate of a possible $250 billion in losses resulting from the impact of deteriorating corporate credit and bond defaults on the $45 trillion (notional amount) credit default swaps market, other commentators have been making improved (but still quick and dirty) calculations.
It began last May. About the end of May, it was. I had to run out to
Glendale to deliver a policy on some
dairy trucks. On the way back I
remembered this auto renewal on Los
Feliz. So I decided to run over there.
It was one of those Calif. Spanish
houses everyone was nuts about 10 or
15 years ago. This one must have
cost somebody about 30,000 bucks --
that is, if he ever finished paying
"Monolines write insurance on debt. But here is the trick. Entities with a worse credit rating than the monoline company can get their bonds insured so that they can have the same rating as the insurance company itself (mostly AAA). So relatively poor-quality debt becomes investment-quality debt because the monoline will pay the interest and principal if the borrower defaults.
This business model is self-limiting, some might say self-destructing! The monolines’ balance sheets fill up with poor-quality debt as the monoline insures only the risk of debt with a worse financial quality than itself. As long as the ratings agencies maintain the monolines’ AAA rating, the trick can work.
But eventually, the market may decide that the poor quality of the debt the monoline insures has irreparably eroded the quality of its own balance sheet. Once that happens, the monolines’ guarantees are worthless and the debt it insures will be downgraded ...
If the monoline guarantees on bonds and credit derivatives were to be removed, the rule of thumb is that every 1 per cent decline in the price of insured bonds would give rise to $10bn of losses on bond portfolios elsewhere in the system. We estimate bond portfolio losses of $150bn-200bn were this to happen ...
Much of this pain (loss) would have to be absorbed through the CDS markets as additional losses to the cost of defaults. Also, the decline in credit quality would also hit CDS prices to the tune of about $40bn-$50bn. In total, we estimate that global losses in CDS markets and the underlying credits they insure would be $365bn-$425bn."
For instance, we're writing a new
kind of fifty percent retention
feature in the collision coverage.
Phyllis stops in her walk.
You're a smart insurance man, aren't
you, Mr. Neff?
I've had eleven years of it.
Doing pretty well?
It's a living.
You handle just automobile insurance,
or all kinds?
She sits down again, in the same position as before.
All kinds. Fire, earthquake, theft,
public liability, group insurance,
industrial stuff and so on right
down the line.
Accident insurance? Sure, Mrs.
His eyes fall on the anklet again.
I wish you'd tell me what's engraved
on that anklet.
Just my name.
As for instance?
Phyllis. I think I like that.
But you're not sure?
I'd have to drive it around the block
a couple of times.
(Standing up again)
Mr. Neff, why don't you drop by
tomorrow evening about eight-thirty.
He'll be in then.
My husband. You were anxious to talk
to him weren't you?
Sure, only I'm getting over it a
little. If you know what I mean.
There's a speed limit in this state,
Mr. Neff. Forty-five miles an hour.
How fast was I going, officer?
I'd say about ninety.
So far, the banking industry has revealed about $65 billion in writedowns for the fourth quarter -- a figure that could climb higher as more results pour in over the next couple weeks. That's more than Bill Gates is worth, higher than the gross domestic product of Bangladesh, and equivalent to nearly 3 percent of the entire U.S. housing market.
I want to ask you something, Mr.
Neff. Could I get an accident policy
for him -- without bothering him at
How's that again.
That would make it easier for you,
too. You wouldn't even have to talk
to him. I have a little allowance of
my own. I could pay for it and he
needn't know anything about it.
Wait a minute. Why shouldn't he know?
Because I know he doesn't want
accident insurance. He's superstitious
A lot of people are. Funny, isn't
If there was a way to get it like
that, all the worry would be over.
You see what I mean, Walter?
Sure. I've got good eyesight. You
want him to have the policy without
him knowing it. And that means without
the insurance company knowing that
he doesn't know. That's the set-up,
Is there anything wrong with it?
What's the matter?
Look, baby, you can't get away with
Get away with what?
You want to knock him off, don't
That's a horrible thing to say!
Who'd you think I was, anyway? A guy
that walks into a good-looking dame's
front parlor and says "Good afternoon,
I sell accident insurance on husbands.
You got one that's been around too
long? Somebody you'd like to turn
into a little hard cash? Just give
me a smile and I'll help you collect."
Boy, what a dope I must look to you!
I think you're rotten.
I think you're swell. So long as I'm
not your husband.
Get out of here.
... NEFF'S VOICE
So I let her have it, straight between
the eyes. She didn't fool me for a
minute, not this time. I knew I had
hold of a redhot poker and the time
to drop it was before it burned my
hand off. I stopped at a drive-in
for a bottle of beer, the one I had
wanted all along, only I wanted it
worse now, to get rid of the sour
taste of her iced tea, and everything
that went with it. I didn't want to
go back to the office, so I dropped
by a bowling alley at Third and
Western and rolled a few lines to
get my mind thinking about something
else for a while.
A-41 DRIVE-IN RESTAURANT - (DAY)
Shooting past Neff sitting behind the wheel of his car The
car hop hangs a tray on the door and serves him a bottle of
A-42 INT. BOWLING ALLEY
Neff bowling. He rolls the ball with an effort at
concentration, but his mind is not really on the game.
A-43 EXT. APARTMENT HOUSE - (DUSK)
It is late afternoon. The apartment house is called the LOS
OLIVOS APARTMENTS. It is a six-story building in the Normandie-
Wilshire district, with a basement garage. THE CAMERA PANS
UP the front of the building to the top floor windows, as a
little rain starts to fall.
I didn't feel like eating dinner
when I left, and I didn't feel like
a show, so I drove home, put the car
away and went up to my apartment.
It had begun to rain outside and I
watched it get dark and didn't even
turn on the light. That didn't help
me either. I was all twisted up
inside, and I was still holding on
to that red-hot poker. And right
then it came over me that I hadn't
walked out on anything at all, that
the hook was too strong, that this
wasn't the end between her and me.
It was only the beginning.
The doorbell rings.
So at eight o'clock the bell would
ring and I would know who it was
without even having to think, as if
it was the most natural thing in the
Neff goes to the door and opens it.
Neff just looks at her.
You forgot your hat this afternoon.
She has nothing in her hands but her bag.