Is Insurance Exchange a 'Trade Off' for AIG's Credit Default Problem

(MoneyWatch)  Did we really need to pay those American International Group traders $165 million in bonuses to keep them around? The vast majority of Americans say "No." On the other hand, more Americans would know about a wife swap than a credit default swap.

AIG Chief Executive Edward Liddy thinks these bonus babies are worth it. At Wednesday's House Financial Services Committee hearing he pointedly said he paid them not because of a legal contract, but because they were desperately needed to wind down AIG's $1.6 trillion portfolio of credit default swaps. Since few people understand this runaway market, they remain in high demand. Liddy doesn't want to see them poached by Deutsche Bank and the other institutions that trade these default swaps.

First, let's explain credit default swaps. They are insurance policies for a portfolio of bonds or loans, often mortgage loans, and the buyer is betting that they won't go into default. AIG wrote trillions of dollars worth of them. So did others, including Goldman Sachs and Societe Generale. All told there are about $70 trillion out there. At least they were worth $70 trillion last year when AIG employees were awarded those bonuses. But what are they worth now?

No one knows. They should, as Liddy says, be marked to the market, which is whatever anyone will pay for them. But with no public market, that information is in the hands of a few people at Society Generale, Goldman Sachs and, yes, AIG.

Why not create a public market that would make these esoteric insurance policies, and for that matter, all insurance policies, transparent? That's what New York Insurance Superintendent Eric Dinallo suggested in an interview with BNET Financial earlier this month. Dinallo is pushing the idea of a New York Insurance Exchange, where insurance contracts could be traded as easily as oil contracts are traded on the New York Mercantile Exchange.

Other commodities, including gold, aluminum, wheat and pork bellies, are also publicly traded, and while these markets are volatile, the public always knows the price. Could credit default swaps be traded the same way? Dinallo thinks so.

Here's how it would work. On an exchange, the members put up capital, and basically insure each other against default. Government money isn't needed or wanted. Standard contracts are worked out with a month-by-month horizon. They extend out 18 months and are sold on a public market to companies that want to take the risk. While every conceivable default swap wouldn't be covered, the oil market and others have an off-exchange method for dealing with that: buy a standard contract and then work out the individual ramifications of the deal between yourselves. That way only a small part of the risk is left uncovered.

Some say Dinallo is a dreamer; he says just the opposite. Many hedge funds have made money as the market tumbled and insurance, because it isn't linked with other kinds of risk, makes a great hedge. In other words, the weather isn't tied to the stock market, so you can buy a group of Florida homeowners' policies with the assurance that hurricanes aren't going to correlate to the earnings of Microsoft.

Dinallo points out that New York State already has an Insurance Exchange, but it became moribund in the 1980's when the industry was hit by losses.

Perhaps it's time to reenact it and give transparency to the whole insurance market, including credit default swaps. Doesn't this make more sense than a Congressional hearing? Or anything that Congress does, for that matter?