Insuring your Neighbor's House

(1)
Imagine you want to insure yourself against your house burning to the ground. How do you do that? Well, in a free market you buy a contract from a financial institution.

The contract says:
"Institution X pays the owner of this contract 100.000 Euros should house Y burn down."

This is great for both of you! Institution X probably can take the risk that your house Y might in fact burn down. And you couldn't bear that risk. That's why you just payed money to get that contract. Instead of having a 99% chance of not going bankrupt and a 1% chance of going bankrupt, you pay a small fee so that you can never go bankrupt.

Wonderful free markets at work!
Actually you might also want to buy that contract for your neighbor's house. Why? Well, perhaps because you are pretty sure that his house is going to burn down soon ...

And we see: Insurance is great, as long as you own what you insure ..

(2)
Imagine you have a lot of money. And you want more money. Now, you could insure yourself against French bonds becoming worthless (France going bankrupt). Luckily somebody has created a contract:

The contract says:
"Institution X pays the owner of this contract 1 Mio Dollars should French bonds become worthless."

Let's assume you buy lots and lots of these contracts. Now, you already bought French bonds over a long time. But you're not stupid. Of course you don't want to own French bonds, anymore. In fact, you sell all of them; at the same time!
French bonds drop by 5% due to this. A lot of people see that and, since they are nervous for other reasons, they sell, too.

Due to that drop a lot more people want to insure themselves against the bonds becoming worthless. And they are willing to pay more money to buy the contracts.

Now, you lost a limited amount of money by first buying the French bonds over a long time and then selling them all at once at up to 5% less. But you also gain a lot of money from selling the insurance contracts. And this money is without limit. You could have bought as many of these contracts as you desired!

And that's why insurance papers, like Credit Default Swaps (CDS), are great as long as the owner owns what he insures, but terrible, if he does not. I'm not the first guy to find out. Warren Buffet called CDS "financial weapons of mass destruction". .. in 2003!

(3)
Why am I unable to buy insurance contracts for my neighbor's house? Because no sane institution would sell me papers that insured my neighbor's house. Just like no institution offers insurance against divorce. And that's the difference between these two markets.

The institutions that create bond-insuring contracts are actually performing terribly (banks, for example). But the people in charge do great. They make great money from selling the contracts and should the insured event occur, the government saves their employer with tax-dollars.
Hell - and even if not! They just got their bonus for selling a million contracts. Moral hazard at work.