This scam is in fact exactly what Paul Volcker was talking about in the piece quoted on the 9th:
“I wish someone would give me one shred of neutral evidence that financial innovation has led to economic growth — one shred of evidence,” said Mr Volcker, who ran the Fed from 1979 to 1987 and is now chairman of President Obama’s Economic Recovery Advisory Board.
He said that financial services in the United States had increased its share of value added from 2 per cent to 6.5 per cent, but he asked: “Is that a reflection of your financial innovation, or just a reflection of what you’re paid?”
Effectively, what the financial system has done is siphon off an increasing portion of the rents charged for various activities while justifying the increasing prices (that is, lower risk and therefore less reserve against "adverse events") through concealment via bogus "risk-shifting" and "risk-management" that in fact never really occurred.
Remember, "rent" is a generic term. We think of it as what you pay to occupy an apartment, but in fact "rent" is charged for the use of capital in all of its forms - as a place to live, as a means of financing investment, as a means of financing speculation. All involve the charging of rent of one form or another, and all the financial system has done over the last 20 years is find ways to increase the amount of rent that lands in the financial system itself - instead of being distributed to the actual owners of the capital that is being lent out!
The simple reality is that CDOs, CDS and similar articles when used to hedge large quantities of financial instruments or events (such as by a bank) are an artifice. The only way that one can "deal in" CDS and make a profit, as the banks have done, is if someone is willing to sell you protection at less than the true risk-adjusted cost, or you can manage to sell it at higher than the risk-adjusted price.
Both require that someone be deceived - that is, that someone intentionally misrepresent either by commission or by intentional concealment of material facts.
This is the definition of fraud!
Fraud is generally defined in the law as an intentional misrepresentation of material existing fact made by one person to another with knowledge of its falsity and for the purpose of inducing the other person to act, and upon which the other person relies with resulting injury or damage. Fraud may also be made by an omission or purposeful failure to state material facts, which nondisclosure makes other statements misleading.
It is not possible for you to buy protection for less than the actual risk of default from a party who can pay in the event of default. This should be instantly obvious to anyone who applies more than 15 seconds of thought to the problem - on balance it is impossible to insure a pool of risks for less money than the risk of loss across the pool.
Let's assume the risk of default is 1% and recovery if there is a default is 50. Therefore, if you have $100 million of such bonds 1% of them, or $1 million worth, will default, and of that $1 million there will be a $500,000 loss.
The price of purchasing insurance against that pool must always be more than $500,000.
If it is less then the company writing it will not be able to pay. If it is in fact equal they will not be able to pay, since the company must expend some amount of money (no matter how small) employing their staff and maintaining their facilities (buildings, etc.)
It is reasonable for someone to buy insurance against a single event, as a single actor, holding a single risk. That's because their individual risk is large for the return they receive. It is why you buy insurance against a fire in your house - the risk of a fire is small, but the damage if you suffer a fire is large.
But if you own 100,000 properties dispersed across the nation with no particular concentration you're an idiot to buy insurance against each and every property having a fire. Why? Because it is axiomatic that you will pay more for the insurance than you will lose to fires! You must - otherwise the insurance company that sells you the policies will go broke and be unable to pay at all!
The key point here is that when you buy below risk-adjusted cost "insurance" you have in fact bought nothing and are just as exposed as if you had not purchased said "insurance" at all.
It is therefore never prudent and appropriate for anyone who holds a large enough pool of risk to "transfer" that risk to a third party because the cost of doing so will always be higher than the cost of simply absorbing any losses that occur.
This must always be the case unless the organization holding the large pool of risks is able to find someone who will write that insurance at a loss. This, in turn can only happen if the entity writing the insurance either (1) is unable to appropriately judge the risk compared to the person purchasing the insurance or (2) is unable to pay if the loss occurs.
This is the root of the scam folks, and that we refuse to understand and face the math is part and parcel of why it is that we continue to be abused by these large financial interests.
The sooner we wake up the better, as the math is never, ever wrong.
See original for helpful formatting.