$10,000 for Every Man, Woman & Child on the Planet!!!

House insurance is something we all have to safeguard against disaster. Now, keep this theme in mind as I attempt to spin a tale of possible horror and mayhem.

Let's suppose there is a house and it sits on a potential earthquake zone. Inside the house lives a normal everyday family. There has never been an earthquake on this ground before, but experts warn that it could happen.

Now, let's suppose you approach an insurance company and you make moves to take out an insurance policy on the house. Remember, you do not live there. You just know it sits on a potential earthquake zone and that there could be an earthquake. If there is and if the house is destroyed, you would be able to collect on the insurance policy. True, it has cost you money to purchase this insurance, but you are quite certain that an earthquake will come and you will get to collect.

Now, let's say you mention what you have done to your buddies on the golf course. Being profit seekers, they too approach the insurance company and they too take out insurance policies on the same house that you did !! The insurance company collects even more fees and is quite happy to do so because there has never been an earthquake on the ground where the house sits and as far as the insurance company experts are concerned there never will be. Let's suppose your buddies tell a few friends about their strategy. These friends make their way to the insurance company and they too take out policies on this house. Cha-ching!! Cha-ching!! The insurance company has made a serious amount of money selling these policies.

One day somebody at the insurance firm does an audit of the books and quickly calculates that if there ever were to be an earthquake and if this house ever were to be destroyed, the insurance company would have to pay out over and over and over again to all those people who had taken out insurance policies on the house. This could totally wipe out the insurance company. To mitigate at least some of the risk, the insurance company decides to sell some of these insurance policies to a Mutual Fund manager and a few to a Pension Plan manager. Now if disaster strikes at least the Mutual Fund and the Pension Plan will share in some of the economic loss. True it may destroy them too, but they were dumb enough to buy these policies from the insurance company so who cares?

At long last one day, disaster does strike and an earthquake occurs demolishing the house. True to form, the insurance company, the Mutual Fund and the Pension Plan all find themselves with their backs to the wall having to make huge payouts. The insurance company goes totally bust. The Mutual Fund finds itself having to liquidate some of its equities in its portfolio of NYSE listed stocks to meet its payout obligations and the Pension Plan finds itself having to reduce monthly payouts to its beneficiaries as it struggles to figure out what hit it.

If this sounds a tad far fetched, let me assure you it is not. What I have just described in this cute story is the concept of Credit Default Swaps. Nobody knows for sure the true status of these swaps, but at the end of 2007 it was estimated that there was something like $62 trillion in notional value of these swaps in the global financial system. If they were to all start to unwind, it would take a cash contribution of $10,000 from every man, woman and child on the planet to make good on the losses.

Criticize Ben Bernanke and make fun of him all you want. You better just hope that he is successful in printing enough money quick enough to plug all the holes in the leaking financial levee. Because if he fails, the deluge of debt that will follow will be devastating.