Donald MacKenzie looks at the End-of-the-World Trade — which only really pays off if the economy totally collapses — and explains why it would become popular:
All this activity [in CDOs and credit indices] explains the attractiveness of the end-of-the-world trade. The trade is the buying and selling of protection on the safest, super-senior tranches of the investment-grade indices. No one buys protection on these tranches because they are looking for a big pay-out if capitalism crumbles: if nothing else, they have no reason to expect that the institution that sold them protection would survive the carnage and be able to make the pay-out. Instead, they are looking to hedge their exposure to movements in the credit market, especially in correlation. Traders need to demonstrate they’ve done this before they’re allowed to book the profits on their deals, so from their viewpoint it’s worth buying protection, for example from ‘monolines’ (bond insurers), even if the latter would almost certainly be insolvent well before any pay-out on the protection was due.
So many financial decisions are made for less-than-obvious reasons:
Processes of this kind [e.g., unwinding highly levered positions to avoid catastrophic losses] — changes internal to the world of credit derivatives, not in the level of the risks being insured against — have meant that investment-grade indices sometimes move by up to 20 per cent in a single day. At times, the price of end-of-the-world insurance has corresponded to utterly implausible correlation levels in excess of 90 per cent: meaning, in effect, that if one investment-grade corporation were to default, almost all of them would.Why aren’t such mispricings being corrected by savvy investors, eager to seize the opportunities for profit they create? Why, for example, have people not been selling end-of-the-world insurance when the returns from doing so have jumped ten-fold while the risk of having to pay out remains small? A crucial part of the answer is that, paradoxically, a fact-generating mechanism is blocking the restoration of fact. The mechanism is ‘marking-to-market’, the compulsory revaluation of portfolios as market prices fluctuate. Its motivation is entirely sensible: for example, when regulators insist that banks mark-to-market, it should force them to disclose losses to their investors and creditors.
Unfortunately, however, marking-to-market makes market participants extremely sensitive to short-term price fluctuations. To sell end-of-the-world insurance, for example, is almost certainly an excellent long-term bet, but traders don’t do it because of the fear that in the short run its price may increase even further, causing a mark-to-market loss. Although it would be a paper loss, it would have real consequences, damaging your bank’s balance sheet and profits, threatening your bonus, and typically forcing you to transfer valuable collateral to the custody of the buyer of the insurance.