Profiting from death arbitrage

Add this one to the unintended consequences file. Matt Levine writes in this Bloomberg article:

The normal way to shift the risk of death is life insurance -- you die, the insurance company gives you money -- but there are other, more esoteric versions, and they are more susceptible to arbitrage. One version involves "medium and long-term bonds and certificates of deposit ('CDs') that contain 'survivor options' or 'death puts.'" Schematically, the idea is that a financial institution issues a bond that pays back $100 when it matures in 2040 or whatever. But if the buyer of the bond dies, he gets his $100 back immediately, instead of having to wait until 2040. He's still dead, though. 

But the bond can be owned jointly by two people, and when one of them dies, the other one gets the $100 back. If you and your friend buy a bond like that for $80, and then your friend dies, you make a quick $20.

But what are the odds of that? "Pretty low" was presumably the thinking of the companies issuing these bonds.

At this point you can probably see where this is headed:

 But they didn't reckon with Donald F. "Jay" Lathen Jr. and his hedge fund Eden Arc Capital Management: 

"Using contacts at nursing homes and hospices to identify patients that had a prognosis of less than six months left to live, and conducting due diligence into the patients’ medical condition, Lathen found Participants he could use to execute the Fund’s strategy. In return for agreeing to become a joint owner on an account with Lathen and/or another individual, the Participants were promised a fixed fee—typically, $10,000."

The problem is that the bond issuers priced the bonds as if they were dealing with bondholders of average lifespan. If people of shorter-than-average lifespan are buying the bonds, then the risk of early repayment is much higher than estimated and the bonds are underpriced, providing a profit opportunity. All Lathen did was take advantage of the underpricing of the bonds to pocket some profits, which is exactly what we would expect any rational and fully-informed market participant to do.

Read the full story to hear about the Securities and Exchange Commission crying foul and how they are fighting back. How often would you expect to see the SEC protecting financial institutions from the negative consequences of the terms and conditions in their own contracts?

[HT: Marginal Revolution]