Wednesday, September 17, 2008

Insurance against Catastrophic Failure

An interesting suggestion by Yale School of Management professor Jonathan Koppell in today's NY Times (Op-Ed Contributor - "A Failure Tax"): companies that are "too big to fail" ought to pay premiums for catastrophic risk insurance that would fund their rescue in the event they are at risk of failure. There would be all sorts of challenges in implementing this in practice (e.g., Which firms would be covered? How much should the premiums be?, etc.), and Koppell briefly touches on them, but in principle, it's an idea worthy of consideration.


J K said...

Interesting idea but I don't know how they'd implement it without lobbyists and the unscrupulous twisting it from its original intent and making things worse.

Better idea: Make a consistent, blanket statement "We are never going to bail anyone out...EVAR!!!" Repeat the statement often, in calm markets and in rough seas. Live by that statement. Don't go to lunch and shmooze with execs like Ben does. Stay detatched. Make people believe you live by that statement. Make them believe it so much, that they know they had better learn how to swim if they want to go in the deep end of the risk pool.
Then, help sparingly if everyone really really really needs it. And don't determine this by the projections and data of those asking for help and taking you out to lunch, act from independnt analysis.

But first, establish and enforce the right expectations and culture (this is a free market and you are on your own as a private company). I don't see that being done. These guys would thow a fit if the government intervened to help the consumer if the consumer was suffering and big institutions were fine. "Government, only intervene when I'm hurting" is the motto now it seems.

DaveinHackensack said...

I was going to add a paragraph to the post about some of the political issues that might affect implementation of something like this, but decided to delete it. But since you've brought the topic up, here are a couple of thoughts.

1) If we had such a catastrophic insurance policy already, would politically-connected Fannie and Freddie have managed to lobby their way out of it? My guess is that they would have.

2) The Pension Benefit Guarantee Corporation (PBGC) comes to mind. In this case, the premiums were set too low for political reasons: Congressional Dems didn't want to discourage companies from establishing or maintaining defined benefit pension plans by setting the premiums high enough to cover the risk of default. Nevertheless, the concept of the PBGC makes a lot of sense -- a government sponsored but privately funded (mostly) insurance company to protect against the failure of defined benefit pension plans.

I don't have a problem, in principle, with a similar insurance set-up to deal with the risk posed by the failure of financial institutions.

Two points of contention with what you wrote:

1) I'm not worried about execs buttering up Ben Bernanke in the hopes that he will wipe out 80% of their equity as part of a takeover. With these terms, I don't think a lot of companies will be eager for this sort of intervention.

2) Most corporate execs don't throw a fit when the government throws money at consumers (e.g., the tax rebate); that's more consumer spending they can compete for.

doofus said...

But isn't the risk of failure what keeps companies honest? The idea of failure insurance strikes me as a little bit odd since 1) no company is supposed to be too big to fail- it is why we have competitive markets and antitrust regulation; 2) failure is supposed to be the stick that keeps people & companies chasing the carrot. Fail and your company becomes part of the 'creative destruction' of the next business cycle; 3) Who would insure you, given that AIG (of all companies) has now failed? AIG insures just about everything, but even these insurance experts miscalculated the risks associated with the financial industry.

DaveinHackensack said...


Antitrust laws are about maintaining competition, not (as far as I know) keeping companies from becoming 'too big to fail'. The other problem here is that a company apparently doesn't have to be that big for the systemic risks of its collapse to be great. Consider, for example, Bear Stearns, which was one of the smaller publicly-traded investment banks.

If the 'rescues' of the 'too big to fail' firms have terms similar to those of the AIG deal -- getting an 80% haircut on your equity and having current management shown the door -- I think this will still act as a stick for corporate execs.

There are other ways to approach this. One might be to apply similar regulations regarding leverage to investment banks that the government currently applies to commercial banks.

doofus said...

Sorry if I was unclear. I jumped ahead a little, in thinking that any company "too big to fail" is likely so because it is in an industry with insufficient competition. That's why I mentioned antitrust regulation.

I don't really buy that the execs involved are really suffering. They make bets with other people's money and if the firm collapses because of their choices, they still have millions in the bank thanks to years of ridiculous bonuses- their shareholders (and the huge institutional investors) are on the hook. Sure, when the rubber meets the road, Joe Schmo shouldn't have taken an interest-only 5yr ARM on a house worth 10X his annual income. But the incentives to sell him that loan, bundle it into securities, then spread that risk throughout the entire financial system have become perverse.

MD Law professor Michael Greenberger had an interesting take on this mess during an interview on NPR, taking it back to the Commodity Modernization Act of 2000. A bit long, but worth listening to.