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Stopping Earthquakes

Mike Rorty recently sat down with banking expert Perry Mehrling for an informative chat about the shadow banking market. There's a lot of good stuff in there, but I particularly liked Mehrling's conclusion:

Floating the system with money market liquidity, which is what the Fed did, didn't solve the problem, because it wasn't getting to the capital markets. That's why we need a credit insurer of last resort, to put a floor on the value of the best collateral in the system. I say the new Bagehot Rule should be: Insure freely but at a high premium.

Why a high premium? If you insure an earthquake, you are not making earthquakes more likely. The insurance contract is a purely derivative contract, it isn't influencing earthquakes. That is not true of insurance of financial risk. When AIG is selling you systemic risk insurance for 15 basis points, that price is too low. People said: "If I can get rid of the whole tail risk that cheaply, I should load up. I should take more systemic risk." So the prices were wrong. So the important thing for government intervention here is to get that price closer to a reasonable rate to prevent people from creating earthquakes.

That's an important point: Insurance, and its related products, are supposed to reflect the fundamental of the market. In this case, however, they pretty much recreated the fundamentals of the market. Perry Mehrling seems to agree with Michael Lewis that AIG was really the key player in that scam, but there's every chance that if it wasn't AIG, it would have been someone else: There was a short-term market opportunity for a company with a AAA-credit rating and an insufficient understanding of housing market risk. And there will probably be companies in the future who are all too happy to play that role again.

The clue that something was wrong, however, was that the addition of this one company appeared to change the fundamentals of the market: The addition if, in effect, a risk insurer suddenly transformed how much risk could be carried, and how much money could be made, and how much lending could happen even in a period when interest rates were rising. When your efforts to spread the consequences of risk actually appear to be eliminating the threat of risk, something is very wrong in your market.

By Ezra Klein  |  July 14, 2009; 10:39 AM ET
Categories:  Financial Crisis , Financial Regulation , Solutions  
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While it is true that the existence of earthquake insurance does not increase the likelihood of earthquakes, it can increase the amount and value of the property that is exposed to earthquakes, by encouraging more construction in earthquake-prone areas. Of course, even if earthquake insurance was basically free, market forces would stop real estate prices in those areas from rising too much above comparable properties in earthquake-free areas, but this does not guarantee an avoidance of disaster (after all, subprime mortgages never became more valuable than their prime counterparts, even with all the hedging, repackaging, and leverage, and look what happened with that).

Anyway, the point is that even "benign" insurance does have some distorting effect on the market it insures.

Posted by: terry17 | July 14, 2009 1:34 PM | Report abuse

This is the problem known to economists as "moral hazard". Like adverse selection, it is one of the most profound causes of market failure in insurance markets.

In many cases it is mitigated by the fact that there are non-financial costs to becoming ill, having your a fire or earthquake destroy your house, etc. Even so, it is still necessary to enforce laws against arson. It is not easy to see how to fix the problem of moral hazard when the risk being insured is entirely financial.

Posted by: davidand36 | July 15, 2009 12:26 AM | Report abuse

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