Can We Insure Against Systemic Risk?

Mike Rorty follows up on this post, discussing the ins and outs of the shadow banking system, with further ruminations on the topic Tuesday. He quotes Fischer Black saying:

I don’t see that the private market, in creating this wonderful array of derivatives, is creating any systemic risk. However, there is somebody around creating systemic risk: The government… Perhaps the biggest systemic risks that the government creates come from its debt guarantees...

And remarks:

I take a deep breath before saying this, but my man Fischer is wrong – AIGFP created systemic risk out of nothing by mispricing CDS contracts over a few year period. Systemic risk is the risk that effects us all, the risk we can’t diversify or innovate our investments away. It’s the risk that hits my boring index fund of stocks that I want to use to retire.

How do they do that? By underpricing CDS contracts – charge 2 or 15 bp on some accounts – they encourage people on the other end to take on more risk thinking they are insured, when they are not. This chains through the system to the point where it hits my boring index fund.

Perhaps I'm splitting hairs here, but it seems like the issue isn't so much who is creating systemic risk as who is accidentally increasing vulnerability to it. There is plenty of systemic risk out there at any given time. A housing price collapse in combination with an oil price spike would have generated a nasty recession, financial crisis or no, which probably would have affected all asset categories.

But firms are aware that these risks are out there and generally try to give themselves a cushion to survive them. But Mr Rorty is saying that AIG was selling default insurance on the highest rated securities—things that don't blow up unless the entire economy is blowing up—and pricing it pretty cheap, to boot. The problem, of course, is that when everything blows up—when the roll of the systemic risk die turns up an economy wide downturn—it's very difficult for any private actor to make good on its obligations. The collapse is the moment that AIG (AIG) has to pay out to everyone, and it's also the moment AIG can't get its hands on enough funding.

It's a dubious proposition at any time that a private firm can credibly offer systemic risk insurance, but presumably if a private firm is going to offer it, it's going to cost a lot of money. Why? So that not everyone pays for it, and so that those that do are providing a lot of cash to fill up the insurer's rainy day fund. But AIG was offering it for a pittance.

And so AIG was selling insurance it couldn't afford to make good on, and people were buying it. And the people buying it were acting as though AIG could afford to make good on it. And so when collapse came, everyone was unprepared for the losses they sustained, and the pain grew very rapidly.

Does this mean that AIG was creating systemic risk? Maybe, in a sense. But another way of looking at this is that the systemic risk was always there, but both the buyer and seller of insurance on AAA securities wildly underestimated its scope.

This article originally appeared on The Economist.com

Comments

[Dave Wrixon:]

Try asking your insurance broker if he has a policy for victims of Ponzi Schemes.

Jul 15 07:45 AM

[MinAkkar20:]

Ryan, you are correct when you say there is systemic risk out there all the time. The quotes you posted aren't necessarily incompatible. You have to look at what the CDS were written on. At the bottom of the pyramid of derivatives was trillions in mortgages that were packaged largely by Fannie & Freddie. Some CDS were written directly on these MBS, while others were written on the debt of firms who held MBS as collateral or income-producing assets.

Fannie & Freddie have operated with an implicit government guarantee which implies no risk of default. So it's not necessarily unfounded to price their CDS at the cheap levels they did, because they knew they could rely on the government to bail everyone out. And the gov't did not fail. Combine that with the short-termed performance goals set at AIG and you have a petri dish for failure. The goal isn't to eliminate systemic risk, but to price it properly and the government should not be absolved of its hand in the mis-pricing. Barney Frank said AIG giving out bonuses is rewarding failure, however so was re-electing the man who pushed the Fannie & Freddie agenda onto the market. If anything, we now further pushed risk off people's minds because the backstop of the federal printing press is in full swing.

Jul 15 07:51 AM

[john s. gordon:]

the perfect storm occurs when all the little systemic risks that are out there created by various players in the system get together and add up and multiply like rabbits and .....
> jack

Jul 15 08:40 AM

[BerkeleyBob:]

It isn't clear to me that the contracts AIG was peddling were insurance as the term is commonly understood. The absence of requiring an insurable interest, state regulated reserves, and nominal premiums suggest that it was more akin to an unregulated offshore casino. Of course, the rating agencies had a role in the scam. AIG carefully structured its activities to circumvent the woefully lax regulatory structure, including a feckless SEC, etc. etc.

Jul 15 12:34 PM

[Gtarras:]

Here are two major points nobody mentions:

1. AIG was brought down not by the REAL losses on these tranches, but by mark-to-market SWINGS. It was offering to post collateral through a mechanism called CSA, if prices went too far against the protection buyer. Other players like AIG (monolines), did not offer these margin posting service.

2. It is still not clear whether the real losses that AIG will suffer will be enough to wipe out its capital. For example, MBIA seems to be ok in this regard.

The CSA offer from AIG was a suicide. Their exposures were close to $1 billion in each deal, with VERY ILLIQUID deals 5-8 years in maturity. With this type of setting, if a price on your tranche jumps from 10 bps to 100 bps, you get slaughtered. (they clearly thought it would not happen.)

For example, if you sell 5y protection, $10 mill exposure on a liquid name and things go against you, i doubt you'd suffer that much.

Thats the reason its critical that this systemic risk issue is brought up. NOBODY is big enough to withstand this type of hit (except the govt). Of course, there was a reason the banks wanted to unload these tranches- to free up capital. Easy fix would be to make changes in Basel to view these types of exposures as "capital light".

Jul 15 01:26 PM

[Fund Insider:]

Acccording to Michael Lews (a prolific writer on Wall Street greed)
AIG went against industry practice and refused to post collateral to dealers when they first started trading CDS (selling insurance).
It is this lack of collateral obligation that allowed them to run amok writing unlimited amounts of insurance, they didn't need any collateral at hand to fund them. At some point they had to do it, but could only do so with govt help to fund the collateral payments to Goldman, etc.

Interesting read
www.vanityfair.com/pol...

On Jul 15 01:26 PM Gtarras wrote:

> Here are two major points nobody mentions:
>
> 1. AIG was brought down not by the REAL losses on these tranches,
> but by mark-to-market SWINGS. It was offering to post collateral
> through a mechanism called CSA, if prices went too far against the
> protection buyer. Other players like AIG (monolines), did not offer
> these margin posting service.
>
> 2. It is still not clear whether the real losses that AIG will suffer
> will be enough to wipe out its capital. For example, MBIA seems to
> be ok in this regard.
>
> The CSA offer from AIG was a suicide. Their exposures were close
> to $1 billion in each deal, with VERY ILLIQUID deals 5-8 years in
> maturity. With this type of setting, if a price on your tranche jumps
> from 10 bps to 100 bps, you get slaughtered. (they clearly thought
> it would not happen.)
>
> For example, if you sell 5y protection, $10 mill exposure on a liquid
> name and things go against you, i doubt you'd suffer that much.<br/>
>
> Thats the reason its critical that this systemic risk issue is brought
> up. NOBODY is big enough to withstand this type of hit (except the
> govt). Of course, there was a reason the banks wanted to unload these
> tranches- to free up capital. Easy fix would be to make changes in
> Basel to view these types of exposures as "capital light".

Jul 15 01:43 PM

[Fund Insider:]

All insurance is designed to protect against what is called idiosyncratic risk but can also suffer from system risks.

Take for instance your home owners insurance. The property insurers can easily withstand a single claim on a single home, but a hurricane can potetnially wipe out an insurer if enough damage is done, that's systemic risk. They used to price a policy considering the potential that YOUR home will be damaged, but they got smarter and started charging higher premiums if your home was in an flood zone, coastal area etc. Problem is, in financial insurance the persons at AIG needed to be able to identify such hot spots and charge appropriately. They didn't know, nobody knew how easily then entire real estate market could collapse. The closest we have come to this in decades was the S&L collapses of the early 90s when mainly real estate in Texas was affected. Once could price a policy differently for mortages concentrated geographically than one distributed, based on that bit of history, but when the entire country goes down the tube, yes, systemic risk impacts us all.

Let's hope there is no plague. Whomever is left living will criticize life insurers for not forseeing the potential that a very large % of policy holders would die in a short span of time ! If they considered that potential, you couldn't affort life insurance. In the end, our society is always backed by the govt, or not and then you end up with the great depression under Hoover.

Jul 15 01:53 PM

[Gtarras:]

Well, Michael Lewis.... I'd be very careful believing what he has to say, as he prefers sensational journalism to fact checking.

I too was under impression that AIG was not offering to post collateral, but the latest facts show that they were (for example, google AIG internal memo, which resurfaced couple of weeks ago, where they specifically say how much they'd have to post for each of their counterparty). When I saw it, I could not believe myself. I was under impression that their problems were due to the downgrade (they'd have to post as well), but it looks like they were even more suicidal.


On Jul 15 01:43 PM Fund Insider wrote:

> Acccording to Michael Lews (a prolific writer on Wall Street greed)
>
> AIG went against industry practice and refused to post collateral
> to dealers when they first started trading CDS (selling insurance).
>
> It is this lack of collateral obligation that allowed them to run
> amok writing unlimited amounts of insurance, they didn't need any
> collateral at hand to fund them. At some point they had to do it,
> but could only do so with govt help to fund the collateral payments
> to Goldman, etc.
>
> Interesting read
> www.vanityfair.com/pol...
>
> On Jul 15 01:26 PM Gtarras wrote:

Jul 15 02:01 PM

[Tom Armistead:]

AIG agreed to post collateral and the requirements increased if they were downgraded. As of this moment 3% of the bonds they insured is not paying, so the losses of 50% they took via Maiden Lane were far in excess of what the losses are going to be. They set themselves up to guarantee the market value of the securities. MBIA doesn't post collateral and is still afloat after taking far more serious losses.

Systemic risk if viewed as financial catastrophe risk is difficult to insure for the fact that all the losses happen at once which the insurance mechanism can't handle. Paying for example bond insurance losses over the life of the bond without posting collateral somewhat improves the possibility of making it work.

Ultimately society as a whole, ie big government, is responsible to pick up the pieces and get things rolling again in the event of a financial catastrophe. Long-term it might be more effective to admit this, set up an FDIC like mechanism Depression type loss scenarios. The premiums or taxes would have to be segregated and accumulated over time to pay for the big one, or the government could simply print money to fund it. The premiums if proportionate to the systemic risk created by the activity would be a deterrant to excessive risk taking.

Since the government is the insurer of systemic risk it makes sense to formalize the arrangement and specify how it works in advance, rather than making it up like Paulson as he cruised around with his Bazooka picking the winners and losers.

Jul 15 05:07 PM

[Gtarras:]

thanks for your views Tom, I am in total agreement with all you said here.

the issue of the systemic insurance is extremely interesting, and has been discussed at various blogs this week. I think it deserves a lot of attention. Simple reason: the backstops that AIG, monolines, SIVs etc were providing to the investors in the past few years are gone. These guarantees, or, in case of SIVs, high rated conduits, were a huge source of liquidity. I am not sure how big exactly, but I would say easily in the single digit trillions of dollars, and maybe even more. My personal, very soft estimate (i have spent ten years in the structured finance area, and dealt with SIVs) is more than $10 trillion of liquidity provided (on aggregate, i am looking at SIVs, guarantors etc).

With this source gone, no wonder money is not flowing through the system. banks are lending but this "shadow banking" source is gone or severely wounded. The FED increased the monetary base, but the money is still not flowing. How will it come back? I dont know. Thats the reason I believe, this topic deserves a lot more attention it is getting.


On Jul 15 05:07 PM Tom Armistead wrote:

> AIG agreed to post collateral and the requirements increased if they
> were downgraded. As of this moment 3% of the bonds they insured
> is not paying, so the losses of 50% they took via Maiden Lane were
> far in excess of what the losses are going to be. They set themselves
> up to guarantee the market value of the securities. MBIA doesn't
> post collateral and is still afloat after taking far more serious
> losses.
>
> Systemic risk if viewed as financial catastrophe risk is difficult
> to insure for the fact that all the losses happen at once which the
> insurance mechanism can't handle. Paying for example bond insurance
> losses over the life of the bond without posting collateral somewhat
> improves the possibility of making it work.
>
> Ultimately society as a whole, ie big government, is responsible
> to pick up the pieces and get things rolling again in the event of
> a financial catastrophe. Long-term it might be more effective to
> admit this, set up an FDIC like mechanism Depression type loss scenarios.
> The premiums or taxes would have to be segregated and accumulated
> over time to pay for the big one, or the government could simply
> print money to fund it. The premiums if proportionate to the systemic
> risk created by the activity would be a deterrant to excessive risk
> taking.
>
> Since the government is the insurer of systemic risk it makes sense
> to formalize the arrangement and specify how it works in advance,
> rather than making it up like Paulson as he cruised around with his
> Bazooka picking the winners and losers.

Jul 15 05:48 PM

[conceptwizard:]

The Government is not big enough to withstand these losses either. They are printing money from air. Putting the whole marketplace at risk again. We are not through this, we are just beginning.
Obama rolled the biggest dice of all, he risked the dollar. He has the rest of the world running scared wanting out of the dollar, and for good reason.
Ben Bernanke told Congress to either reduce entitlements or he cant roll the debt. I dont think he was in the mood for a joke.

So where is the systemtic risk now, we have backstopped the whole Financial System on the hope that the world will Finance the American debt. Which they are not going to do forever. The average term for debt rollover is 48 months now and shortening.

So if the Congress follows through what does that mean for the American people, lower standard of living. That is a huge tradeoff. Our tax revenues are down 30% so I dont think they will meet bugdet reductions without huge massive cuts somewhere. So if anything the budget deficit will increase by trillions.

The risk is still there we have 200 trillion of exposure with 8 trillion real dollars backing it up, that is huge risk. That loses 10% we lost our principle, if its not gone already.

Folks I dont want to whine , but holy crap that is HUGE RISK!

Its not if or maybe...major changes have to be made or we are in for the worst sort of gumbo that will make the last 20 months look like a Hawian vacation.

Jul 15 07:51 PM

[Mark54:]

This is the most informative blog that have read yet. Great job.

The thesis here is two-fold
(1) AIG's models and/or assumptions and/or motives were broken. With hindsight being 20/20 they way underpriced the insurance they were offering. But could a govt regulator have called that and corrected it? My opinion is NO. For the govt to spot big risk it needs to price it "right". If the govt cracks down and nothing ever happens then it is squashing capitalism. If another blow-up happens then back to the drawing board.
(2) Given that the govt cannot spot big risk in complex products, there needs to be a plan to unwind such a cobweb of counterparties. All counterparties need to post collateral. Perhaps a standard CSA grid based on rating (if there is one). The market needs to be standardized to be regulated by anyone.


On Jul 15 05:48 PM Gtarras wrote:

> thanks for your views Tom, I am in total agreement with all you said
> here.
>
> the issue of the systemic insurance is extremely interesting, and
> has been discussed at various blogs this week. I think it deserves
> a lot of attention. Simple reason: the backstops that AIG, monolines,
> SIVs etc were providing to the investors in the past few years are
> gone. These guarantees, or, in case of SIVs, high rated conduits,
> were a huge source of liquidity. I am not sure how big exactly,
> but I would say easily in the single digit trillions of dollars,
> and maybe even more. My personal, very soft estimate (i have spent
> ten years in the structured finance area, and dealt with SIVs) is
> more than $10 trillion of liquidity provided (on aggregate, i am
> looking at SIVs, guarantors etc).
>
> With this source gone, no wonder money is not flowing through the
> system. banks are lending but this "shadow banking" source is gone
> or severely wounded. The FED increased the monetary base, but the
> money is still not flowing. How will it come back? I dont know. Thats
> the reason I believe, this topic deserves a lot more attention it
> is getting.

Jul 15 10:09 PM

[Arthur Hau:]

"But Mr Rorty is saying that AIG was selling default insurance on the highest rated securities—things that don't blow up unless the entire economy is blowing up—and pricing it pretty cheap, to boot."

Technically speaking, AIG did NOT sell "credit default insurance." The financial instrument sold by AIG should be call "credit default swaps!" Credit default swaps are considered as financial derivatives, not insurance. A financial derivative has underlying assets that have random values. Selling credit default swaps is like short-selling gold futures or any other kind of index futures. A credit default swap, just like an interest rate swap, can be used for speculation or for hedging.

Insurance policies, on the other hand, have to satisfy the Law of Large Numbers and have to go through serious underwriting processes by the issuing insurance company.

Let me reiterate. AIG's insurance operation is healthy and intact. What caused AIG's current financial problem was its investment-bank-like operation.

My 2 cents.

Jul 16 12:36 AM

[morph366:]

"But another way of looking at this is that the systemic risk was always there, but both the buyer and seller of insurance on AAA securities wildly underestimated its scope."

The last sentence of your piece, I believe, poses two very different issues which are wrapped up in the word "scope"

1. The likelihood of systemic risk - it was perceived as much lower than it should have been - the so called Black Swan issue

2. The severity of the losses which would result sequentially from a default - again massively underestimated because of the highly inter-connected web of counter-parties to the CDS market and the implicit leverage involved in the underlying instruments.

The reason for the "wild underestimation" goes to the heart of Nicholas Taleb's critique of the maths involved in measuring the likelihood of extreme or systemic risk. Taleb (in the FT this week) described the mathematical framework for estimating VaR in such critical episodes as basically useless.

Would you still fly in a 747 if you were told that the maths and engineering behind their design was basically useless?
Me neither. But the financial establishment seem quite unfazed about carrying on with their flawed framework for extreme risk management.

Jul 16 02:56 AM

[DWStein:]

To answer the headline question: no, we cannon insure against systemic risk. Systemic risk is here to stay regardless of our collective actions and/or policies.

While is is a favorite pastime of economists and CNBC talking heads, assigning blame for this last financial bubble is a bit of a red herring. Why? Because history is replete with bubbles, panics and crashes; all of which, by the way, managed to take place without the benefit of CDS contracts. Please read Kindleberger’s "Manias, Panics, and Crashes" for many well documented examples.

Yes, CDS contracts played a role in this last blowup. Clearly, they slipped through the regulatory cracks and became vehicles for outrageous leverage and money creation. They do not, however, explain how the savings rate in the country fell below 1%. They do not explain how non-professionals poured into the real estate market to 'flip' houses and condos. They didn’t push the NASDAQ to 5000.

This brings us to the money creation at the Federal Reserve. Yes, it would appear, after the fact, a prolonged policy of low interest rates earlier this decade contributed to these problems. But, without the benefit of hindsight, at the time, there were serious concerns about deflation. If your next thought is to get rid of the Fed, then tell me how that will prevent another bubble. Again please read Kindleberger for a list of bubbles without the benefit of a federal reserve.

Fantasizing about a world without financial bubbles, is like saying if we had right policies, we could stop war or famine. It's an unrealistic goal and is most often used to generate political leverage. Or, in the case of the media, an endless story to sell diapers, cars and retail brokerage services.

The lack of statutory guidelines for such events is what bothers me. The Hobson’s choice of whether or not to bail out theses behemoths on an ad hoc basis yields some terrible results. You end up helping the organizations that did the most damage (AIG, anyone of a number of overleveraged banks..etc.)

A realistic approach would be to accept the inevitability of these integral parts of the human condition. We should, as a society, save money for such eventualities and provide support for individual citizens during time of stress; not companies. A national insurance fund that kicks in during an economic crisis might work.

Pretty crazy idea, right? Saving money for a rainy day…..

Jul 16 07:38 AM

[MinAkkar20:]

Hoover actually inherited a budget surplus. By the time he left office he had increased government spending by 50% and had a 2.7billion dollar deficit. When FDR campaigned he criticized Hoover for his deficit spending and huge (for that time) public works projects. Everyone is entitled their own opinions about government, but the facts shouldn't be re-written to support them

Read Murray Rothbard's "The Great Depression" for a uniqe perspective on the government during that time.


On Jul 15 01:53 PM Fund Insider wrote:

> All insurance is designed to protect against what is called idiosyncratic
> risk but can also suffer from system risks.
>
> Take for instance your home owners insurance. The property insurers
> can easily withstand a single claim on a single home, but a hurricane
> can potetnially wipe out an insurer if enough damage is done, that's
> systemic risk. They used to price a policy considering the potential
> that YOUR home will be damaged, but they got smarter and started
> charging higher premiums if your home was in an flood zone, coastal
> area etc. Problem is, in financial insurance the persons at AIG needed
> to be able to identify such hot spots and charge appropriately. They
> didn't know, nobody knew how easily then entire real estate market
> could collapse. The closest we have come to this in decades was the
> S&amp;L collapses of the early 90s when mainly real estate in Texas
> was affected. Once could price a policy differently for mortages
> concentrated geographically than one distributed, based on that bit
> of history, but when the entire country goes down the tube, yes,
> systemic risk impacts us all.
>
> Let's hope there is no plague. Whomever is left living will criticize
> life insurers for not forseeing the potential that a very large %
> of policy holders would die in a short span of time ! If they considered
> that potential, you couldn't affort life insurance. In the end, our
> society is always backed by the govt, or not and then you end up
> with the great depression under Hoover.

Jul 16 08:14 AM

[RiskAverseA...:]

And what office of "AIGFP created systemic risk out of nothing by mispricing CDS contracts?"

Why, it was the London office!

There simply is no "accidentally increasing vulnerability." This was done for the very purpose of bringing the greatest nation on earth to its knees.

Cut with the sophism about "systemic risk." The effects of excessive leverage are well-known. This is all we should be talking about when considering the shadow banking system. Its purpose -- largely facilitated by City of London offshore financial centers -- simply was to give the United States rope enough to hang itself with.

Yet as long as there is a Congress, there is hope the people might one day come to their senses and vote that the City -- the ageless enemy to the People of the United States -- be turned into a parking lot.

(Of course, we can count on Mr. Dimon's public objection!)

Jul 17 05:32 PM