Tom Armistead

Can We Insure Against Systemic Risk?

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.