Baseline Scenario

The Baseline Scenario
The Perfect Product
Boring and Exciting Finance
The Crisis Next Time: Role Of The Fed
The Perfect Product
Posted: 09 Sep 2009 10:00 AM PDT
I wasn’t planning to write about this weekend’s New York Times article about the securitization of life settlements after reading Felix Salmon’s post saying there was no new news there. But I was thinking about it some more and thought it was an interesting concept, whether or not it gets off the ground.
Life settlements already exist. The idea is that someone has a whole life insurance policy with a death benefit of, say, $1 million. The insured bought it when he was 35 and had two kids; now he’s 70, the kids are working on Wall Street and don’t need the death benefit, but they’ve cut him off and he needs some cash to fill the prescription drug donut hole and pay his Medicare co-pays. The insurance company will give him a cash settlement value of, say, $100,000. I don’t know what this actual number is, but the key point is that it is less than $1 million at the insured’s expected date of death, discounted back to the present (let’s call that the current actuarial value of the policy). In a life settlement, an investor pays the insured a lump sum that is greater than $100,000 – say, $200,000 – and makes the premium payments (if any are left to be made) on his behalf; in return, the investor becomes the beneficiary on the policy. Again, this already happens, although there are concerns about churning, misrepresentation, the whole deal.
In a securitization, an investment bank would buy a whole lot of life insurance policies, pool them, and issue bonds in tranches (just like a CDO) to fund the purchase of the policies. The idea is that investors would get an asset that is uncorrelated or only loosely correlated with other assets, while insureds would get higher prices for their policies because there would be greater demand for them. This is not happening, although the Times articles makes it seem like it is going to start.
I think this is conceptually interesting because basically it is just securitizing an arbitrage trade. The obvious thing to compare it to is residential mortgages. When you securitize residential mortgages, you are expanding the pool of people willing to invest in buying houses, which spills over quite significantly into construction of new houses or improvement of existing houses. That is, you are moving capital to places where it is (theoretically) being productively invested. I’ve written several times about how this went too far, but the basic point is that securitization is promoting value-generating investment.
A life settlement, by contrast, is pure arbitrage: the ultimate thing you are investing in is just a financial product. Today, insurers make money because the cash settlement value is less than the current actuarial value; some people alternatively let their premiums lapse, and then they lose their death benefit, which is even better for the insurer. Expanding the market for life settlements would help those insureds because they would get the current actuarial value (less fees) instead of the cash settlement value. So the first order effect would be a transfer of money from insurers to insureds. But life insurance is a reasonably competitive industry; insurers will predictably raise premiums on everyone since they can’t count on people taking the paltry cash settlement values or letting their policies lapse. So the second order effect will be a transfer of money from insureds who keep their policies until death to insureds who sell them prior to death, with the insurers just as well off as before.*
So at the end of the day, all we’ve done is pushed cash around – except for those fees! So the people involved in originating, packaging, and selling the securitized life settlements take home their 4%, and the rest is a zero-sum game. I’m not sure any value has actually been destroyed, since investment bankers are people, too. It’s just that there used to be $100 shared among insureds and their beneficiaries, and now there are only $96 to share between insureds, their beneficiaries, and investors, and $4 to share among the brokers and the bankers.
Now arguably the way the $96 is being shared is more efficient than the way the $100 was being shared, since you no longer have the people who take cash settlements subsidizing the people who collect death benefits like in the current system. But I don’t think that we’ve gotten any aggregate social welfare in exchange for those $4 in fees. I suppose there might be third-order benefits from efficiency here (might the insurance market function better in some sense? would this increase demand for life insurance? and is that a good thing?), but I’m skeptical.
* I got in an argument about this yesterday with someone who thought premiums could go down, but I can’t tell you the details because it was off the record.
By James Kwak

Boring and Exciting Finance
Posted: 09 Sep 2009 09:00 AM PDT
Taunter has a comprehensive proposal about how to regulate financial services, dividing them into Boring and Exciting. Boring services are the following:
retail deposits
loans to retail customers, including mortgages
retail insurance, including annuity products
any custodial service beyond traditional settlement (i.e., if you hold something after T+3, you’re a custodian)
If you do any of those, then you are a Boring institution, you can do all Boring services, you face some significant regulations, and you get bailed out when necessary. If you do none of those, then you are an Exciting institution, you can do almost anything you want, and there is an ironclad rule preventing the government from bailing you out. Boring institutions cannot offer Exciting services (I think) and Exciting institutions cannot offer Boring services (that’s certain).
It feels like a modern version of Glass-Steagall (although I’m probably not doing it full justice) – create an explicit linkage between tight regulation and a government backstop, and protect the part of the financial system that affects ordinary people.
A key requirement of this system is that you have to be willing to accept the consequences of the collapse of an Exciting institution. I’m not sure that Taunter has sufficiently sealed off the real economy from Exciting firms, however. For example, suppose an Exciting firm offers revolving credit accounts to companies that they dip into to make payroll (to smooth out fluctuations in cash flow over the month). I don’t think this qualifies as Boring in Taunter’s scheme. But if the Exciting firm goes down, suddenly thousands of companies might be unable to make payroll.
I’m not saying this is a fundamental flaw; maybe the lines just need to be drawn differently. Or maybe I’m missing something. In any case, it’s an interesting way to think about the problem, especially for people who want to combine closer regulation of financial services that affect ordinary retail customers with free markets and financial innovation for sophisticated actors.
By James Kwak

The Crisis Next Time: Role Of The Fed
Posted: 09 Sep 2009 05:52 AM PDT
The Federal Reserve is taking a victory lap (e.g., Ben Bernanke at Brookings, next Tuesday morning; no weblink yet available), and the emerging consensus is that its leadership has done a great job over the past 12 months. But we should also take this opportunity to reflect on the longer run role of the Fed, both in the past decade or two and since its founding.
Over on The New Republic website (and in the lastest hard copy), Peter Boone and I suggest that in the absence of effective financial regulation – i.e., both during the 1920s and again since 1990 – the Fed has operated in a manner that encourages the formation of sequential bubbles. This destabilization of our financial system is not a minor matter; the damage caused – human, financial, social – is already enormous.
And we are very far from being done.
Don’t take my word for it. Lou Jiwei, the chairman of China’s sovereign wealth fund said recently, “It will not be too bad this year. Both China and America are addressing bubbles by creating more bubbles and we’re just taking advantage of that. So we can’t lose.”
By Simon Johnson