by Tom Bozzo
I want to recommend that readers make it to the end of Robert’s last post with respect to the disastrous economics of the House Republican (and maybe or maybe not McCain) “insurance” plan (or is that insurance “plan”?). I’ll risk maybe repeating Robert since it’s an important point: either the premiums are subsidized and the losses on the toxic assets end up being socialized by a means that looks less like a bailout for political reasons, or the premiums aren’t subsidized and the plan is maybe worse than nothing. The plan’s basic perversity is that it makes up-front demands on ailing financial institutions which, if they could afford in the first place, the free market fairy would have already solved the problem.
(As a note of political commentary, this isn’t the first Fifth Column insurance-like plan to come out of the House Republicans, some of you might recall the effort to get around the potential problem of inadequate ex post returns for privatized Social Security accounts by having the government guarantee private accounts’ returns. Alas, linkrot has taken away Rep. Paul Ryan’s summary page for the Ryan-Sununu Social Security Personal Savings Guarantee and Prosperity Act.)
Reportedly the Republican plan is vague on the nature of the insurance deal; apparently it would direct Treasury to design something. This should be a neat trick thanks to the adverse selection end of the insurance problem. Remember that for all of the fire directed from the right side of the fence at the GSEs and less financially able mortgage-holders, the GSE end of the sh*tpile has much lower (if increasing) default rates by a substantial margin, as you can see in the graphs in this Econbrowser post. In part, that’s because for their late efforts at self-destruction they were mostly involved in the relatively sensible end of the mortgage business.
To make a crude analogy, the problem is akin to being a term life insurer faced with a prospective customer who’s known to have had a cancer diagnosis but won’t (or to make the analogy a little better to the financial situation maybe can’t) let you see his full medical records. Assuming the customer’s spouse isn’t an extremely wealthy beer distributor, the problem isn’t that the customer doesn’t have a relatively urgent demand for insurance. Just based on the public information, the insurance would have to be sold, if it’s going to represent something other than a gift from the insurance company’s shareholders, at a much higher price than the customer would have paid had the insurance been sought back when cancer was mistakenly thought to have been vanquished. The insurance design trick is to avoid having the customer shake on the deal and then say “sucker,” not least because the customer may live to see the payout eliminating any element of poetical justice.
There may be things you can do to make pooling work like mandating participation (in which case the financially healthy subsidize the financially sick), but certainly we’re out of totally-free market territory already. And it doesn’t seem trivial to ensure full participation, since it’s necessary not jus to identify the universe of “financial institutions” but also the assets requiring insurance. So this may be administratively a lot more complex and in some ways intrusive than letting institutions volunteer assets under a mechanism that discourages them from dumping their lemons at non-lemon prices.