Interesting Q & A on the "shadow banking" system over at The Atlantic. The last answer is illustrative of a major distinction between physical and social systems:
I use the term "Credit Insurer of Last Resort." And here's the idea: The Bagehot Rule - lend freely, at a high rate, in a crisis - dates from 1873. That was a good enough rule for the 19th century British economy, an economy that ran on short term commercial bills of exchange, 90-day paper. You can see for the new capital markets banking system we have a problem. We have 30-year mortgages that are the underlying asset that are being turned into 90-day paper through asset-backed commercial paper, or a repurchasing agreement, or repo, but the underlying asset is still a 30-year mortgage. That is where the system broke, because those mortgages serve as collateral for the short term borrowing.
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.
Brings to mind the idea that the best way to encourage safe driving is to place an iron spike into the steering wheel.
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The dichotomy isn't quite right. If you insure property damage from earthquakes, you make it more likely that someone will build in earthquake-prone areas, reduce the incentive to take careful geotechnical investigations first, etc. So you in fact do make it more likely that there will be property damage from earthquakes.
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.
Well we know what that price should be - if a 10yr Treasury note yield is 3.75%, and a 10 year corporate bond's yield is 6.75%, the price should be 300 basis points - that's the value of the inherent risk of that corporate paper. Perhaps one of your erudite readers can explain why the price (to insure that bond) should be anything else. And given that, how insuring financial risk makes any business sense.
As a side note, while earthquake insurance doesn't make earthquakes more likely, shouldn't it make earthquake losses more likely by encouraging people to build and live in earthquake prone areas?
the point about earthquake (or flood, etc.) insurance is spot on. but that's a social dynamic, and reinforces the point that the author is obviously attempting to make. scoring on that sort of technicality is lame, though perhaps a debate judge would smile upon you ;-)
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