The “F” word hits the road – finds Wall is dead end Street (Part 3 of 3)

Sop knows finance and I, on the other hand, know about working with people who would water a “hedge” if they had one, invest in “cats” that kill mice, and think exotic credit comes from a payday lender.

Hurricane Katrina, however, was a great equalizer; and, three years after the “F” word took people in Mississippi-Louisiana for a ride, the driver reached the end of the road on Wall Street – and was last seen frantically looking for a payday lender.

Financial Crisis: Wall Street dead end for disaster protection.

In the rear view mirror is the “F” word’s detachment as coverage issues became the focus of litigation following Katrina and an OIG report suggesting why – which explains how the “F” word made it all the way to Wall with the financial crisis.

Some blame the crisis on deregulation.

The CDS market, this market for credit default swaps that was created in 2000 by Phil Gramm’s Commodities Future Modernization Act…[and] the 262-page amendment Gramm tacked on to that bill that deregulated the trade of credit default swaps.

Others cite the failure to regulate at all.

Former Federal Reserve Chairman Alan Greenspan said…he was “partially” wrong for opposing the regulation of derivatives…[and] only “onerous” regulation would have prevented the financial crisis. Stifling rules would have suppressed growth and hurt Americans’ standards of living, he said.

Firms that bundle loans into securities for sale should be required to keep part of those securities…Other rules should address fraud and settlement of trades…Greenspan, 82, reiterated his ‘shocked disbelief” that financial companies failed to execute sufficient ‘surveillance” on their trading counterparties to prevent surging losses.

With more than enough blame to go around, there’s truth to both positions, no doubt.  There’s also truth in this statement:

Greenspan said the Fed didn’t know the size of the subprime mortgage market until late 2005. (emphasis added)

Late 2005 – the moment in time when the power of wealth crossed path with the force of nature.

Greenspan’s comment provides the timeline needed to link the current financial crisis to the insurance industry’s response to Hurricane Katrina – a link that connects to even more and the “F” word is right in the middle.

Some consider the cats, hedges and other insurance linked securities the elements of a Ponzi scheme financed by premium payments.  I thought so myself; but, recently, I’ve begun to think the financial crisis is actually the collapse of a pyramid scheme.

A pyramid scheme is a non-sustainable business model that involves the exchange of money primarily for enrolling other people into the scheme, without any product or service being delivered. It has been known to come under many guises.

Think of the red dots at the bottom of the pyramid as representing policyholders and their premiums. The single blue dot at the top represents the highly compensated executives who end up with the “real” money. The two tiers of blue dots below the top illustrate insurance linked securities – reinsurance – in various forms virtually indistinguishable from one another other than by name.

Obviously, there are more red dots than there are blue – an indication of the difficulty of keeping all of the balls in the air.  It’s a constant juggling act for the “dot at the top” and Allstate dropped the ball in 2005 when it didn’t purchase reinsurance for hurricane damage to policyholders in Mississippi and Louisiana.

Allstate Insurance Corp. recently said it didn’t buy reinsurance in Louisiana because models showed a “one-in-500-year” risk of a Katrina striking Louisiana. Instead, Allstate concentrated its reinsurance program on high-risk areas where the company could recoup the cost of the reinsurance through premium increases, such as Florida (BestWire, Oct. 24, 2005).

Because of the lack of transparency, we can only guess at the other insurers without the reinsurance needed to pay policyholders promptly. We do know only one cat bond was triggered:

Kamp Re….issued by the insurance company Zurich.

Katrina was a very short cat fattened by the “F” word until the Rigsby sisters and Branch adjusters discovered who was feeding the kitty NFIP-reinsurance.  This is the rest of that story – the “what” to feed the “F” word to make it happen; “how” that led to an OIG report that says if may have but, then again, maybe not; and “why” that got the “F” word to Wall; the dead end street of the current financial crisis.

The hottest game in town in the nation’s capital, according to the weekend news, is the lobbyist competition for bailout money.  It’s also the oldest game in any capital city, played regularly by those with access to money and not nearly so often by those with access to votes.

Seldom a game of chance, effective lobbying is always a one of opportunity – the opportunity to cultivate relationships with people in positions of responsibility and/or authority. The related section of the RICO complaint, Perdigao v Adams & Reese provides an example that could easily be called a how-to guide.

The magnitude of damage done by Hurricane Katrina exacerbated the magnitude of the problems the insurance industry was facing at the time.  Traditional sources of reinsurance were drying up – a situation that gave birth to the increasing use of cat bonds – and making a bad situation worse, Katrina was a short cat as mentioned earlier.  Policy changes limiting coverage, the ACC for example, could only fill part of the gap and would add to the loss costly litigation.  Time-buying options such as delaying the settlement of the most costly claims also came with the risk of additional cost from litigation.

Allocating as much of the wind damage as possible to NFIP-covered flooding emerged as perhaps the only other option.  However, it was easier said than done unless a few changes were made – changes that made it easy to quickly settle the most expensive claims, those for properties that were a total loss. Virtually all of the elements of the fraud claimed by the two qui tam cases can be traced to a related “cover” in the  expedited procedures developed by NFIP with assistance from the insurance industry.

It surely is no coincidence the OIG report specifically addresses those provisions as the investigation began with NFIP consulting with the industry.  With that beginning, one would expect a better ending. However, as Sop’s post 2.5 points out, the industry’s response rate to the OIG administrative subpoenas for documentation of wind damage was 58% – leaving 42% of the claims examined with only flood damage reported.

The bottom line is the industry didn’t transfer as much risk as it took – and then while victims of Katrina were bailing out damage to their property, it took on even more and now it’s lobbying to Paulson for relief. Before he puts a TARP over the problems, our friend CLS offers a set of recommendations posted on the ALL finance board:

  • Repeal McCarran Ferguson;
  • Add wind coverage to the NFIP (Mr. Gene Taylor’s bill);
  • Delete anti concurrent causation clause FOREVER;
  • No more “PERCENTAGE” Deductibles based on total policy limits; AND
  • The U.S. Treasury will own 80% of Bermuda and the Cayman Islands.
  • I pass them on for your examination and comment as we’ve arrived on Wall, the dead end street that’s the  end of the road for the “F” word.

    2 thoughts on “The “F” word hits the road – finds Wall is dead end Street (Part 3 of 3)”

    1. A very good article. Very nicely put together. I will read it again.

      I have often thought that it is as simple as — things that don’t make sense, really don’t make sense. People want to believe what is convenient to believe at the time and ignore the obvious.

    2. While you had huge amounts of leveraged returns squeezing down the returns of many of the standard investment types, there was a certain amount of money sloshing around the system that was willing to invest in reinsurance and cat-bonds. It is particularly telling that a few years of very high (post Katrina) returns with very low pay-offs have driven the market pricing down again.

      The most immediate problem is not that the insurance companies currently underestimate their risks, but that the deleveraging of the financial system (currently occurring) will drive the required investment returns on various bond products higher to compensate for the more expensive nature of the money and the inability to leverage the rate of return. Bonds that are further out on the food chain (from t-bills, AAA corporate, etc) will see their required yield greatly increase.

      If that occurs, it really won’t matter if the insurers are willing to adequately fund their fat tail risks. They will not be able to afford to do so at current insurance pricing.

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