Arthur F. Burns Fellow Peter J. Wallison

The reason for this is a problem at the very base of our economythat is going to be exceedingly difficult to address. I'm referring tothe deterioration in housing values and the mortgage defaults that areboth its cause and its effect. Despite the fact that almost two yearshave passed since observers of the housing market have recognized aproblem, its dimensions are still not understood. There was an articlein the Washington Post earlier this month which described theproblem in serious terms--something like 9 million subprime and othernon-prime mortgages, many of which are defaulting at unprecedentedrates and will continue to do so throughout this year and into 2010.

However, the Post doesn't know the half ofit--literally--and the fact that the newspaper's research turned up thewrong numbers is a major part of the problem we face today. In reality,there are 25 million subprime and other nonprime mortgagesoutstanding--40 percent of all mortgages on single family homes andalmost three times the number cited by the Post. These junkmortgages have an unpaid principal balance of over $4 trillion. Inother words, the problem we face is much, much larger than what thePost described.

The reason for this failure of information isthe same reason we have so many low quality mortgages--governmentintervention in the housing market through the Community ReinvestmentAct and Fannie Mae and Freddie Mac. Together, these federalpolicies--intended to increase home ownership--caused a steep declinein the quality of mortgages and put taxpayer funds behind buying andguaranteeing them. Because Fannie and Freddie were seen as backed bythe federal government, and did not have to report to the SEC, fewpeople cared what they were doing with the taxpayers' credit card. Nowwe know. They hold or have guaranteed $1.6 trillion in subprime andother nonprime mortgages; they bought over $1 trillion of these between2005 and 2007. I will only show you one picture today, and this isit--Fannie Mae's own report on how its loan portfolio is doing. Notethe rates of delinquency for the 2005-2007 vintages.

What all this means, I'm afraid, is that we are in for a long periodof economic decline, as these mortgages continue to default. Already,the losses in the subprime market are spreading to the prime market.There will undoubtedly be some kind of government policy to attempt tomitigate the effects of the mortgage crisis, but that will involve thegovernment in spending trillions of dollars to shore up banks andmodify mortgages. This money is already being printed, and if we aresuccessful in halting the housing decline and stabilizing the economythe next problem will be serious--really serious--inflation, as all themoney the Fed has pumped into the economy begins to move throughtransactions.

What does all this mean for the property and casualty insuranceindustry? You are going to be infinitely better than I in forecastingthe effects on your business of a prolonged economic downturn and thepotential of huge inflationary government expenditures. But I followpolitics and government regulation pretty closely at the AmericanEnterprise Institute, and in this talk I'd like to tell you what Ithink all this means for government policies--and specificallygovernment regulation--after the election results in 2006 and 2008.

Last week, a subcommittee of the Group of 30--a privately-supportedorganization of financial experts--issued a report on the regulatorychanges that they thought were made necessary by the current financialcrisis. Because the subcommittee was headed by Paul Volcker, a Washington Postreport commented that the group's recommendations were a strong hintabout where the Obama administration might be going with its ownrecommendations on regulatory reform. This past Sunday, the New York Timeschimed in with a report that the Obama administration is planning tomove quickly with regulatory reform in the financial industry,apparently along the lines of what the G30 recommended.

It will not surprise you, if you know anything about Paul Volcker'sviews on regulation, that the G30 report recommended governmentregulation of many of the currently unregulated players in thefinancial markets--what NAMIC in its excellent recent report called the"shadow banking system." The groups to be regulated for safety andsoundness included the usual suspects in the shadow bankingsystem--hedge funds, private equity funds, and broker-dealers. Butthere was one other industry that was not mentioned as part of theshadow banking system by NAMIC which was included in the G30 report asrequiring safety and soundness regulation at the federal level: whatthe G30 called "large internationally active insurance companies."

I wouldn't put too much stock in the idea that mutual insurancecompanies won't be regulated at the federal level if they are not"internationally active." The principal thrust of the report is thatall this regulation is intended to create financial stability, and theauthors apparently believe that this can only be achieved throughsafety and soundness regulation of all companies of any kind that arelarge enough to create systemic risk. So it really doesn't matterwhether your company is internationally active. If it is large enoughto create systemic risk in the United States it will be subject tofederal regulation under the G30 recommendations.

If the danger of creating "systemic risk" or systemic instability isan important idea, we'd better figure out what the G30 group means bythe term. But alas, they don't define it. What they say is that one oftheir "Guiding Principles" is that "Requiring non-bank financial institutions that are also judged potentially to be of systemic importanceto be subject to some form of formal prudential regulation andsupervision to assure appropriate standards for capital, liquidity, andrisk management." [p.17, all emphasis supplied]. There is an effort todefine the characteristics of systemically significant institutions,but all the elements of the definition--size, leverage, scale ofinterconnectedness, and the infrastructure services they provide--leaveplenty of room for covering many property and casualty insurancecompanies, and still don't define what the authors mean by systemicrisk.

As I will show, however, even if your company operates inone state, and could not possibly create a financial crisis if itfailed, you will be directly affected if the G30's plan is adopted andany of your competitors is declared to be "systemically significant."

So, what is systemic risk? As is well known, when Lehman Brothersfailed in September 2008, the entire international financial systemfroze up. Banks stopped lending to one another, solid companiescouldn't sell their commercial paper, and there was the distinctpossibility of runs on money market mutual funds. Actions by theTreasury and Fed have somewhat eased this problem, but is that what wemean by "systemic risk?" If so, it's an exceedingly broad definition.None of the banks or other financial institutions that stopped lendingdid so because they had suffered losses from Lehman's failure. In otherwords, there was no contagion from Lehman.

What happened was that many of these institutions realized thattheir counterparties, like Lehman, were much weaker than they thought,and that the U.S. government, at least, was not going to bail them out.If they wanted to be sure that they would not be the victims of runs bydepositors and counterparties, they decided, they'd better hoard theircash. That is still going on, and is the underlying reason for the lackof credit that now afflicts our economy and the economies of othercountries. If we accept what happened after the Lehman failure as anexample of systemic risk, then "systemically significant" companiesinclude any company that might cause investors, depositors andcounterparties to be fearful that banks or other financial institutionsare in danger of instability or failure. That isn't the same thing assaying that the failure of a particular institution--say, Citibank oreven Lehman Brothers--would cause such large losses to others thatthese losses cascade through the economy and have a systemic effect. Inother words, when we are talking about systemic risk, are we talkingabout a psychological phenomenon--inducing fear in investors andothers--or are we talking about a legal or real phenomenon in whichmany parties suffer losses because they don't receive payments theywere expecting?

The difference is going to be crucial when and if the time comesfor some government agency to determine whether a particular company is"systemically significant" or not. And this designation will beimportant to every competitor of a company that is declared to besystemically significant. The reason for this is simple. If a companyis declared to be "systemically significant" that will be a signal thatthe government will not allow it to fail. After all, that's the wholepurpose of the systemically significant designation--to make sure thatstability reigns in the market because companies that might causeinstability if they failed will not be allowed to do so.

And what happens if a company is declared too big or toointerconnected to fail? Creditors will see it as a better and saferborrower than its competitors. Its borrowing costs will be lower thanthose of its competitors and its representations to potential customersabout its financial reliability will be harder to beat. It will growfaster and larger, and--unless you actually believe that regulationprevents risk-taking--it will be able to take more risks and perhaps bemore profitable despite its additional regulatory costs. It gets worse.The natural tendency of competitors in a market distorted in this wayby government intervention will be to get the designation "systemicallysignificant" for themselves. This will provoke unnecessary anduneconomical consolidation in the insurance industry so that theresulting companies can meet whatever test for size and other criteriathe designating agency seems to be applying in determining whether acompany is "systemically significant." That's why I say that thecompetitors of companies that are declared to be systemicallysignificant will be at least as much affected by the systemicallysignificant designation as the systemically significant companiesthemselves. If we go forward with this idea, in other words, we will becreating an unlimited number of Fannie Maes and Freddie Macs--companiesthat are seen in the market as ultimately backed by the federalgovernment.

What are the prospects that the idea of regulating systemicallysignificant companies will take hold? I assess this likelihood as quitehigh, given the general attitude of the Democratic Party towardregulation, the prestige of Paul Volcker in Congress, his position asan adviser to President Obama, and the fact that many importantbusiness associations in Washington--without thinking of theconsequences--have endorsed the idea. It sounds reasonable that only afew companies in each industry will be regulated for safety andsoundness, and that those will be only the largest companies in theirindustries. Moreover, the pressure to "do something"--to make sure thatthis doesn't happen again--will build among the American people as thefinancial problems I outlined at the beginning of this talk continuethrough 2009. The proponents of regulation are arguing--as they didduring the recent campaign--that the cause of the financial crisis isthe lack of regulation, and I'm afraid that argument will resonate withthe public.

What does this mean for insurance regulation in the future? In itspaper on the regulation of "shadow banking," NAMIC successfullydifferentiates property and casualty insurance from of financialactivities. The paper is a powerful argument for why property andcasualty insurance should not be considered part of the shadow bankingsystem. However, if we go back to the question of systemic risk, howlikely is it that the largest property and casualty insurance companieswill not be considered "systemically significant?" I think the chancesof that are quite small. And if it's not the insurance companiesthemselves, then it will be their holding companies. How likely is itthat when some of the largest financial companies in the United Statesare insurance companies that they will be given a pass on the groundthat the liabilities of P&C companies are different in quality thanthe liabilities of banks?

Let me, as devil's advocate for a moment to lay out the argumentagainst this idea. Like all financial companies, P&C companies haveassets and liabilities that are subject to rapid change. Liabilitiesare subject to huge risks arising from natural calamities such asfloods, earthquakes, hurricanes, and fire. Is there anyone here whowould be able to assure a federal regulator that--in an era of beliefin climate change--there is no significant chance that insurancecompany liabilities will be larger than anyone anticipates? On theother hand, let's look at insurance company assets. Will they notfluctuate in value? For P&C companies, I would expect, assets wouldtend to be long term, which might mean that they cannot be liquidatedquickly to meet unexpected needs. The value of long term assets canfluctuate significantly, as we are seeing today, even if the accountingfor them is more stable than the mark-to-market accounting thatprevails in the banking industry.

What would happen if a large P&C company could not meet itsobligations after an earthquake in California? The guarantee fundobligations of the other insurance companies doing business inCalifornia would then be called upon, but it is certainly not beyondthe realm of possibility that these companies, too, will be havingdifficulty meeting their obligations. What if all or most of theprivate insurance resources in California were unable to meet theirprimary and secondary obligations, and as a result many companies hadto default? Would the fact that millions of people and companies wouldnot be able to repair their homes or businesses be a systemic event?Would anyone like to argue to the systemic regulator that somethinglike this could never happen, or if it did that it would not be asystemic event? The Washington Post reported this pastSaturday that some life insurance companies were trying to becomeS&L holding companies so that they could apply for TARP funds. Thisis not because more people are dying than expected, but because theirassets are declining in value.

Does anyone think that it will be possible to convince a federalregulator that P&C companies should be exempted from the rules thatthe G30--and perhaps the Obama administration--would like to seeapplied to all financial companies that might be systemicallysignificant? And if not, then imagine the effect on competition in theinsurance industry if a few of the largest companies were, in effect,brought under the wing of the federal government as systemicallysignificant companies. They would be tough competitors for financingand for customers, to say the least.

This has very little to do with the question of an optional federalcharter. That may or may not be in prospect for the industry. If a planlike the G30 proposal is adopted, large state- chartered insurers wouldbecome subject to federal regulation. It would not be optional.

What, then, is the right course for NAMIC? I wouldn't presume toadvise you when you have some of the most capable Washington handsrunning NAMIC already, but if the prospects for separating yourselvesfrom the rest of the financial industry are not bright, perhaps youshould be thinking about joining forces with others who will beopposing regulation in general. As Benjamin Franklin said at the timethe Declaration of Independence was signed: "We must all hang together,gentlemen...else, we shall most assuredly hang separately."

Peter J. Wallison is the Arthur F. Burns Fellow in Financial Policy Studies at AEI.