What insurance do insurance companies really give?

“Insurance companies are naturally flawed and need revision because when times are good, they take your money through premiums, but when times are bad, they take your money indirectly through the government”

Zach Blumer, YIC Analyst
Arbitrage Contributor,
www.yorkinvestmentclub.com

Recently, the economy has been looking up and America’s big banks are starting to turn around. In fact, in mid-June, the Treasury Department gave permission to J.P. Morgan Chase, Goldman Sachs, Morgan Stanley and seven other banks to pay back $68 billion in bailout money. However, the government’s investments in insurance companies, particularly AIG, Fannie Mae and Freddie Mac, have not turned around as quickly.

After investing $160 billion in equity into the three companies, there has not been nearly as favourable an outcome as with the government’s investment in the banks, and it is difficult to anticipate when their fortunes will improve. Because AIG, Fannie Mae and Freddie Mac were all affected by instability in the past, one might think they would have learned from their mistakes and be quick to recover, but this has not been the case.

AIG, for example, through its insurance program, was so deeply knit into the financial system that its failure could have brought the entire financial system down. Fannie Mae and Freddie Mac, together, own and guarantee approximately half of American mortgages. In doing so, they are insuring American mortgages when they securitize them and sell them globally as guaranteed investments.

Although banks also have insurance arms, the most significant damage they had to sustain was through their ownership of toxic assets, or bad debt. Banks required bailout money because the leverage they employed was too high and because they had a shortage of cash to continue operating due to the frozen credit market and the fact that their assets’ market values were much lower than they had listed on their balance sheets (because of defaulted loans, fallen stock prices, etc.).

AIG, Fanny, and Freddie were in a different boat; they needed money because their liabilities began to increase more and more as the economy steadily sunk. This led to AIG’s bailout being upwardly revised four times. Furthermore, while it is relatively easy to look at a bank’s balance sheet and determine that certain assets can be marked to zero, it was next to impossible to know what the liability was of each one of these three insurance companies. In fact, with respect to AIG’s sales of Credit Default Swaps, the company hit a point in September 2008 when they covered $440 billion worth of bonds and nobody knew how much of it was a liability. Fannie Mae and Freddie Mac were liable to cover half of the country’s mortgages, with no accurate measure of what proportion would be written down as the economy spiralled downwards.

When times are good, the three companies simply earn premiums, but the inherent risk of default is always looming. For AIG, when one company defaults on its loans, it is more likely that another company will do the same and the risk grows exponentially. When the housing market takes a turn for the worse, people are paying a mortgage that is worth more than their house and defaults rise, again, exponentially.

The Economist predicts the government’s equity investment in the three companies could reach $300 billion and a total bailout of $800 billion including loans. Although insurance is supposed to protect us when disaster strikes, it has only made things worse and the damage more widespread. There is much that needs to be done to reform these companies and taxpayers will not easily forget what has happened, diminishing the validity of these three businesses in the foreseeable future.