So now the US government has decided to save the insurer AIG from imminent collapse. AIG is one of the insurers most deeply exposed to the toxic waste of bad loans. Yesterday I waffled on about Lehman Brothers, concentrating on one particularly problematic aspect of their business. Today we see another consequence of bad lending.
There are various ways in which insurance companies provide cover to banks and other commercial lenders, the most common of which is to agree to pay part of a loan if the borrower fails to do so. In return for a premium the insurer will pay out a certain amount if a loan is called in and there is a shortfall after the security for the loan has been realised. This type of insurance was often taken out by mortgage lenders, when it was known as Mortgage Indemnity insurance. The standard practice was for the lender to have a limit to the amount it would be prepared to advance, usually 75% or 80% of the value of the property, but to extend that to 90% or even 100% provided the extra sum borrowed was insured. For example, on a property valued at £150,000 the usual maximum loan would be £120,000 (80%) but the borrower would be allowed to borrow the additional £30,000 provided he paid for that £30,000 to be insured.
The trick was to get the premium right. While the market was rising steadily it was money for jam for the insurers because there would rarely be a shortfall. The £150,000 property would go up 10 or 15% in a year; default after two years and the increase in value would be enough to absorb the costs of repossession and sale and the fact that less than a full market price would be achieved on a forced sale. The insurers were falling over themselves to attract business from the lenders and had to offer lower and lower premiums in order to get that business. To an extent it did not matter to the bank how much the premium was because the borrower was required to pay it, but if one bank's insurance cost £1,000 and another's cost £200, it is pretty clear where the borrowers would go.
There came a stage in the mid 1980s when the insurers did not really treat this type of business as insurance at all. They perceived such a low risk of claims that it was just free money. Then came the crash and an inevitable juxtaposition between chickens and roost. Premiums charged over the boom period had averaged between 3% and 5% of the sum insured, £900-£1,500 to borrow an extra £30,000 and get the money needed to buy. The borrower would be required to pay the premium but the insurance was for the benefit of the lender not the borrower. On the borrower defaulting the lender would repossess the house, sell it and claim against the insurance company if there was a shortfall.
The property crash of 1989-1992 saw insurers having to pay out on a lot of claims. One might think that premiums averaging something like 4% of the sums insured would have provided sufficient funds to meet all possible claims, but these were the very riskiest of loans. Out of the premium income the insurance company had to pay its operating expenses leaving at most 2% or 3% in the kitty, call it 2.5% if the money was invested well. It only takes one in forty to default before all net receipts have to be paid out, one in forty-one and a loss is made. That was the position of some insurers in the early 1990s. Of course it was only part of their business but the great storm of 1987 drained huge resources and economic downturns have a funny way of causing a lot of failing shops and factories to catch fire, when times are hard people also do not renew what they consider to be unnecessary insurance or reduce their level of cover.
AIG has been caught by an extraordinary level of default in both business and mortgage loans triggering claims by banks, and this against a background of substantial claims in other areas. Unlike Lehman Brothers, AIG's business was not skewed towards high risk areas, they just happened to be caught by circumstances. The decision of the US government to bail them out with a loan of $85billion (yes, that is billion) was perhaps inevitable given the reach of AIG across a vast area of the American economy. The damage done by collapse could have been far worse than the cost of rescue.
Time will tell whether the bail-out will prove to be a good move. What is certain is the risk to the American taxpayer is far less than it would have been in bailing-out a bank because the businesses, and the bail-outs, work in opposite ways.
Banks take money and pay interest, they have to use the money they take to earn the interest they pay. They get into trouble when the interest they earn is less than the aggregate of the cost of running the bank and the interest they pay their customers. Government support does not increase the profit the bank can make on its investments but it does provide a cushion for such time as costs and interest paid amount to more than interest earned. As we are seeing with Northern Rock, that cushion can be very large and stuffed to the gills with £50 notes. Until such time as the business is profitable the cushion just gets fatter and fatter. There is nothing the government can do to increase revenue and decrease costs, it is just a guarantor of bad debt.
Insurance companies, on the other hand, take money in return for a promise to pay a certain amount in the event that some problem occurs causing a claim. The presence of government backing cannot increase the number of valid claims or increase the sum payable on each claim but it can increase premium income because the customer knows that, in the unlikely event he has a claim, his claim is guaranteed to be paid. He cannot be assured of that from other insurers because they could go belly-up at any time. Customers can easily be persuaded to pay a slightly higher premium in return for the guarantee of payment when they make a valid claim. All it takes is a small tightening of the terms of insurance, so that fewer risks are insured or risks are insured for smaller sums, combined with payment of slightly higher premiums, and the business is back afloat without the taxpayer being exposed to a long-term risk. In the meantime claims will be paid while premiums are insufficient and the Treasury loan has been made to cover that position.
The American government is not stupid. It has taken a massive controlling interest in AIG and will correct the imbalance in its business, if it can be corrected, within a year or two. At that time it will sell off it's interest, probably in stages, and make a massive profit. There is no guarantee, but it is a pretty sound proposition.
Our government, on the other hand, is having to wind-down Northern Rock slowly, turning it from a big player in the mortgage market into a small regional bank. The property market will be tight for a long time and the core of Northern Rock's previous business cannot be recovered. There is no means to make the profit necessary to repay the Treasury in the short term and once it is stabilised as a secure bank it will have to be sold. A massive overall loss to the taxpayer is assured.
There are various ways in which insurance companies provide cover to banks and other commercial lenders, the most common of which is to agree to pay part of a loan if the borrower fails to do so. In return for a premium the insurer will pay out a certain amount if a loan is called in and there is a shortfall after the security for the loan has been realised. This type of insurance was often taken out by mortgage lenders, when it was known as Mortgage Indemnity insurance. The standard practice was for the lender to have a limit to the amount it would be prepared to advance, usually 75% or 80% of the value of the property, but to extend that to 90% or even 100% provided the extra sum borrowed was insured. For example, on a property valued at £150,000 the usual maximum loan would be £120,000 (80%) but the borrower would be allowed to borrow the additional £30,000 provided he paid for that £30,000 to be insured.
The trick was to get the premium right. While the market was rising steadily it was money for jam for the insurers because there would rarely be a shortfall. The £150,000 property would go up 10 or 15% in a year; default after two years and the increase in value would be enough to absorb the costs of repossession and sale and the fact that less than a full market price would be achieved on a forced sale. The insurers were falling over themselves to attract business from the lenders and had to offer lower and lower premiums in order to get that business. To an extent it did not matter to the bank how much the premium was because the borrower was required to pay it, but if one bank's insurance cost £1,000 and another's cost £200, it is pretty clear where the borrowers would go.
There came a stage in the mid 1980s when the insurers did not really treat this type of business as insurance at all. They perceived such a low risk of claims that it was just free money. Then came the crash and an inevitable juxtaposition between chickens and roost. Premiums charged over the boom period had averaged between 3% and 5% of the sum insured, £900-£1,500 to borrow an extra £30,000 and get the money needed to buy. The borrower would be required to pay the premium but the insurance was for the benefit of the lender not the borrower. On the borrower defaulting the lender would repossess the house, sell it and claim against the insurance company if there was a shortfall.
The property crash of 1989-1992 saw insurers having to pay out on a lot of claims. One might think that premiums averaging something like 4% of the sums insured would have provided sufficient funds to meet all possible claims, but these were the very riskiest of loans. Out of the premium income the insurance company had to pay its operating expenses leaving at most 2% or 3% in the kitty, call it 2.5% if the money was invested well. It only takes one in forty to default before all net receipts have to be paid out, one in forty-one and a loss is made. That was the position of some insurers in the early 1990s. Of course it was only part of their business but the great storm of 1987 drained huge resources and economic downturns have a funny way of causing a lot of failing shops and factories to catch fire, when times are hard people also do not renew what they consider to be unnecessary insurance or reduce their level of cover.
AIG has been caught by an extraordinary level of default in both business and mortgage loans triggering claims by banks, and this against a background of substantial claims in other areas. Unlike Lehman Brothers, AIG's business was not skewed towards high risk areas, they just happened to be caught by circumstances. The decision of the US government to bail them out with a loan of $85billion (yes, that is billion) was perhaps inevitable given the reach of AIG across a vast area of the American economy. The damage done by collapse could have been far worse than the cost of rescue.
Time will tell whether the bail-out will prove to be a good move. What is certain is the risk to the American taxpayer is far less than it would have been in bailing-out a bank because the businesses, and the bail-outs, work in opposite ways.
Banks take money and pay interest, they have to use the money they take to earn the interest they pay. They get into trouble when the interest they earn is less than the aggregate of the cost of running the bank and the interest they pay their customers. Government support does not increase the profit the bank can make on its investments but it does provide a cushion for such time as costs and interest paid amount to more than interest earned. As we are seeing with Northern Rock, that cushion can be very large and stuffed to the gills with £50 notes. Until such time as the business is profitable the cushion just gets fatter and fatter. There is nothing the government can do to increase revenue and decrease costs, it is just a guarantor of bad debt.
Insurance companies, on the other hand, take money in return for a promise to pay a certain amount in the event that some problem occurs causing a claim. The presence of government backing cannot increase the number of valid claims or increase the sum payable on each claim but it can increase premium income because the customer knows that, in the unlikely event he has a claim, his claim is guaranteed to be paid. He cannot be assured of that from other insurers because they could go belly-up at any time. Customers can easily be persuaded to pay a slightly higher premium in return for the guarantee of payment when they make a valid claim. All it takes is a small tightening of the terms of insurance, so that fewer risks are insured or risks are insured for smaller sums, combined with payment of slightly higher premiums, and the business is back afloat without the taxpayer being exposed to a long-term risk. In the meantime claims will be paid while premiums are insufficient and the Treasury loan has been made to cover that position.
The American government is not stupid. It has taken a massive controlling interest in AIG and will correct the imbalance in its business, if it can be corrected, within a year or two. At that time it will sell off it's interest, probably in stages, and make a massive profit. There is no guarantee, but it is a pretty sound proposition.
Our government, on the other hand, is having to wind-down Northern Rock slowly, turning it from a big player in the mortgage market into a small regional bank. The property market will be tight for a long time and the core of Northern Rock's previous business cannot be recovered. There is no means to make the profit necessary to repay the Treasury in the short term and once it is stabilised as a secure bank it will have to be sold. A massive overall loss to the taxpayer is assured.
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