September 2002
Shadow Financial Regulatory Committee
The Shadow Financial Regulatory Committee is a group of publicly recognized,
independent experts on the financial services industry, including banking, insurance, and securities. The Shadow Committee meets to study and critique regulatory policies affecting the financial sector of the economy.
The committee's most recent meeting was held at AEI on September 22 and 23, 2002. The agenda for this meeting focused on the International Monetary Fund proposal for dealing with default on sovereign debt, the European Union's proposal requiring home country supervisions for investment banks, the Sarbanes-Oxley corporate responsibility bill, terrorism and non-terrorism insurance, and an update on the proposed legislation for government sponsored enterprises. The committee presented two statements: Fannie Mae's Duration Gap (no. 181) and the Proposed Federal Backstop for Terrorism Insurance and Reinsurance (no. 182).
Excerpts from Statement 181:
Fannie Mae's Duration Gap
Last week Fannie Mae reported that its duration gap--a simple measure of the mismatch between the maturity of its assets and the maturity of its liabilities--fell to negative fourteen months. The Office of Federal Housing Enterprise Oversight (OFHEO) stated on September 16 that Fannie's interest rate risk exposure was unacceptably high, that it had instructed Fannie Mae to decrease its interest rate risk exposure, and that OFHEO would increase its scrutiny of Fannie Mae.
The increase in the duration gap to negative fourteen months appears to imply a significant increase in the risk of loss to Fannie Mae, and thus is a matter of concern to taxpayers in light of the implied guarantee from taxpayers enjoyed by Fannie Mae and other Government Sponsored Enterprises (GSEs). Given Fannie Mae's highly leveraged position, a duration gap of negative fourteen months implies that a one-percentage point decline in interest rates could result in about a 40 percent decline in its capital. Fannie Mae currently holds only slightly more than its minimum required capital. Such a decline in capital could push Fannie Mae substantially below its minimum required capital, which is already low relative to that of any private financial institution.
Fannie Mae's bet that interest rates will rise places taxpayers at risk. It reinforces the committee's longstanding view (see Statements 131, 134, 159, 164, 171, and 178) that these entities should be fully privatized, which would entail the elimination of implicit government guarantees, the reform of corporate governance, and the enhancement of public disclosure. In the meantime, alternative measures--including proposals to prohibit GSE purchases of mortgage backed securities, which are a primary means for undertaking interest rate risk--may be advisable as a means of limiting taxpayers' exposure to risk.
Excerpts from Statement 182:
A Proposed Federal Backstop for Terrorism Insurance and Reinsurance
Updated estimates of insured property and casualty losses from the destruction of the World Trade Center now total approximately $35 billion. In the weeks immediately following the attack on September 11, 2001, those losses and uncertainty concerning the future course of terrorism caused reinsurers around the world to threaten withdrawal of terrorism coverage. Primary property and casualty insurance companies indicated that, unless the government stepped in to provide last resort coverage, they would seek to exclude terrorism risk from new and renewal insurance contracts beginning in 2002. There was substantial concern that a shortage of terrorism coverage would have large spillovers on the availability of real estate loans and on new construction. In our prior statement on this subject (Statement No. 172, December 3, 2002), we suggested that insurance markets were beginning to digest the September 11 attack and that, "over time--and a relatively short time--private insurance markets will be able to price and devote the resources necessary to provide terrorism coverage efficiently."
Since that time, the dire predictions of many observers have not come to pass. Insurers and reinsurers have raised over $30 billion in new capital with at least another $10 billion in new issues pending. Although primary insurers excluded terrorism coverage from their basic commercial property programs in the large majority of states that approved such exclusions, separate stand-alone coverage initially became available with total limits in the $250 million range. Limits as high as $1 billion are now available, and further increases in available limits are likely. While the prices of coverage are often high, the insurance brokerage community estimates that prices have declined by 50 to 75 percent since early 2002, indicating that the market is adjusting. The availability of separate, stand-alone reinsurance for terrorism losses also has expanded since that time. Several catastrophe-modeling companies have developed, or are developing, models for use in forecasting terrorism losses, which should help insurers and reinsurers price and manage the risk.
In June 2002 the Senate enacted its backstop bill. Under the Senate bill, the federal government would pay 80 percent of losses above individual insurer retentions, which would likely equal roughly 7-8 percent of an insurer's premiums. If industry losses reached $10 billion, the federal share would increase to 90 percent. The committee believes that those thresholds also are too low. They would crowd out private sector coverage and impede efficient adjustments by insurers, lenders, developers, and other businesses exposed to the risk of loss from terrorism.
In conclusion, private insurance, reinsurance, and lending markets have made and are continuing to make substantial progress in adjusting to the post-September 11 world. Given those developments, the case for a federal backstop for terrorism insurance, which was not clear-cut late last year, is certainly less compelling now. If some intervention is appropriate, the thresholds for government involvement should be materially higher than in either the House or Senate bills.
AEI staff assistant Jessica Browning prepared this summary.
