Arthur F. Burns Fellow Peter J. Wallison

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

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

The reason for this failure of information is the same reason we have so many low quality mortgages--government intervention in the housing market through the Community Reinvestment Act and Fannie Mae and Freddie Mac. Together, these federal policies--intended to increase home ownership--caused a steep decline in the quality of mortgages and put taxpayer funds behind buying and guaranteeing them. Because Fannie and Freddie were seen as backed by the federal government, and did not have to report to the SEC, few people cared what they were doing with the taxpayers' credit card. Now we know. They hold or have guaranteed $1.6 trillion in subprime and other nonprime mortgages; they bought over $1 trillion of these between 2005 and 2007. I will only show you one picture today, and this is it--Fannie Mae's own report on how its loan portfolio is doing. Note the rates of delinquency for the 2005-2007 vintages.

What all this means, I'm afraid, is that we are in for a long period of 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 to mitigate the effects of the mortgage crisis, but that will involve the government in spending trillions of dollars to shore up banks and modify mortgages. This money is already being printed, and if we are successful in halting the housing decline and stabilizing the economy the next problem will be serious--really serious--inflation, as all the money the Fed has pumped into the economy begins to move through transactions.

What does all this mean for the property and casualty insurance industry? You are going to be infinitely better than I in forecasting the effects on your business of a prolonged economic downturn and the potential of huge inflationary government expenditures. But I follow politics and government regulation pretty closely at the American Enterprise Institute, and in this talk I'd like to tell you what I think all this means for government policies--and specifically government regulation--after the election results in 2006 and 2008.

Last week, a subcommittee of the Group of 30--a privately-supported organization of financial experts--issued a report on the regulatory changes that they thought were made necessary by the current financial crisis. Because the subcommittee was headed by Paul Volcker, a Washington Post report commented that the group's recommendations were a strong hint about where the Obama administration might be going with its own recommendations on regulatory reform. This past Sunday, the New York Times chimed in with a report that the Obama administration is planning to move 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's views on regulation, that the G30 report recommended government regulation of many of the currently unregulated players in the financial markets--what NAMIC in its excellent recent report called the "shadow banking system." The groups to be regulated for safety and soundness included the usual suspects in the shadow banking system--hedge funds, private equity funds, and broker-dealers. But there was one other industry that was not mentioned as part of the shadow banking system by NAMIC which was included in the G30 report as requiring safety and soundness regulation at the federal level: what the G30 called "large internationally active insurance companies."

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

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

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

So, what is systemic risk? As is well known, when Lehman Brothers failed in September 2008, the entire international financial system froze up. Banks stopped lending to one another, solid companies couldn't sell their commercial paper, and there was the distinct possibility of runs on money market mutual funds. Actions by the Treasury and Fed have somewhat eased this problem, but is that what we mean by "systemic risk?" If so, it's an exceedingly broad definition. None of the banks or other financial institutions that stopped lending did so because they had suffered losses from Lehman's failure. In other words, there was no contagion from Lehman.

What happened was that many of these institutions realized that their 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 by depositors and counterparties, they decided, they'd better hoard their cash. That is still going on, and is the underlying reason for the lack of credit that now afflicts our economy and the economies of other countries. If we accept what happened after the Lehman failure as an example of systemic risk, then "systemically significant" companies include any company that might cause investors, depositors and counterparties to be fearful that banks or other financial institutions are in danger of instability or failure. That isn't the same thing as saying that the failure of a particular institution--say, Citibank or even Lehman Brothers--would cause such large losses to others that these losses cascade through the economy and have a systemic effect. In other words, when we are talking about systemic risk, are we talking about a psychological phenomenon--inducing fear in investors and others--or are we talking about a legal or real phenomenon in which many parties suffer losses because they don't receive payments they were expecting?

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

And what happens if a company is declared too big or too interconnected to fail? Creditors will see it as a better and safer borrower than its competitors. Its borrowing costs will be lower than those of its competitors and its representations to potential customers about its financial reliability will be harder to beat. It will grow faster and larger, and--unless you actually believe that regulation prevents risk-taking--it will be able to take more risks and perhaps be more profitable despite its additional regulatory costs. It gets worse. The natural tendency of competitors in a market distorted in this way by government intervention will be to get the designation "systemically significant" for themselves. This will provoke unnecessary and uneconomical consolidation in the insurance industry so that the resulting companies can meet whatever test for size and other criteria the designating agency seems to be applying in determining whether a company is "systemically significant." That's why I say that the competitors of companies that are declared to be systemically significant will be at least as much affected by the systemically significant designation as the systemically significant companies themselves. If we go forward with this idea, in other words, we will be creating an unlimited number of Fannie Maes and Freddie Macs--companies that are seen in the market as ultimately backed by the federal government.

What are the prospects that the idea of regulating systemically significant companies will take hold? I assess this likelihood as quite high, given the general attitude of the Democratic Party toward regulation, the prestige of Paul Volcker in Congress, his position as an adviser to President Obama, and the fact that many important business associations in Washington--without thinking of the consequences--have endorsed the idea. It sounds reasonable that only a few companies in each industry will be regulated for safety and soundness, and that those will be only the largest companies in their industries. Moreover, the pressure to "do something"--to make sure that this doesn't happen again--will build among the American people as the financial problems I outlined at the beginning of this talk continue through 2009. The proponents of regulation are arguing--as they did during the recent campaign--that the cause of the financial crisis is the lack of regulation, and I'm afraid that argument will resonate with the public.

What does this mean for insurance regulation in the future? In its paper on the regulation of "shadow banking," NAMIC successfully differentiates property and casualty insurance from of financial activities. The paper is a powerful argument for why property and casualty insurance should not be considered part of the shadow banking system. However, if we go back to the question of systemic risk, how likely is it that the largest property and casualty insurance companies will not be considered "systemically significant?" I think the chances of that are quite small. And if it's not the insurance companies themselves, then it will be their holding companies. How likely is it that when some of the largest financial companies in the United States are insurance companies that they will be given a pass on the ground that the liabilities of P&C companies are different in quality than the liabilities of banks?

Let me, as devil's advocate for a moment to lay out the argument against this idea. Like all financial companies, P&C companies have assets and liabilities that are subject to rapid change. Liabilities are subject to huge risks arising from natural calamities such as floods, earthquakes, hurricanes, and fire. Is there anyone here who would be able to assure a federal regulator that--in an era of belief in climate change--there is no significant chance that insurance company liabilities will be larger than anyone anticipates? On the other hand, let's look at insurance company assets. Will they not fluctuate in value? For P&C companies, I would expect, assets would tend to be long term, which might mean that they cannot be liquidated quickly to meet unexpected needs. The value of long term assets can fluctuate significantly, as we are seeing today, even if the accounting for them is more stable than the mark-to-market accounting that prevails in the banking industry.

What would happen if a large P&C company could not meet its obligations after an earthquake in California? The guarantee fund obligations of the other insurance companies doing business in California would then be called upon, but it is certainly not beyond the realm of possibility that these companies, too, will be having difficulty meeting their obligations. What if all or most of the private insurance resources in California were unable to meet their primary and secondary obligations, and as a result many companies had to default? Would the fact that millions of people and companies would not be able to repair their homes or businesses be a systemic event? Would anyone like to argue to the systemic regulator that something like this could never happen, or if it did that it would not be a systemic event? The Washington Post reported this past Saturday that some life insurance companies were trying to become S&L holding companies so that they could apply for TARP funds. This is not because more people are dying than expected, but because their assets are declining in value.

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

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

What, then, is the right course for NAMIC? I wouldn't presume to advise you when you have some of the most capable Washington hands running NAMIC already, but if the prospects for separating yourselves from the rest of the financial industry are not bright, perhaps you should be thinking about joining forces with others who will be opposing regulation in general. As Benjamin Franklin said at the time the 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.