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CURRENT EVENTS
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Whitcomb Perspective
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Last Updated: 4/18/2010
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Reverse Retros
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You will soon be reading about how a formerly prestigious and internationally famous
investment bank colluded with investors to package sub prime loans and sell them
off to banks and small towns in Norway. At the same time they may have taken out
an insurance policy to pay if the packages failed. This device enjoyed a period
of popularity in the insurance business in the mid 1970’s and at the time we called
it a “reverse retro” or Chinese retro”.
A conventional retrospective (retro) rating plan rewards an insured by reducing
the premium back if the insured’s loss experience is favorable. For instance, I
insured a major commercial airline. The standard, going- in premium was $12,000,000
and the maximum premium, if the airline suffered losses could become as much as
$18,000,000. We were asked to insure against that retro penalty by covering the
difference between the minimum and the maximum.
That spread was of course $6,000,000 and we put up that limit for a rate of 10%
on line, or $600,000. The airline’s board of directors, wishing to “fix” their insurance
costs for that year paid the extra $600,000 to guarantee that their total insurance
expense would not exceed $12,000,000 plus the “penalty policy”, or $12,600,000 rather
than take the chance of having losses that caused the retrospective rating to increase
the premium to as much as $18,000,000.
Then an instrument that came to be known as a “Chinese retro” was introduced that
paid off in the event the loss experience did deteriorate. I was also offered these
but declined as I felt they were against public policy inasmuch as they rewarded
bad loss experience. Chinese or reverse retros were reviewed by the State of California
Department of Insurance and in 1977 ruled unlawful for the same reason I declined
to participate in them. You will find that, as the ongoing financial scandal unravels,
that was the practice they participated in and that is what they did. In my opinion,
the credit default swaps written were an insurance instrument. The brokers and bankers
utilized an insurer to guarantee the cds’s and did so strictly because of the insurer’s
triple A bond rating. The insurer is a New York domiciled insurance company, subject
to “triennial” review by the state of New York Department of Insurance.
The state of New York has a guarantee insolvency fund. The insolvency of that insurer
would have fallen on the New York insolvency fund. The State of New York Insurance
Commissioner took the position that the financial instruments written by that insurer
and caused it’s collapse were not insurance and therefore were beyond the purview
of the New York Insurance Departments triennial review and not subject to the State
of New York Guarantee insolvency fund.
The insolvency “fund” is created upon the collapse of an admitted insurer, that
is, one domiciled in the state and the fund is paid for by assessing other companies
admitted to do business in that state by charging a percentage of the premiums paid
by policy holders in that state as an “assessment”. Had the New York commissioners
position that those policies written by that insurer for those banks and brokers
weren’t actually “insurance” been set aside the federal government would have had
no call to step in and using taxpayers money bail out the insurer. It would have
been a matter for the state of New York and its residents to confront.
A technique similar to credit default swaps was utilized to provide a stop loss
protection to a well known New York Bank for its book of lease business. I arranged
a cover of up $100,000,000 excess lease default cover for the bank’s book of leases
to protect in case the book of leases default rate exceeded a certain percentage.
It occurred to me midway through the policy term that I had significantly reduced
if not eliminated the banks lease officers need to carefully underwrite the leases
they made. Why should they? If they messed up they had my cover to fall back on.
Fortunately we had no loss and I did not renew.
Reflecting on the credit market in general, if the wholesale cost of money is 4%
and the interest rate charged on loans is 7% the gross spread is only 3%. Overhead
must be factored in. In the insurance business, overhead exclusive of profit is
6% plus acquisitions costs (commissions, advertising etc). I don’t know what a bank
or lending institution’s overhead is, but if our rate on the stop loss insurance
for instance is 1.5% to 2% on limit, and it was, the net to the lending/leasing
institution is very thin. Thus once started down this path the lenders were driven
to larger and larger transactions.
As respects credit default swaps and loans packaged and sold as investments to others,
the red flags at the other end were homebuyers encouraged to overextend themselves
by buying homes they could in no way afford. For federal regulators and economic
advisors and all the others to miss that obvious fact is inconceivable and really
demonstrates their complete disconnect with Americans .
Of course everyone in the chain was responsible:
- Borrowers for gambling on increasing home prices and increasing earnings
- Loan and lease officers for deliberately setting aside sound loan underwriting practices,
guidelines that history had proven valid
- Lending institution management for encouraging what they knew were those unsound
practices
- Regulators for turning a blind eye to an obvious inevitable train wreck and allowing
the institutions to transfer capital and surplus to outstanding loans ratios requirements
to insurers and others outside the credit community.
For the government to have reacted to the outcome by giving taxpayer money to bail
out the very villains that perpetrated this fiasco is as big a mistake as any made
by any other participant in this charade. That goes to everyone, from the foolish
and too easily dupable homebuyer to the lenders to the regulators. The oddity in
all this is that there are plenty of banks and lending institutions that didn’t
go along with this tidal wave of bad practices but they are being painted with the
same brush as their competitors who did throw prudence to the wind.
The end result is that the rest of us no longer have any confidence in the system
and rules we thought we all lived within.
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