Irrational Economist_ Making Decisions in a Dangerous World - Erwann Michel-Kerjan [86]
• Crowding Out. Since the government reinsures the top tier of risk at no charge, it clearly crowds out any private reinsurance market for these risks. However, it is unclear whether any reinsurance firms would offer such coverage even in the absence of the government program. The experience of European countries is telling: Reinsurers have reentered this market but their participation is always extremely limited and embodied in public-private programs (e.g., Gareat in France, Extremus in Germany). Moreover, under TRIA, private insurers bear the major risks below that threshold, and it could be said that the government is “crowding in” the private markets, since private terrorism insurance might not exist in the absence of TRIA.
RE-REGULATING LOAN MARKETS IN THE AFTERMATH OF THE SUBPRIME CRISIS
I now apply the lessons learned from the long U.S. experience with catastrophes and governmental catastrophe insurance to the issue of regulatory reform in the aftermath of the subprime mortgage crisis. It is important to recognize in this context that making or investing in risky loans with possibly highly correlated losses is tantamount to providing catastrophe insurance. Indeed, the subprime mortgage crisis has created a set of conditions that strongly echoes this country’s experience following the occurrence of major natural disasters and the 9/11 terrorist attacks:7
• Private insurance/loan markets have systematically failed.
• Private markets and institutions are calling for government help, basing their claims largely on negative externalities that otherwise would affect the real economy.
• Government appears to be the only currently available and dependable remedy.
The experience with the government’s catastrophe insurance programs suggests that governmental loan guarantees/insurance may provide an efficient mechanism to revive the failing loan markets. Loan guarantees would allow private market participants to continue originating risky loans and transferring them to final investors, given that the upper tail of catastrophic losses is covered by government insurance.8 Loan guarantee programs may also be, and should be, designed to maintain private-sector expertise in evaluating the default risks and setting the proper risk-based interest rates. In this fashion, the worst negative externalities of the subprime crisis on loan markets and associated goods markets may be eliminated, while using the available private-sector expertise for loan analysis and underwriting. In addition, if the government program is designed to protect only against the largest systemic failures, it could then be maintained on a continuing basis as a low-cost automatic stabilizer against future financial catastrophes.
The details of applying governmental loan guarantees and insurance to revive loan markets can best be illustrated by reference to an application to municipal bonds and municipal bond insurance, which I discuss in the next section. (In the Summary and Conclusions, I suggest additional applications.)
GOVERNMENT REINSURANCE FOR MUNICIPAL BOND INSURANCE
For more than twenty years, there has been an active U.S. market to provide insurance against municipal bond default risk. This insurance expedites the purchase of state and local government bonds by delegating the analysis of the underlying default risk to the insurers. Municipal bond insurers are chartered under state laws requiring that they be “monoline,” meaning that their capital is available only to pay claims against municipal bond losses. The goal is to make the municipal bond insurer bankruptcy remote from losses that might occur on other insurance lines covered by the same holding company (i.e., with no possible contagion). In addition, the chartering laws