• Choose a category
• All
• Classic-Fiction

By Root 922 0

’ long-standing experience with government-backed catastrophe insurance (covering natural disasters and terrorism) to regulatory reform in the aftermath of the subprime mortgage crisis. Specifically, I discuss a proposal to apply the concepts of government catastrophe insurance to help maintain a functioning market for new municipal bond default insurance. The same principle could be applied, if necessary, to other loan markets—such as credit card and auto loans—if these markets were to fail. The motivation in all these cases is to forestall a negative externality through which a failure in a loan market brings down associated markets for real goods, thus enlarging the systemic crisis.

Mortgage loan markets represent an even greater concern, both because they are particularly stressed as a result of the subprime mortgage losses and because they are simply much larger in size (given approximately $11 trillion in outstanding single-family home mortgages). As with the example of municipal bonds, there is the dual problem of how to deal with the existing losses, including mortgage foreclosures, and how to reform the market to carry on new business. Dealing with the existing losses is particularly complex, and again there is no relevant past experience with governmental catastrophe insurance plans to fall back on. Regarding new mortgages, there may well be a role for excess-of-loss government catastrophe insurance, in parallel with the plan offered here for municipal bonds and with the existing Federal Housing Administration mortgage insurance for low-income borrowers. I have also proposed elsewhere a plan to replace Fannie Mae and Freddie Mac with a direct government program by applying the same basic concept of government-backed excess-of-loss catastrophe insurance.12

RECOMMENDED READING

Jaffee, Dwight (2009). “The U.S. Subprime Mortgage Crisis: Issues Raised and Lessons Learned.” In Michael Spence, Patricia Clarke Annex, and Robert M. Buckley, eds., Urbanization and Growth, World Bank (http://www.growthcommission.org/storage/cgdev/documents/ebookurbanization.pdf ).

Jaffee, Dwight, Howard Kunreuther, and Erwann Michel-Kerjan (2008). “Long Term Insurance for Addressing Catastrophe Risk.” NBER Working Paper No. 14210, National Bureau of Economic Research, Cambridge, MA.

Jaffee, Dwight, and Thomas Russell (1997). “Catastrophe Insurance, Capital Markets, and Uninsurable Risks.” Journal of Risk and Insurance 64, no. 2: 205-230.

Kunreuther, Howard, Daniel Kahneman, and Nathan Novemsky (2001). “Making Low Probabilities Useful.” Journal of Risk and Uncertainty 23:103-120.

Kunreuther, Howard, and Erwann Michel-Kerjan (2009). At War with the Weather. Cambridge, MA: MIT Press.

Kunreuther, Howard, and Mark Pauly (2006). “Rules Rather Than Discretion: Lessons from Hurricane Katrina.” Journal of Risk and Uncertainty 33: 101-116.

20

Toward Financial Stability

Lessons from Catastrophe Reinsurance

KENNETH A. FROOT

UNDERSTAND WHY THIS HAPPENED: TWO DIVERGENT VIEWS

As this chapter is being written, the United States and world economies are experiencing probably the most intense contractions witnessed since the Great Depression. There is much debate about the downturn’s underlying drivers and their respective primacy, but the discussion can be categorized under two main views.

One view is the “bubble-has-burst” hypothesis. It holds that excessive consumer demand fueled by lax borrowing standards, principally in the United States, drove asset prices to high levels generally, and real estate in particular, to levels not previously seen. These bubbles then popped. And, before they popped, upward price movements first stalled in mid-2007. The timing was driven by concerns that newly incurred and poorly qualified subprime and alt-A mortgage debt would be unserviceable by borrowers without continued price appreciation or interest rate decline. As borrowers began to feel pinched and housing values began to decline, consumption naturally fell. Households needed to pay their debts, without the benefits of continuing