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relative to actuarial, or fair, values. Prices on hurricane insurance jumped to more than six times actuarial value in 1994 and to five times or so in 2006. There is little question that the reinsurance was expensive and that writing cat reinsurance was an attractive proposition after these events. This brings us to the second point—namely, that while the cat risk was badly mispriced, and despite the fact that the cat risk market is fairly transparent and simple, it nevertheless took years after Hurricane Andrew for prices to return to normal (again, see Figure 20.4). Capital did flow into this sector to take advantage of the attractive opportunities available, and it eventually brought rates down. However, a long time was required. Competition among capital providers exists, but it is far from instantaneous. Capital arrives slowly when such opportunities arise and the early arrivers earn excess returns for a while before they are essentially competed away.

Figure 20.5 then makes the point that this cycle is predominantly a supply-shock story: The depleted capital of reinsurance intermediaries requires prices to rise and quantities of reinsurance transacted to fall. This result cannot be

FIGURE 20.4 Prices of U.S. Property Reinsurance Relative to Actuarial Value Following Hurricane Andrew in 1992 (1988-2000)

Source: Ken Froot 2001.

TABLE 20.1 Prices of U.S. Property Reinsurance Relative to Actuarial Value Following the Hurricanes of 2005 (Katrina, Rita, and Wilma)

Source: Nephila Capital, Ltd. © Ken Froot.

FIGURE 20.5 Transaction Prices and Quantities of U.S. Property Reinsurance Relative to Actuarial Value (industry price-quantity pairs, 1975:1-1993:4)

Source: Ken Froot 2001.

driven by a demand shock, because higher demand after an event generally results in both high prices and high quantities of reinsurance provided. In fact, the amount of reinsurance falls considerably in the aftermath of an event, tracing out the negative correlation between price and quantity. This is the pattern suggested by supply—not demand—shocks.

UNDERSTANDING THE 2008-2009 FINANCIAL CRISIS

This correlation between price and quantity is very similar to what we have seen on a broad scale in the 2008-2009 crisis. Much has been made of the fact that credit extension by financial intermediaries has fallen considerably as the crisis has worsened. See, for example, the evidence on overall bank lending during the second half of 2008 and early 2009 highlighted by Ivanisha and Scharfstein (2009). There is also evidence of this behavior in the securities markets.

FIGURE 20.6 Difficulties in Bank Financing Were Coincident with Underpricing in Corporate Bonds Relative to CDS, but Dissipated Faster

Source: Ken Froot 2001.

At the point when Lehman Brothers collapsed, many financial intermediaries faced real difficulties financing themselves: Balance sheets were over-leveraged and there was substantial risk that counterparties would not get paid in time. These circumstances virtually destroyed lending to major banks. Overnight rates spiked to extraordinary levels, high not only in absolute terms but also relative to longer-term borrowing to the same institutions. In other words, the market seemed to sense that either banks would fail then and there or, if they survived, they would go on to operate more normally in the future. Intermediaries had difficulty tapping external markets for capital and so the initial reaction was a decline in the quantity of intermediary capital.

Figure 20.6 makes this point by showing the LIBOR OIS spread (which compares overnight to three-month LIBOR rates)2 and its behavior beginning in 2007 and through the end of first quarter of 2009. While the onset of the problems in mortgage markets in the summer of 2007 shows up in this figure, it is dwarfed by the shock that occurred around the time the Lehman Brothers failed. In September, intermediary capital was clearly constrained: No one was going to put funds into additional intermediation at that time.

But this is only the first part of the story. The