Friday, January 25, 2008

Insurance companies and lenders: while pulling FICO "risk predictor" scores, capable of so much recklessness

A couple of stories in the Business Section D of The Washington Post this morning (Friday Jan. 25, 2008) illustrate the uncertainty that the economy is up against.

Steven Pearlstine has a column “Over an Insurance Barrel.” The link is here. He also has a Post discussion forum from Jan. 23, here. He creates a metaphor for bond insurance companies (previously discussed on this blog) with property and casualty companies. In that industry, you could get “pretty good” or “good enough” coverage from a company with a lower rating. (The same would be true of life insurance.) But then when some huge mega-disaster happens the company goes under with the volume and total of claims. Companies do have some ways to forestall this, by not writing some kinds of unquantifiable risks: war, asteroid hits, and, as we know from Hurricane Katrina, floods. A property company’s credit rating is certainly related to the risk grab bag that it has taken on. Imagine making a Parker Brother’s board game out of this. We’ve had an issue like this with media perils (or media risks) insurance, where some companies are unwilling to insure bloggers or amateurs because the risk, while probably very low, is still impossible to calculate from experience.

In the next column, there is an article by David Cho, “Complex Financial Trades Worry Economy Watchers: Rise of Bets Called Swaps Could Worsen Subprime Damage,” here. Here, the “accounting equation” is used to construct entities represented by securities to be traded, where one party’s debt or even contingent liability becomes an investor’s asset, with considerable buffering. They make good scenarios for final exam problems in business school courses. But such mechanism encouraged normally more conservative institutions to invest in risky ventures which perhaps they did not fully understand or take responsibility for.

All of this presents a certain paradox. We constantly hear about personal FICO scores and credit ratings, and the way they are used by lenders, landlords, employers and insurance companies to make decisions about individual people. One wonders if “online reputation” could be scored and used in a similar way. Yet, the whole subprime crisis indicates lender behavior that went in a “pi” opposite direction (sort of like an arrow in a box and whiskers diagram).

Update: Feb. 10, 2008

For a contrasting view, look at Matthew Goldstein, "Do Bond Insurers Need CPR? Fears of a muni market meltdown may be overblown," p. 20, Business Week, Feb. 18, 2008, link here. The article mentions that the municipal bond insurance business came into being after the 1994 bankruptcy in Orange County, CA, and that muni bankruptcies are rare. Remember, however, the 1975 New York City financial crisis, and the Oct. 30, 1975 New York Daily News headline, "Ford to City: Drop Dead!," here.

On Feb. 12, 2008, Warren Buffett offered to help bail out the bond insurers. The AP story is by Josh Funk, here.

The Bush administration announced a plan to give some homeowners 30-day reprieves on foreclosures, AP Story Feb 12 by Marcy Gordon here.

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