Federal Financial Guarantees: Problems and Solutions

Besides insuring bank deposits, the federal government guarantees a number of other financial transactions, including farm credits, home mortgages, student loans, small business loans, pensions, and export credits (to name a few).

In order to better understand the problems faced by federal financial guarantee programs, consider the conditions which give rise to a well-functioning private insurance market. In private markets, insurers segregate policyholders with similar exposures to risk into separate risk classifications, or pools. As long as the risks of the policyholders are not significantly correlated (that is, all policyholders do not suffer a loss at the same time), pooling reduces the risk of the average loss through the operation of a statistical principle known as the “law of large numbers”. Consequently, an insurer can cover its costs by charging a premium that is roughly proportional to the average loss. Such a premium is said to be actuarially fair.

By limiting membership in a risk pool to policyholders with similar risk exposures, the tendency of higher-risk individuals to seek membership in the pool (commonly referred to as adverse selection) is controlled. This makes participation in a risk pool financially attractive to its members. Although an individual with a high chance of loss must consequently pay a higher premium than someone with a low chance of loss, both will insure if they are averse to risk and premiums are actuarially fair. By charging risk-sensitive premiums and limiting coverage through policy provisions such as deductibles, the tendency of individuals to seek greater exposure to risk once they have become insured (commonly referred to as moral hazard) is also controlled.

In contrast, federal financial guarantees often exaggerate the problems of adverse selection and moral hazard. Premiums are typically based on the average loss of a risk pool whose members’ risk exposures may vary greatly. This makes participation financially unattractive for low-risk members, who end up subsidizing high-risk members if they remain in the pool. In order to prevent low-risk members from leaving, the government’s typical response has been to make participation mandatory. However, various avenues exist by which low-risk members can leave “mandatory” risk pools. For example, prior to the reorganization of the Federal Savings and Loan Insurance Corporation (FSLIC) as part of the Federal Deposit Insurance Corporation (FDIC) during the savings and loan crisis of the 1980s and 1990s, a number of low-risk thrifts became commercial banks. This change in corporate structure enabled these firms to switch insurance coverage to the FDIC, which at the time charged substantially lower premiums than FSLIC. Similarly, terminations of overfunded defined benefit pension plans enable firms to redeploy excess pension assets as well as drop out of the pension insurance pool operated by the Pension Benefit Guarantee Corporation (PBGC).

Although financial restructuring makes it possible to leave mandatory insurance pools, the costs of leaving may be sufficiently high for some low-risk firms who don’t leave (at least not right away). Unfortunately, the only way risk-insensitive insurance can become a “good deal” for remaining members is by increasing exposure to risk; for example, by increasing the riskiness of investments or financial leverage. Furthermore, this problem is even more severe for high-risk members of the pool, especially if they are financially distressed. The owners of these firms are entitled to all the benefits of risky activities, while the insurance mechanism (in conjunction with limited liability if the firm is incorporated) minimizes the extent to which they must bear costs. Consequently, it is tempting to “go for broke” by making very risky investments that have substantial downside risk as well as the potential for upside gain. The costs of this largely insurance-induced moral hazard problem can be staggering, both for the firm and the economy as a whole.

Ultimately, the key to restoring the financial viability of deposit insurance and other similarly troubled federal financial guarantee programs is to institute reforms that engender lower adverse selection and moral hazard costs. Policymakers would do well to consider how private insurers, who cannot rely upon taxpayer-financed bailouts, resolve these problems. The most common private market solution typically involves some combination of risk-sensitive premiums and economically meaningful limits on coverage. Federal financial guarantee programs should be similarly designed so that excessively risky behavior is penalized rather than rewarded.

On the ancient origin of the word “algorithm”

Fascinating quote from page XXXIII of Peter Bernstein’s 1996 book “Against the Gods: The Remarkable Story of Risk” (cf. https://www.amazon.com/Against-Gods-Remarkable-Story-Risk/dp/0471295639/):

“The earliest known work in Arabic arithmetic was written by al­Khowarizmi, a mathematician who lived around 825, some four hun­dred years before Fibonacci. Although few beneficiaries of his work are likely to have heard of him, most of us know of him indirectly. Try saying “al­Khowarizmi” fast. That’s where we get the word “algo­rithm,” which means rules for computing.”

Note: The book cover shown above is a copy of a 1633 oil-on-canvas painting by the Dutch Golden Age painter Rembrandt van Rijn.

Today’s required reading: The Day Coronavirus Nearly Broke the Financial Markets

The Day Coronavirus Nearly Broke the Financial Markets
“The March 16 stock crash was part of a broader liquidity crisis that pummeled even seemingly safe bonds, threatening the viability of companies and municipalities across America. Only action from the Federal Reserve brought things back from the brink.”

A Movement Rises to Take Back Higher Education

I am very proud to be a member of Heterodox Academy. Heterodox Academy is a politically diverse group of more than 2,000 professors and graduate students who have come together to improve the quality of research and education in universities by increasing viewpoint diversity, mutual understanding, and constructive disagreement. HxA’s website is located at https://heterodoxacademy.org.

For a PDF version of the (gated) WSJ article linked below, see http://bit.ly/takeback_academia.

Heterodox Academy, now more than 2,000 strong, stands against censorship and for free inquiry.

The Finance Industry’s Incredible Ability to Keep the Money Rolling In

Quoting from this article, “From the era of railroads and the telegraph to that the internet and smartphones, the price charged by the finance industry to turn a dollar of savings into a dollar of investment has mostly remained between 1.5 cents and 2 cents for every dollar that passes through the finance industry.” See https://goo.gl/4fo7KD for PDF version of this gated article.

The Finance Industry’s Incredible Ability to Keep the Money Rolling In

The Stupidest Thing You Can Do With Your Money

I highly recommend this Freakonomics podcast (and transcript) about passive versus actively managed investment strategies. It provides historical context for the development of some of the most important ideas in finance (e.g., the efficient market hypothesis) and the implications of these ideas for investing in the long run. Along the way, you get to “virtually” meet with many of the best, brightest and most influential academic and professional finance thinkers who played important roles in shaping this history.

Prior to listening to this podcast, I was not aware of how a quip in a 1974 Journal of Portfolio Management article authored by the MIT economist Paul Samuelson inspired Vanguard founder Jack Bogle to launch the world’s first index fund in late 1975. Samuelson suggested that, “at the least, some large foundation should set up an in-house portfolio that tracks the S&P 500 Index — if only for the purpose of setting up a naive model against which their in-house gunslingers can measure their prowess.” (source: “Challenge to Judgment”, available from http://www.iijournals.com/doi/abs/10.3905/jpm.1974.408496).

It’s hard enough to save for a house, tuition, or retirement. So why are we willing to pay big fees for subpar investment returns? Enter the low-cost index fund.

Talk Is Cheap: Automation Takes Aim at Financial Advisers—and Their Fees

From page 1 of today’s Wall Street Journal – how automation is increasingly (and in many cases, adversely) affecting the livelihoods of financial advisors.

Talk Is Cheap: Automation Takes Aim at Financial Advisers—and Their Fees
Services that use algorithms to generate investment advice, deliver it online and charge low fees are pressuring the traditional advisory business. The shift has big implications for financial firms that count on advice as a source of stable profits, as well as for rivals trying to build new businesses at lower prices. It also could mean millions in annual savings for consumers and could expand the overall market for advice.

Derek Zoolander, spherical cows, the Guardian, and econophysics

Wonderful explanation of the logical fallacy associated with dismissing theories based upon modeling assumptions that are not literally true… HT to Scott Cunningham.

Derek Zoolander, spherical cows, the Guardian, and econophysics

In Zoolander, the titular character is presented with a model of a building.  He inspects the model and responds with anger and indignation:

Derek Zoolander: What is this? [smashes the model for the reading center] A center for ants?

Mugatu: What?

Derek Zoolander: How can we be expected to teach children to learn how to read… if they can’t even fit inside the building?

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