A previously unpublished essay finally gets to see the light of day!

Keith Murphy writes, “Déjà vu, which is French for “already seen,” is the feeling that you have already witnessed a scene or a situation even though you are seeing it for the first time.” The Financial Crisis of 2008 is having this very effect upon me. The last time that the U.S. suffered through a financial catastrophe related to the real estate sector of the economy was during the so-called savings and loan (S&L) crisis of the 1980s. The Troubled Asset Relief Program (aka “TARP”) which has been proposed by Treasury Secretary Hank Paulson is essentially the 2008 version of the Resolution Trust Corporation (RTC), a governmental entity created by the Financial Institutions Reform Recovery and Enforcement Act (FIRREA) of 1989 for the purpose of liquidating assets of failed thrift institutions.

The S&L crisis stimulated considerable public policy and academic interest in the roles played by federal financial guarantee programs. At the time of the S&L crisis, I was an assistant professor of finance at University of Texas-Austin, and I was motivated to write an essay which explored various moral hazard and adverse selection aspects of mispriced financial guarantees. While I never published this essay before, I have used it on occasion in my teaching. Although this essay is now nearly 20 years old, I think that it nevertheless raises a number of important issues which lie at the heart of the current financial crisis.

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Federal Financial Guarantees: Problems and Solutions

by

James R. Garven

Besides insuring bank and thrift 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). Recently, the financial difficulties of the banking industry have focused considerable attention on the structure and viability of the deposit insurance system. However, the structural problems of deposit insurance are shared by many of these other programs.

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 upon 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), 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 did the 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 that they will remain. Unfortunately, the only way risk-insensitive insurance can possibly 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 of 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 which have substantial downside risk as well as 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.

In light of this analysis, it is interesting to consider the current policy debate over the financial difficulties of the banking industry and the FDIC. Recently, capital requirements as well as deposit insurance premiums have been raised in response to the crisis. Ironically, as Professor George Kaufman of Loyola University has noted, the banking industry is undercapitalized largely because federal deposit insurance has permitted banks to substitute government capital for private capital. Although increased capital requirements will (at least in the short run) mitigate the moral hazard of increased risk exposure, in the long run the cycle of increased risk exposure and higher premium costs is likely to continue so long as the structure of the present system is not reformed.

Ultimately, the key to restoring the financial viability of deposit insurance and other similarly troubled federal financial guarantee programs is to institute reforms which 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.

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