Subprime Lending Crisis May Affect Industry After All

September 24, 2007

If terrorism presents some “uncertain” aspects, the subprime lending crisis does so in spades. Financial markets react negatively to uncertainty more than anything else, as no one knows what may happen. Why has a relatively local event – the increasing number of defaults on home loans in the U.S. – triggered such global concern?

While there’s no simple answer to that question, the subprime crisis has put the spotlight on one major factor – global financial markets are increasingly linked. Money moves around the world instantly. Hedge funds base their trades on markets from New Delhi to New York. The complexity of financial instruments has made it increasingly difficult to ascertain with any certainty what their underlying value is.

In the case of the U.S. mortgages they are now routinely bundled into securitized funds, which are then sold to investors – banks, mutual funds, hedge funds and, yes, insurance companies. The Insurance Information Institute has said that the “insurance industry exposure to subprime mortgage turmoil is limited and manageable” (www.iii.org or See IJ Magazine Sept. 24). Insurers usually only invest in ‘A’ rated or higher instruments, which do not, at least in theory, pose a great deal of risk.

However, one New York banker (who requested anonymity) explained that when those mortgages are packaged into securitizations, it’s very difficult to gauge what their intrinsic value may be. Perfectly solid mortgages are bundled in with very risky ones. Nonetheless “the rating agencies [mainly Standard & Poor’s and Moody’s Investors Services] have rated many of them triple ‘A’,” she said. “Now we’re finding out that a lot of them aren’t all that solid. The rating agencies didn’t anticipate that this would happen.”

No less a figure than AIG’s former head Maurice “Hank” Greenberg, who now heads CV Starr, sounded a similar warning. In his keynote speech to the delegates at the International Union of Marine Insurance (IUMI) Conference in Copenhagen he essentially described the subprime market as a house of cards, built on models for a market that didn’t exist. He also faulted the rating agencies for doing a very “poor job” of analyzing these financial products.

Nor does Greenberg share the I.I.I.’s optimism as to the extent of the insurance industry’s exposure. He thinks it will take the biggest hit, not only from direct losses – when the hedge funds can’t pay their debts – but also from the D&O and E&O claims that inevitably follow any financial melt down.

In today’s financial world borrowing and lending billions of dollars is standard practice. When the lenders become fearful that a lot of that debt can’t be repaid, they stop lending. Commercial paper, the main instruments through which businesses finance their daily operations, becomes suspect. This explains why the Federal Reserve Bank, the European Central Bank, and other national banks stepped in to pump money into the financial markets. If they hadn’t, a freeze on lending could have resulted in a worldwide financial meltdown.

Those actions have at least temporarily averted such a crisis, but, if Greenberg is right, there could be a good deal more trouble in store for the insurance industry.

Topics Market

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