Shots Across the Bow

A Reality Based Blog

 

Scuttling the Bailout

For those of you who believe this is a market fluctuation and that it will correct itself, I want you to know that I agree with you. You are exactly right; the market will correct itself if we just give it time.

Of course, last time it took 10 years of deep economic depression and a global war, but it did correct itself.

A few days ago, I mentioned that I don't know a lot about finance at this level. But instead of proclaiming my ignorance, as if it were something to be proud of, I've been studying. I still don't know enough to make policy, but I've learned enough at least to understand where we are, and why we must take action.

In a nutshell, our entire economy is built on smoke and mirrors. Our currency, our houses, our real estate, our investments, everything that we have is valued solely by our combined opinions of its value. If we believe a house is worth $150,000, we pay that much for it, and presto, the house is worth $150,000. If we decide that the same house is worth $90,000, and nobody else thinks it's worth more, then presto, that house is worth $90,000. $60,000 has just vanished from the economy in an instant. And if you own the house next door, your personal wealth just took a significant hit as well.

Banks make loans based on an asset to liability ratio. If you lose 40% of your assets, as in the example of our house, the bank is going to be significantly less willing to loan you money because even though your liabilities haven't changed, your assets have, even though you haven't done anything or lost anything real.

Banks loan each other money on the same principle. If a bank holds a significant number of mortgages that are downgraded, whether they are defaulting or not, that bank's ability to attract capital investment is crippled. It can't make anymore loans, and without interest on loans, banks will have a hard time paying interest on deposit accounts.

It gets worse.

Insurance companies take you premiums and invest them in securities. By making that money grow, they can offer lower premiums and attract more business. Regulations require that these companies maintain a certain ration of their assets in cash, and the rest can be invested, and they have to maintain an asset value that is equal to a certain percentage of their insurance liability to their customers. If their investments fail, they fall below those required ratios and must acquire more capital. Except right now, there is no capital to be acquired because their ratios are screwed.

Are you beginning to get the picture now? The biggest investment in most people's lives are their homes, and those homes are rapidly becoming liabilities rather than assets, and the ripples from that one simple fact will be enough to shake the whole house of cards to the ground.

Depression? This thing could turn out to be the single greatest economic collapse in the history of the world.

I'll let y'all in on a little secret. At this point, it doesn't matter what they do in Washington. They just have to do something big enough to convince us that our homes are worth what we used to think they were. If they can pull that off, and it doesn't matter how, we can pull out of this mess with minimal damage.

If not, a 780 point drop on Wall Street is going to look like a good day.
Posted by Rich
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Hey Rich..glad to see that you've taken an interest. Just thought I'd clarify some of what you've written (I hope I don't come off as a smart-ass):

<i>Insurance companies take you premiums and invest them in securities. By making that money grow, they can offer lower premiums and attract more business</i>

Depending on the line of business, many insurers actually collect less in premiums than they pay out in claims. The reason they can do this and make a profit is essentially the time value of money. You pay premiums at the start of the year and over the year, payouts get made. While they are holding this money they are essentially earning investment income on it and that income is enough to cover their expenses, pay that little bit more in claims and make a profit. This money is referred to as "float".

Now if an insurance company were only to exist for one year and have a bunch of clients at the start of the year, this is how it would work...they would take your premiums at the beginning of the year, invest them in short term securities and then over the course of the year cash out those investments and pay their expenses as well as claims (hopefully with something left over at the end of the year as a profit). In this case, the float starts out high at the beginning of the year and gradually decreases.

However, insurance companies are ongoing enterprises. They are taking on new business every day, people renew their policies, premiums go up, etc. What this means is that there is a constant level of float and assuming that premium income is increasing, more and more of it. Insurers will then take this money and invest it long term.

This ability to invest long term means higher returns and that's passed onto the consumer in the form of lower premiums (as noted low enough such that the premiums don't even cover claim costs). Of course, its also happened that insurers facing a bad year in the market are forced to raise rates.

The potential downside is if an insurer starts to shrink is that the float that is invested long term would suddenly need to be liquidated.

Warren Buffet's company, Berkshire Hathaway, is basically an insurance company and his investments are from his float. He does have large stock and bond holdings which are easily liquidated.
Posted by Manish  on  09/30  at  11:02 PM

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