If anyone had thought that credit crunch has faded in significance, had been replaced by a deepening – and now acknowledged – global recession, but that basically things were back to some sort of known territory where we’ve been before and know how to get out of it eventually, this morning we were reminded that this was not the case.

Clearly, we are very, very far from being out of the woods, with banks continuing to be on the brink of disaster and still struggling to quantify the extent of their losses.

The new £50bn plan: The new bailout plan, announced in the UK this morning, will allow the Bank of England to buy up to £50bn of risky assets directly from any company (not just financial institutions) that agrees to enter into a voluntary insurance scheme for its expected losses on specified toxic debts. In return, banks have to pay for this insurance – typically with cash, but possibly also their shares. The scheme aims to insure companies against 90% of their losses on specified debts which resulted from the collapse of the sub-prime market and the ensuing global meltdown.

Two bailouts, two stories: This scheme, of course, exists on top of the first bailout in October 2008 where several key financial firms received £37bn as a capital injection to top up their reserves. The second UK bailout, however, has very different features to the first one. Not only the recipients of “aid” are different, but the insurance scheme “twist” is a new one. It is closer, albeit not idential, to the earlier US’s bailout model of buying up bad assets from struggling firms.

Taxpayer assumes the risk: Whilst I am sure much will be written and debated about the merits and demerits of this new bailout, it is a huge subject and I will restrict this post today to stating that the essence of the scheme is that the risk of bad loans is yet again transferred onto the taxpayer and away from companies who made shockingly bad lending decision and caused the meltdown in the first place. Like it or hate it, we have no choice as the government has made up its mind. The BBC website has a reasonable account of the nature of the plan announced today.

What I would like to write more about is the parallel with Lloys of London in 1990ies that this immediately brought to my mind this morning.

Lloyds of London – the background. Does anyone remember this? Lloys of London is an insurance market underwriting all sorts of contracts. In a nutshell, the key distinguishing feature of this organisation (it’s not actually a company – maybe I should call it a meeting place for insurance business, like Wikipedia does) is that it is its members or financial backers, called Names, who provide and pool capital and underwrite insurance business with unlimited liability for any claims. Names – all private individuals in those days – were typically attracted into this arrangement with very little or no knowledge of insurance, having a bit of spare capital, and seeing Lloyds of London as a relatively risk-free and easy way to make a bit of extra money out of insurance premiums.

Disaster strikes: It all blew up spectacularly as the result of catastrophic losses of 1980ies and early 1990ies, primarily relating to asbestos which was then demonstrated to be the cause of serious illnesses and terminal cancers. Claims from people who were exposed to asbestos over many decades quickly turned into an avalanche of massive losses for underwriters of their health, liability, etc insurance policies. With Names’ liability being unlimited, a huge number of them had to liquidate their personal assets to pay up, and thus lost their fortunes, 500 of them (as of 2004) became bankrupt; all faced devastation to their lives. There were 15 suicides.

Crucially, and particularly unfairly, what has led to the ruin of many Names is that they were held accountable (in many cases, without their prior understanding of this fact) for past claims relating to asbestos – not just for those claims which happened after they came to be members of Lloyds of London.

For more background check out this article.

Equitas is formed: What’s notable is that the way in which the industry aimed to solve this disaster. Lloyds of London faced collapse. To prevent it, all pre-1993 insurance liabilities which were threatening to bring it down were ringfenced into a new company called Equitas, and thus reinsured: Equitas was set up with what was then seen to be appropriate capital to back up potential claims, and has effectively taken on Lloyds’  assets being its old insurance contracts. This exercise cost £21bn and had an enormous financial impact to Names which had to settle up again using their personal funds. But Lloyds could go on with its new business after that, having made some changes to its structure and approach. That’s another story – I believe now there are no Names who are private individuals, for starters.

So what of Equitas? The problem is that the full extent of losses resulting to asbestos claims on old policies was very difficult to assess. And if these continue to rise – and they did even 10 years after Equitas was formed – any well-padded reserves might not be enough to pay up. For intance, in 2004, apparently the amount of potential liabilities was £7.2bn, and reserves amounted to £5.4bn, with claims on old policies rising 27%. If Equitas reserves are not enough in the years to come, Names will have to pay up more cash to settle liabilities, with even more devastation to their lives!

I could not find information about the 2008/9 position of Equitas. But the moral of the story is that not being able to clearly quantify the extent of possible losses is very risky ground.

Where does this leave us? Back to the second bailout, then. If the Bank of England places itself in the shoes of a glorified reinsurer and takes on some toxic assets which have a high probability of going bad, it needs to know that it has done the following:

(a) quantitified the extent of its possible write-offs and

(b) has charged an appropriate risk premium for taking on such assets to cover against the losses which might happen.

The issue is, the market for these toxic assets has pretty much collapsed, they are nigh to impossible to price, and it is very difficult to accurately estimate the probability of default on these. I would imagine this makes the job of pricing the “reinsurance premium” a doubly tricky one.

You and I and insurance for UK debts: But whilst the debacle of Lloyds of London has faded into the background by now and was always isolated to one industry – insurance (and of course the lives of the unfortunate victims, aka the Names), the problem now is that every UK citizen is impacted now as the government is taking a huge risk with taking on corporate bad debts on our behalf.

We are, in a way, without any intent whatsoever (unlike the Names), have become unwilling underwriters of corporations’  bad debts, and we will be paying for this dubious priviledge, in one way or another, for a long while to come. Whether we like it or not.

 

Copyright 2009 by CuriouslyInspired

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