On Nov. 12, the huge German financial services company Allianz Group announced that it had successfully closed an offering of "catastrophe bonds" linked to windstorm risks in seven European countries. So-called cat bonds offer insurance companies a way to offload their own risk of having to pay out huge sums in the case of a disaster onto the wider shoulders of global financial markets. As the Private Sector Development Blog noted, "by transferring the risks from insurance companies to willing market investors, these bonds provide an additional instrument for risk management."
Michael "Liar's Poker" Lewis wrote the definitive article on cat bonds in the Aug. 26 issue of the New York Times Sunday Magazine. As he laid out the problem with his usual clarity, even the very biggest of the reinsurance companies whose business is insuring other insurance companies against losses couldn't afford to cover the costs of a major disaster hitting a major American city -- like a hurricane hitting Miami dead-on, or an earthquake leveling San Francisco. But what would crush the mightiest insurance company would be a trifling matter to the financial markets.
But by their very nature, the big catastrophic risks of the early 21st century couldn't be diversified away. Wealth had become far too concentrated in a handful of extraordinarily treacherous places. The only way to handle them was to spread them widely, and the only way to do that was to get them out of the insurance industry and onto Wall Street. Today, the global stock markets are estimated at $59 trillion. A 1 percent drop in the markets -- not an unusual event -- causes $590 billion in losses. The losses caused by even the biggest natural disaster would be a drop in the bucket to the broader capital markets ... That's where catastrophe bonds came in: they were the ideal mechanism for dissipating the potential losses to State Farm, Allstate and the other insurers by extending them to the broader markets.
But this principle requires taking as a given the notion that Wall Street can accurately judge the risks posed by catastrophes and place an appropriate price on them. This is a theme that runs through the entirety of Lewis' piece; he even closes by holding out the hope that "the financial consequences of catastrophe will be turned into something they have never been: boringly normal."
The great irony is that Lewis' article appeared just after the credit markets where "risk management" products are a multi-trillion-dollar business had frozen completely, causing what now appear to be hundreds of billions of dollars of losses, because Wall Street utterly failed to properly evaluate the risk inherent in subprime mortgages. The mood in financial markets is quite different now from what it was when Lewis was researching and writing his piece. For decades, we've been hearing that financial innovation has been contributing to greater stability by dispersing risk more widely. But as the Financial Times' inimitable Gillian Tett wrote earlier this week, in a very gloomy piece evaluating what could still go wrong, "Draining away: four problems that could beset debt markets for years," the conventional wisdom has shifted:
But aside from its size, there is a second feature of the credit crisis now spooking investors: uncertainty about how the credit pain will affect the financial system as a whole. In previous crises, credit losses were usually relatively well contained: in the S&L debacle, for example, bad loans were held by a limited group of U.S. banks, which were well known to regulators.
But the feverish financial innovation seen this decade has enabled banks to turn corporate and consumer loans into securities that have then been sold all over the world. Until recently it was presumed that this innovation had made banks stronger than before, because they had passed credit risk on to others. Consequently, regulators and investors tended to presume that the main threats to stability in the modern financial world came not from banks but risk-loving players such as hedge funds. Recent events have, however, turned these assumptions on their head. Although some hedge funds have run into problems, their losses have generally not posed any wider systemic threat. Instead, share prices of the banking groups have slid as it became clear that banks had offloaded less risk from their books as investors and regulators had presumed. Indeed, the interbank market is gripped by fears that more banks could soon tumble into crisis, as they run out of capital with which to write off loans.
With this in mind, there is something very disquieting about learning that the market for cat bonds is growing healthily. There's an obvious reason: Cat bonds offer higher yields than conventional bonds, a reflection of the fact that if the catastrophe occurs, the principal is gone. But as we saw in the subprime mortgage debacle, Wall Street's appetite for high-yielding financial instruments created a huge incentive for mortgage lenders to offer loans to anyone with a pulse, so that lenders and banks would have the raw material to construct their bewildering portfolio of securities with.
Could something similar happen in the cat bond market? Could the appetite for high-yielding risk encourage insurance companies to offer unwarranted policies to other insurance companies and individual consumers simply to satisfy Wall Street's hunger? If the insurance companies lay off the liability for making good on their claims to Wall Street, and Wall Street demonstrates the same incompetence at pricing the risk of a hurricane wiping out a city that it did with respect to subprime borrowers defaulting on their mortgages, then a very disconcerting scenario can be imagined. In a globalized, risk-diversified world, an earthquake in Tokyo could take out New York.