Six Degrees of Separation
Financial Failure's Effect on D & O Insurance and EPI
THE RHA REVIEW
Volume 14, No. 1, Fourth Quarter 2007
By Robert N. Hughes, CPCU, ARM
Item … “Losses from the falling value of subprime mortgage assets may reach $300 billion to $400 billion worldwide, Deutsche Bank AG analysts said.” —Copyright 2007 The Miami Herald
Item … “As the housing market crumbles, homeowners are worried about mortgage payments and sellers are worried about slumping prices—but the companies that insure their loans are worrying about their very survival in the face of billions of dollars in claims.”—Copyright 2007 The Journal Gazette
The villain in this little vignette, of course, is something called “subprime lending.” Willis North America, in its October 2007 issue of Financial Institutions defined subprime lending as follows:
“Subprime lending refers to the practice of lending to home buyers with less than stellar credit histories who cannot obtain financing in the usual (prime) market. Individual subprime borrowers generally have a credit score of 620 or lower. This risk has been notched up recently with subprime lending utilizing more hazardous types of loans, including variable interest rate loans, interest-only payment loans and loans with little to no money down. One estimate is that 14 percent of the US residential mortgage market is subprime.”
Now, let’s complicate the issue by introducing Mortgage Backed Securities, aka collateralized mortgage obligations (CDOs). This is a security that is secured by a share in a pool of mortgages. The investors get interest and a piece of the principal each month. The cash flow is produced by the property owner’s mortgage payments. Financial institutions and investors worldwide now hold about $800 billion in these mortgage-related securities. According to the Willis report, many of these portfolios contain subprime loans. Similar securities backed by receivables other than real estate are known as collateralized debt obligations (CDOs) — same beast in different clothing.
My father was not a financial genius, but often when I asked his opinion about a deal, he would say, “Son, this is a deal that either everyone ought to be doing or no one ought to be doing.” I’m sure, if he were alive today, he would impart those same words of wisdom if I said to him, “Dad, here’s the deal. I’m thinking about buying some securities, called ’mortgage backed securities,’ which are securities backed by a share of a pool of mortgages. The cash flow is created by the borrower’s mortgage payments. And, oh, by the way, these mortgages are for people with bad credit who can’t get a loan in the regular market. Also, some of them are ’no down payment’ loans. So, Dad, what do you think?”
My father’s good judgment notwithstanding, the gleam of high interest rates was irresistible to financial institutions, hedge funds and private investors who gobbled up subprime-mortgage-backed securities like hot waffles with syrup. Michael Brush of MSN Money, in his article entitled “Who’s to blame for the mortgage mess?,” dated 11/15/2007, made his own list of those most responsible for the mess. They were:
- Alan Greenspan … who took Fed funds rates down to 1% for a year and who championed adjustable-rate mortgages.
- Angelo Mozilo … Countrywide Financials CEO, with a name and a face straight out of The Godfather, who made $310 million selling stock options in his company and now claims he could not have foreseen the current problems.
- Christopher Ricciardi … the Merrill Lynch banker who with abandon flogged CDOs, which eventually led to an almost $8.0 billion write-down.
- Ralph Cioffi and Jim Kelsoe ... hedge fund gurus whose subprime-fueled dynamos blew up in their faces, costing investors billions of dollars.
- The ratings agencies, Standard & Poor’s, Moody’s Investors Service and Fitch Ratings, et al. … who turned impartial and professional rating into big business, ignoring the conflict of interest created by getting paid by the people they were rating.
- Mortgage brokers…. who were zoning out on commission income. Here’s just one notable quote from a former mortgage broker: “It was like kids in a candy store. You had to be a complete screw-up not to make money. There were basically no guidelines, no restrictions and no oversight.”
I’m sure, by now, you are wondering where an insurance guy like me is going with all of this. Trust me, we’ll get there. But, first, I want you to listen again to these words … “Less than stellar credit histories .… Cannot obtain financing in the usual market … The risk has been notched up … no guideline, no restrictions and no oversight.” Does that sound like something you would be thirsting to insure? No? Well, guess what? According to The Journal Gazette, in a 11/14/2007 copyrighted article, Mortgage Insurance Companies of America, an industry trade group, reported that “… there was $776 billion in private mortgage insurance in force as of September. …” One of the better known of the private mortgage insurers, MGIC, has a portfolio of $196.6 billion in home mortgage insurance policies.
While the exposure to the mortgage insurance companies is obvious and serious, a more obscure and insidious danger that could affect insurers and, as a result, policyholders lurks in the wings. This crisis is expected by most observers to result in financial failures in banks, hedge funds, investment companies and brokerage firms. The subsequent fallout will likely produce a plethora of litigation. (Wait, what is that scurrying noise I hear in the background? Oh, it’s the rush of lawyers dashing from the no-longer-hot stock option backdating scandal to new lawsuits related to subprime lending.) Willis quotes one such attorney, Dale Ledbetter of Ledbetter & Associates, as stating, “We think this is just the tip of a huge iceberg.”
So what insurance products will be most affected? Well, certainly directors & officers liability markets are steeling themselves, as are the errors and omissions liability underwriters (many of whom are one and the same.) While these markets don’t directly affect the general public, any shrinkage in the market will stimulate rate increases, which will ultimately be passed on to the consumer. Pension plan managers are likely going to be faced with increased premiums and tighter underwriting from their fiduciary liability insurance underwriters.
Closer to home for most businesses and individuals, however, will be the possible effects on the cost and availability of comprehensive general liability and umbrella coverage. As layoffs occur, employment practice liability claims (a coverage generally provided under a CGL) could snowball. As insolvencies occur, potential claimants will likely structure their allegations and complaints to target coverage provided by the bankrupt companies’ CGL and umbrella carriers.
So the situation could easily be likened to the amusing, but frivolous, recently invented exercise known as “six degrees of separation,” which theorizes that any one person is only six contacts away from any other (principally applied to well-known personages). I think, however, that the poet John Donne hit it on the nose when he said over 400 years ago:
No man is an island, entire of itself
every man is a piece of the continent,
a part of the main
if a clod be washed away by the sea,
Europe is the less,
As well as if a promontory were,
As well as if a manor of thy friends or of thine own were,
Any man's death diminishes me, because I am involved in mankind
And therefore never send to know for whom the bell tolls
It tolls for thee.
Let’s hope not.