Year 2008 - Insurance Industry after current finanical tsunami

22 2008 YEARBOOK 二 〇 〇 八 年 年 刊 Feature SinceAugust, 2007, approximately 40 banks, a major US insurance company, US government sponsored enterprises (Fannie Mae & Freddie Mac), and several investment banks have either failed or required substantial government assistance. Still, the financial crisis has yet to show signs of coming to an end. One may wonder, how did problems that first manifested in a relatively small part of the mortgage market led to a contagion affecting so many types of credit and then quickly spread to threaten the liquidity and possible solvency of many financial institutions including insurance companies worldwide. Background The current crisis started in the housing sector in the USA. The root cause of the problem was that from the early 1990s to 2006, the continuous growth in housing prices (mainly in the USA) meant that even as a borrower’s personal finances was stressed, the increase in his home value often gave him the option to re-finance or sell instead of going into delinquencies. Furthermore, because mortgage rates remained low from most of 2000 to 2005, one was usually able to refinance into another low-rate product. As a result, subprime (higher risk) mortgage origination and securitization increased substantially between 2000 and 2006. Along with this rise in lending came innovative instruments including the use of adjustable rate mortgages and hybrid loans. The same time period also witnessed an increase in supply of credit for housing and the use of non-traditional mortgage products such as interest-only and negative amortization loans. However, as interest rates rose between 2004 to 2006, delinquencies and foreclosures began to surge. By 2007, it became evident that credit deterioration extended well beyond subprime mortgages. Other collateral such as prime mortgages, credit cards, automobile loans and student loans all showed declines in credit quality. Structured finance and other innovative financial products, some of which are discussed below, may have served to magnify the impact of credit deterioration. Securitization of mortgage debts allowed financial institutions easy assess to new capital. The fact that Fannie Mae & Freddie Mac guaranteed many of these mortgage-backed securities also made them more popular. Thus, the subsequent default of the underlying mortgages led to significant write off at Fannie Mae & Freddie Mac. Collateralized Debt Obligations (CDO) are special purpose entities that hold debt as collateral and issue long- term liabilities in the form of tranched securities. CDOs are used to hedge credit risk, reduced regulatory capital requirement and served other purposes. When the underlying collaterals defaults, CDOs became affected. Incorrect assumptions about co-relation risks contributed to the poor performance of many CDOs. Many securitized products are structured based on the assumption of a certain degree of diversification in the performance of the underlying collateral. When different types of collaterals all underperformed at the same time following the decrease in housing prices, the portfolio effect of risks spreading failed, triggering liquidations of CDOs. A Credit Default Swap (CDS) is a contract that provides insurance against the risk of a default by a particular entity. A significant part of AIG’s problem arose from CDSs. These are bilateral agreements used to spread costs of credit events (such as default or bankruptcy) and enable participants to hedge against the credit worthiness of companies or sometimes even countries. While there has not been many actual claims against CDSs as a results of default, these contracts often contain provisions where as the capital base of the issuer of the CDS declines, additional collaterals must be lodged with the holder of the CDS. Thus, many of the billion of dollars supplied to AIG via the government rescue package are now tied up as collateral with holders of CDS. The weakness associated with these financial