As usual, my friend Caroline Baum wrote another good piece on the credit crisis called Anatomy of Crisis Starts With Skewed Incentives.  I want to take her idea, and run with it a little, because the insurance industry has faced similar problems.

In the P&C insurance industry, there has often been the problem of “giving away the pen.”  For those not familiar, that means letting someone else make the underwriting decision, while you accept the policy onto your books.  Why might a company do that?  Simple — they see opportunity in some neglected market where an experienced Managing General Agent says he has a program that is very effective.  Unfortunately in the old days, the MGA would get compensated on sales, and modestly on underwriting results.  As Caroline put it: skewed incentives.

Anytime you offer significant money for sales without some significant underwriting check, you are asking for trouble.  The agents will write all that they can.  One of my greatest successes in business was designing a compensation formula for pension representatives that aligned their incentives with the company’s profitability.  Worked well for four years, and that was a lifetime in this business.

On another level, we can consider the issue of credit triggers.  Credit triggers are designed to deal with small issues, not large ones.  Anytime credit triggers can be so big as to bring a company down, the company should refuse to enter into such a course of business.  But where have we seen this before?

• Life Insurers with fixed rate GICs (early 90s)
• Life Insurers with floating rate GICs (late 90s)
• Utilities in the early 2000s (think Enron-like structures)
• P/C reinsurers in the early-to-mid 2000s

With respect to the last of those, the representative from S&P and I lectured the World Insurance Forum in Bermuda in 2004 that it would not work.  Sadly, a few companies had to fail because no one changed.

Both AIG and Lehman went down because of capital calls from derivative agreements.  Anytime one puts a clause onto an agreement where more capital has to be posted on a downgrade, it sets up a cliff, and wise companies don’t set up the cliff.  Normal companies stay away from the cliff.  Dumb companies get pushed over the cliff, and complain about shorts before the failure, and creditors after the failure.

Our current credit crisis boils down to two factors: excessive leverage, and lousy underwriting standards.  Those resulted from a system that rewarded mortgage origination without much adjustment for credit quality.  Now we suffer for it, while bad debts get liquidated, or inflated away.

Here’s my updated graph of the composition of the Fed’s balance sheet, with modifications as suggested by some of my readers:

As you can see, the percentage of the Fed’s balance sheet containing Treasuries, whether held for itself, or together with the government is declining.  Let’s look at it another way that contains some editorializing by me:

By lower quality assets, I simply mean assets less creditworthy than the US Government or its agencies.  That’s an estimate on my part.  Why does balance sheet quality at the Fed matter?  If the Fed wants to extend credit, it can more easily do so by having higher quality assets, like Treasuries.  Now, the Fed can lose money, and it means that seniorage profits that go to the US Treasury get reduced, or go negative, which implies increased borrowing or taxation.

I can’t remember which Greek philosopher said something like, “Democracy is doomed when people learn that they can vote to get money for themselves from the public treasury.”  I know Tyler and de Tocqueville said something like that as well.  At a time like this there are a lot of demands on the public treasury, and they are growing:

• U.S. May Help Private Funds To Purchase Troubled Assets
• Fed Will Lend Directly to Corporations

There is a trouble here.  In the absence of a functioning market, how can the bureaucrats at the Fed figure out the right prices/yields to charge?  This is the same problem as valuing level 3 assets, but without a profit motive to aid in focusing the efforts of the businessman.

Now, the little graph above (from The Economist) describes the real cause of the problems.  As in the Great Depression, there was too much debt financing of assets.  The debt was more liquid than the assets, as well.  Borrow short, lend long.  Oh, and remember, the graph above does not contain the hidden debts of the Federal Government (Medicare, Social Security, and old unfunded DB plans), the states (low funded DB plans and unfunded retiree medical plans), and corporations (poorly funded DB plans).  Nor does it take account of the synthetic leverage from derivatives.

What we are seeing at present is not a reduction of the debt structure of the economy, but a shift from public to private hands.  That can lead to four results, when the debt of the US Treasury is so large that it cannot be serviced:

• Inflation when the Fed monetizes the debt,
• Depression from vastly increased taxes,
• Debt repudiation (whether internal, external, or both), or
• Japan-style malaise for a long time.

Japan-style malaise is sounding pretty good.   No growth for several decades while the government debt bloats, and financial balance sheets slowly normalize.  Trouble is, we don’t internally fund our debts.  At some point, our creditors will tire of throwing good money after bad, and then the next cycle can begin in earnest, when the neomercantilistic nations give up, and accept that their investments in the US are worth a lot less than they had thought, and allow their currencies to come to a fairer level against the US dollar.

Financial intermediation has limits.  Financial and economic systems function better at lower levels of leverage if you want it to be sustainable.  Granted, you can have big boom phases if you pile on the leverage, but they will be followed by big bust phases, where the deleveraging is painful.

All of the government’s/Fed’s choices are bad here.  Dr. Bernanke is on a hopeless task, and his theories, borne out his academic studies of the Great Depression, means that we will get a new sort of Great Depression.  There is no easy solution; it is merely a situation where we choose which poison we want to take while the deleveraging goes on.  My guess is that we see some combination of malaise plus inflation.

As Martina McBride said in her song “Love’s the Only House,” “Yeah, the pain’s gotta go someplace.”  The pain is going somewhere; our policymakers are merely determining where.

PS — I am by nature a moderate optimist.  I invest in equities, and many of my sub-theories of the world, i.e., how well will the life insurance business fare, and how well will global demand fare versus that of the US, are being tested now, and I am finding myself the loser on both counts.  Yeah, the pain’s gotta go someplace