Credit insurance trap

Imagine a simple financial system with just three institutions: A, B and C. Let's say that each has capital of $1bn, gross assets of $10bn and gross liabilities (excluding shareholder's funds) of $9bn. Half of each bank's assets are mortgages and half are interbank loans. Of the liabilities, $5bn are interbank loans and $4bn are depositors' accounts. Finally assume there's a regulatory minimum capital limit: 8% of total assets.

Now imagine that A starts to offer credit insurance on the debts of B. C has lent some money to B, so it decides that it would be smart to insure it; and takes out a $5bn policy from A.

As this is a competitive market, B and C soon start to offer insurance too. A buys a policy from B insuring A's lending to C, and B insures its debt to A with C.

Now say there's a 10% decline in the housing market. A's gross assets are written down to $9.5bn, eliminating half of its capital base and breaching regulatory limits. This counts as a credit event in B's insurance policy and it claims $1bn from C from its $5bn policy.

C has to recognise this loss, creating gross liabilities of $10bn to set against its depleted assets (don't forget it had mortgages too) of $9.5bn. C becomes insolvent.

This certainly triggers a payout on A's policy held with B, and it claims $2bn. B's liabilities are now increased to $11 bn against $10bn of assets (including the $1bn it is due from C, written down to $0.5bn as C is unlikely to pay up in full). B is insolvent too, and even more so.

By the time C gets around to claiming $2.5bn on its insurance from A, making A insolvent too, all three banks are out of time. The public sector - or possibly Warren Buffett - is the only agent that can step in and rescue them. All deposits and debts are guaranteed, all three banks are nationalised and the accountants spend half an hour cancelling out the cross-holding of debts and insurance; leaving the following:

A: capital $0.5bn, assets $4.5bn, liabilities $4bn
B: capital $0.5bn, assets $4.5bn, liabilities $4bn
C: capital $0.5bn, assets $4.5bn, liabilities $4bn

The public sector privatises the banks again, raising $1.3bn to help pay for the 2012 Olympics (the accountants charged $100m for their services and A, privatised first, charged $50m to underwrite each of the other flotations). The banks, protected by government guarantees, start lending to each other again. Once the housing market recovers they're back in the same position as before, but somehow the Treasury has extracted half of the total equity from shareholders along the way.

Windfall taxes? Who needs 'em.


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