Flood Insurance: Needed In Galveston But Not On Wall Street

Imagine watching the water rise in your home…first just a trickle through the bottom of the door, then to your ankles, then to your waist…

People in New Orleans and now Galveston have experienced the feeling of literally watching their homes flood before their eyes.

Thankfully, many people in Galveston evacuated before Hurricane Ike hammered the island south of Houston before this weekend’s storm. However, even those who left are now facing the aftermath of a storm that flooded most of Galveston Island.

Some of these homeowners will be able to pick up and start over thanks to the flood insurance policies they purchased. Unfortunately, some homeowners did not buy insurance, and for these unlucky few, when they return home they will have almost nothing left.

A similar phenomena has been occurring in the financial markets.

Many institutions took risks, and rather than buying insurance (in the form of conservative practices), they decided to rough it, perhaps convinced like a few stubborn Galveston homeowners, that because it had not flooded for the last twenty years, that it would not flood this time around.

The horrible irony of the flood analogy is that for many of these institutions, and more offensively their shareholders, they did not have to buy insurance because the federal government stood waiting in the wings to bail them out. At the same time, many home owners will not be as lucky…sure they might get a FEMA check to help with some of their relocation expenses, but they will be wiped out – because they took a risk (living by the water) and did not protect against it (buy flood insurance).

Tonight the Federal Government has agreed to loan AIG $85 B dollars in exchange for a majority stake in the company in order to avoid the dreaded CDS Scenarios alluded to in my previous post (AIG Gets $85 Billion Fed Loan, Cedes Control to Avert Collapse).

In the most twisted of ironies, the Federal Government is acting as an insurer to an insurer who failed to insure itself like any responsible citizen.

Although it is unclear from the current news whether AIG shareholders will be completely wiped out, if they – like their Bear Stearns brethren before them – receive anything more than $0, this is truly a deplorable decision.

As I mentioned at the time of the Bear Stearns decision, I understand that the government feels the need to prevent the kind of systematic calamity that would exist if a massive counterparty failed  – especially one the size of AIG who is a participant as a principal in far more markets than Lehman or Bear Stearns. However, they should do as they did for Freddie and Fannie and eliminate the equity value of the firm. If AIG has truly failed, then let it be so.

The alternative – for the Fed to act as an after-the-fact insurance policy when the storm comes – undermines the very free market that the current administration claims to support.

My heart goes out to the families in Galveston, and the workers at Lehman and on main street who are suffering in the midst of our nations greatest financial challenge since the Great Depression.

I only hope our leaders use these decisions as lessons learned to develop more reasonable principles and to reach fairer decisions in the future…and in the mean time, I hope they have not done what it appears they might have done in jeapordizing the financial wherewithal of the federal government to protect shareholders of irresponsible institutions.

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