Wall Street Journal reports this morning under the headline, “The Next Big Bailout Decision: Insurers”:

A dozen life insurers have pending applications for aid from the government’s $700 billion Troubled Asset Relief Program, and the industry is expecting an answer to its request for a bank-style bailout in the coming weeks. The government so far hasn’t said whether insurers will be eligible for the program.

As I wrote March 1 under the title “The Bank Insurance Daisy Chain,”

Historically the insurance industry is the largest investor in commercial bank Tier I capital securities, preferred shares, and so forth, such that a nationalization of the banking system and a repeat of the Fannie Mae/Freddie Mac conservatorship would have fatal consequences for the insurers. They already are beset by huge problems in their commercial mortgage portfolios.

The credit of major insurers has collapsed on the credit default swap market with many of the major players (Hartford, Prudential, Metlife) trading in the LIBOR +1000 basis point range that used to indicate extreme distress. At these levels the insurers can’t fund. I have already seen anecdotal evidence that they are pushing up premiums to compensate, which will mean a loss of business in a tough economic environment.

The insurers were yield hogs. They are inherently in a weaker position than the banks because they tended to buy tranches of structured product backed by commercial mortgages and other assets with greater exposure to prospective default. AIG is the extreme case, writing protection for banks’ collateralized debt obligations. The insurers, as I have noted in other posts, own about 40% of the $800 billion in bank hybrid securities outstanding. That is why AFLAC was so punished by the market during past weeks; it was a heavy investor in the capital securities of British banks.

For many families, a whole life insurance policy or an annuity is the financial shelter of last resort. An intimation that these might not be safe would have catastrophic effects on consumer behavior. The economy is in free fall because households are playing catchup with life-cycle savings. Rather than substitute capital gains on homes for ordinary savings, Americans are attempting to save as much as they can, which is to say that they are spending less, depressing economic activity. That prompts a secondary effect, or what economists call precautionary saving. Last year you started saving because you realized that your retirement wasn’t funded; this year you save even more because your job isn’t safe. That is how auto sales end up falling by half, and so forth.

There is yet a third-order effect that could take hold were the insurane companies’ viability to come into doubt, and that is the possibility that your savings aren’t safe. Not only do you not have a retirement plan, and not only do you not have enough in the cookie jar to tide you over if you lose your job, but the cookie jar itself might not be safe! In this event we will get full-tilt, uncontrollable panic, something America has not seen since the run on the banks when FDR was inaugurated.

That’s the sort of thing that academic tinkerers like Profs. Krugman and Roubini do not think about, and that is the government cannot let the capital securities of the banks evaporate.

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