This sort of thinking is exactly what we need to turn things around.

After the mortgage business imploded last year, Wall Street investment banks began searching for another big idea to make money. They think they may have found one.

The bankers plan to buy “life settlements,” life insurance policies that ill and elderly people sell for cash — $400,000 for a $1 million policy, say, depending on the life expectancy of the insured person. Then they plan to “securitize” these policies, in Wall Street jargon, by packaging hundreds or thousands together into bonds. They will then resell those bonds to investors, like big pension funds, who will receive the payouts when people with the insurance die.

The earlier the policyholder dies, the bigger the return — though if people live longer than expected, investors could get poor returns or even lose money…

Indeed, what is good for Wall Street could be bad for the insurance industry, and perhaps for customers, too. That is because policyholders often let their life insurance lapse before they die, for a variety of reasons — their children grow up and no longer need the financial protection, or the premiums become too expensive. When that happens, the insurer does not have to make a payout.

But if a policy is purchased and packaged into a security, investors will keep paying the premiums that might have been abandoned; as a result, more policies will stay in force, ensuring more payouts over time and less money for the insurance companies.

“When they set their premiums they were basing them on assumptions that were wrong,” said Neil A. Doherty, a professor at Wharton who has studied life settlements.

Indeed, Mr. Doherty says that in reaction to widespread securitization, insurers most likely would have to raise the premiums on new life policies…

Goldman Sachs has developed a tradable index of life settlements, enabling investors to bet on whether people will live longer than expected or die sooner than planned. The index is similar to tradable stock market indices that allow investors to bet on the overall direction of the market without buying stocks.

This is my favorite part:

In addition to fraud, there is another potential risk for investors: that some people could live far longer than expected.

It is not just a hypothetical risk. That is what happened in the 1980s, when new treatments prolonged the life of AIDS patients. Investors who bought their policies on the expectation that the most victims would die within two years ended up losing money.

It happened again last fall when companies that calculate life expectancy determined that people were living longer.

Hooray we cured cancer! Oh no the economy is now destroyed because all the banks are insolvent.

This really highlights the major problem in our financial system that hasn’t been resolved and indeed is getting worse in many respects. Our monetary and fiscal policies are designed in a way where it should be impossible for banks, et. al to lose money as long as they put it towards productive uses on average. However these days they are just out to make the most money in the least amount of time, without regard to whether it is actually a sustainable investment or makes sense in the long term social context.

The proponents argue that this will help the terminally ill have better quality of life because they can turn in their insurance policy, but as noted in the article (and learned about from first hand experience) that has been offered at a small scale for many years. I haven’t read any complaints that there wasn’t enough money in it.

Yves Smith addresses this very issue:

The Japanese approach regulation very differently from the way Americans do. First, just about nothing is codified in writing. Lawyers are few and far between (by design, the bar exam is difficult to pass). If you try to get an opinion on whether a new idea will pass muster, you are certain not to get a crisp answer. One reason is the Japanese have somevery different fundamental ideas. The Anglo-Saxon construct is that something is permitted or it isn’t. The Japanese, by contrast, will tolerate new products that are provided by firms that are in their good graces if the activity stays at a low level. If it becomes significant, it becomes subject to official study, and that is often a death sentence.

This is not as nutty an idea as it may seem. Risky activities, if kept to a modest scale, can address needs of select customer groups, and if the purveyors have to operate the business on a contained basis, they will hopefully focus on the best quality customers, thus limiting the exposure of their firm (and by extension, the financial system). Consider subprime loans. Even though that product has fallen into disrepute, there was a portion of the market that was worth serving. In fact, FHA loans, which have 3% downpayments, were the original subprime and had a very good track record on defaults (the product that has shown big losses was a zero down payment offering that the FHA had asked to shut down).

Why the disparity in results? The FHA did borrower screening. The FHA lost market share to private sector subprime lenders because their process was faster and less demanding (and people who would have failed FHA standards did get credit). Similarly, not for profit mortgage lenders have seen default rates similar to those of prime borrowers, when they serve subprime customers.

[Author Note: FHA got in trouble when the private sector subprime blew up and there was immense political pressure for FHA to step in and lower their standards in order to “prop” up the housing market. Yves is right that they were doing OK before then.]

Wall Street has its eyes on another potential hot new market, and appears likely again to screw up what was a good product for customers.

The life settlement business is one where investors buy life insurance policies from holders who need the dough, say someone sick or elderly, at a much better rate than what the insurance company offers as a cash settlement value. The investor then continues to make payments and is gambling that the insured party will die on or ahead of schedule (as determined by actuarial tables).

On a small scale, this is a useful service to people who are in a bind. But the ramp up that Wall Street intends, of marketing the idea more aggressively and securitizing the policies, is likely to put all life insurance customers at a disadvantage.

Why doesn’t Wall Street make investments in actual…investments? For example, solar power panel prices are plummeting and expected to fall to between $0.50 and $1.00 per watt. This will put solar power near grid parity in many parts of the country and that’s before Federal and state tax rebates (true those would be scaled down if there were large scale interest in the program, but you get parity even without it). There would still be a risk of losing money, but only if electricity prices over the next 25 years averaged less than they are now (for $1/watt panels, if it actually falls below then the math gets even better). I find this highly unlikely and think there is a good chance that it will be double due to carbon taxes, lack of capacity in the power grid, resource shortages, etc. [It should also be noted that the bulk of cost at that point would be from the inverters, batteries and installation, in which the latter two have much more room to fall through technological innovation over the next few years].

Of course in the twisted world of investment banking, this isn’t a good investment (despite having very similar return rates as mortgage bundles) because the market can’t be scaled up to $500 billion off the bat, and would have to wait for increased production of panels to kick in. They also couldn’t extract large fees in the beginning, which as the NY Times article points out, is the primary purpose of the life insurance bundles. In the end, instead of investing money in proven technology to help make life better, we’re going to have people making or losing billions based on death.

Addendum: Now that I’ve read this I feel my point at the end wasn’t quite clear. The word “investment” implies that today’s capital is set aside and gradually used in order to lead to economic growth in the future, either through innovation or increased infrastructure. That economic growth then disproportionately rewards the investors under the idea that they risked their money and provided a marginal benefit to society at large. Of course investments can go bad when they are put in something that doesn’t work or lead to too much capacity.

However Wall Street has become big on flat out speculation. Speculators don’t provide any economic growth benefit, but still have market benefit in theory because they provide liquidity and make the market more efficient (and hence cheaper). In practice, the number of speculators in a market has to be rather small compared to the size of the market, or else bubbles will form and the market will become very inefficient and/or there will be a lot of meaningless trades that are generated for transaction costs and nothing else. When two-thirds of stock market volume is in high frequency trades, or the securitization market (and thus creation fees) becomes a large percentage of the securities, then the price of doing business in that market increases and for all intents and purposes becomes a “tax” on the other participants. Several economists have pointed out that the FIRE (financial, insurance and real estate) sector has stopped providing efficiency to markets in a way that allows for greater economic growth, and instead has become so large that it acts as a tax on economic growth. The NYT article was very clear that the securitization idea will lead to increased premiums for the customers as a whole, and that “tax” is where all the big profits are coming from.

I gave the example of the solar energy investments (and they could be securitized even) as something that would allow for greater economic growth, both by increasing power generation and decreasing demand for central power, and which there is a surfeit of demand at present. I hope that’s more clear now.