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Fed Will Render Insurers Insolvent, Bail Them Out

Flattening sovereign yield curves, particularly in the U.S. and Germany, are depriving insurance companies of cash-flow return on their investments. I've written about the dangers posed by flat sovereign yield curves to global capital infrastructure before, and falling yields for U.S. and German notes today provided a good excuse to raise this important issue again.

The problem this poses for insurance companies is also a conundrum for the Federal Reserve. Since the failure of Lehman Brothers in 2008, the Fed has lowered short rates and used quantitative easing and operation twist to lower long rates. The idea was that eventually, the cost of capital would decline enough that lenders would lend and borrowers would borrow, especially for homes and autos. That would increase economic activity, allowing long rates to rise and widening yield spreads across the curve.

The problem is it hasn't worked, and it doesn't look like it is going to work anytime soon. Now that the private capital markets have pushed the 10-year Treasury below 1.5%, the best another operation twist can do is maintain those levels. But that will not be enough to stimulate borrower demand, especially for mortgages. Therefore, it's logical for the Fed to broaden the classes of assets banks can park on their balance sheets to include more mortgage-related products, with the goal of driving mortgage rates down even faster.

The par 30-year fixed-rate mortgage is 3.5% at Wells Fargo (WFC - Get Report), which has become the marginal rate setter for U.S. mortgages. That rate could be driven to 3% or lower very quickly if the Fed makes that a target. For the insurance industry, this process will set the clock ticking on how long it can continue to operate without causing imminent solvency issues.

Maintaining insurance industry viability, however, is not the Fed's direct mandate. If the industry becomes insolvent because of a flat yield curve, it will almost certainly have to be given access to the Fed's capital in the future. That process may also involve a TARP-like federal intervention, and that could require nationalizing the industry, similar to what happened to AIG (AIG - Get Report) in 2008.

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