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), 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) in 2008.

Although publicly traded U.S. insurance companies were down today, there appears to be little recognition by equity holders of the real dangers faced by the industry. In the event that the recent global weakness is short lived, these concerns may not be borne out. If, however, the U.S. and world economies are now in or are heading into a recession, it is probable that low, long-end rates and flat yield curves will render the U.S. and the global insurance industry insolvent before the recession ends.

The National Bureau of Economic Research doesn't date the beginning of a U.S. recession until about a year after it has started, so investors do not have the luxury of waiting. Given increasingly weak economic indicators, it is plausible that the U.S. is already in a recession. If so, given the time frames, it is possible that at least some insurance companies will not survive.

At the time of publication, Arnold had no positions in the stocks mentioned.

Roger Arnold is the chief economist for ALM Advisors, a Pasadena, Calif.-based money management firm specializing in income-generating portfolios. Concurrent with his other business responsibilities, Arnold was a radio talk show host for 15 years. He focuses on behavioral economics and chaos theory, better known as the "butterfly effect." He explains the relationships between political, economic and social systems, and how they are all reflected in the financial markets -- stocks, bonds, commodities, currencies and real estate.

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