The Application of Monoline Insurance Principles to the Reregulation of Investment Banks and the GSEs

• Author: Dwight M. Jaffee
• Date: 01 March 2009
• DOI: http://doi.org/10.1111/j.1540-6296.2009.01151.x
• Published date: 01 March 2009

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Risk Management and Insurance Review, 2009, Vol.12, No. 1, 11-23

INVITED ARTICLES

THE APPLICATION OF MONOLINE INSURANCE

PRINCIPLES TO THE REREGULATION OF INVESTMENT

BANKS AND THE GSES

Dwight M. Jaffee

ABSTRACT

This article explores the benefits of reregulating the investment banks and

government-sponsored enterprises (GSEs, namely, Fannie Mae and Freddie

Mac) by applying the monoline principle that has been long established in reg-

ulating insurers that offer coverage against mortgage and bond default risks.

The monoline regulatory principle was created to ensure that losses on a risky

insurance line would not endanger other safe lines. The principle is applicable

to both investment banks and the GSEs because both sets of institutions have

operated with two basic divisions: a hedge fund division that maintained a

highly risky investment portfolio and an infrastructure division that carried out

activities with high direct value for the overall financial or mortgage markets.

The monoline principle involves placing the two divisions in a new regulatory

structure whereby the infrastructure division is bankruptcy remote from any

losses that might occur within the hedge fund division.

INTRODUCTION

The financial distress of investment banks and the government-sponsored enterprises

(GSEs, namely, Fannie Mae and Freddie Mac) has received intense focus recently in

both financial markets and regulatory circles. An investment bank (Bear Stearns), an

insurer/investment bank (AIG), and the GSEs have already required specific govern-

ment bailouts.1Even larger but dispersed cash infusions are now in process. As a result,

Dwight M. Jaffee is the WillisBooth Professor of Banking, Finance, and Real Estate at Haas School

of Business, University of California, Berkeley,CA 94720-1900; phone: 510-642-1273; fax: 510-643-

7441; e-mail: jaffee@haas.berkeley.edu.This article is an updated version of a presentation made

August 4, 2008 at the annual meeting of the American Risk and Insurance Association, Portland,

Oregon.

1The Bear Stearns bailout is detailed in the Congressional testimony of Securities and Exchange

Commission (SEC) Chair Cox (2008), Federal Reserve Chair Bernanke (2008), and Federal Re-

serve Bank of New YorkPresident Geithner (2008). The GSE bailout is described in the statement

of the Director of the Federal Housing Finance Agent Lockhart (2008). The first AIG bailout was

announced by the Federal Reserve (2008). In this article, I treat AIG as an investment bank, since

the losses and systemic externalities that required its bailout were unrelated to its traditional

insurance business.

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