With our combined strength we can put an end to this destructive conflict

Let's think for a moment of the concept of a mutual insurance company, and to make my analogy, let's strip it down to something very simple.

Let's say that 5 otherwise unaffiliated hospitals decide to get together to form a mutual insurance company. The newly formed company would insure each hospital against malpractice liability. To make life easy, let's assume each hospital is the same size with the same basic patient mix. In other words, each has about the same potential liability. At least on paper.

Anyway, so each hospital makes an equity contribution to the insurance company, which we'll call Spread Out Our Malpractice Exposure, or SooMe. This money is invested. They form a board by each nominating one person, then the board hires a CEO and hires the staff necessary to run an insurance operation. They also buy a reinsurance policy for liability over some pre-determined limit.

In forming SooMe, the hospitals avoid being at the mercy of outside insurers. And if they collectively keep their malpractice losses low, the investment income from their portfolio could eventually be paid out in dividends. In other words, the hospitals directly benefit from improving their performance. This is as opposed to buying outside insurance, where the insurer would be the only beneficiary from reduced liability.

On the other hand, the owners of SooMe are taking risk on each other. And while the board of SooMe might create certain risk standards or what have you, SooMe would never be able to control its members fully. For example, its possible that some hospitals have better hiring practices than others. Or that one hospital starts accepting more high-risk patients than others. These things would be difficult to control fully. So in forming SooMe, each hospital would have to be comfortable with assuming a portion of the risk of the other hospitals. This probably means becoming quite familiar with the management of each hospital as well as the policies and procedures each has currently in place.

They need to buy the reinsurance policy to protect against the possibility, however likely, that their collective liability swells beyond what they've contributed. In bond parlance, SooMe is in a subordinate position and the reinsurer is in a senior position. Only once SooMe's assets have been drained would the reinsurance kick in. (OK I know it's a bit more complicated than that, but stay with me.)

So notice that the whole thing happens without any tricky off-balance sheet maneuvers. No accounting gimmicks. Nothing nefarious. Just a group of self-motivated agents coming together for mutual benefit.

Now, let's say, as yesterday's post describes, a group of banks got together to form a new company called LoanCo. And LoanCo buys a set of loans from each bank. Wouldn't that be awfully similar to the mutual insurance company described above? The banks have risks they'd like to limit. They aren't actually eliminating risk, because they are putting up the cash to form
LoanCo in the first place.

Notice that the banks would have to recognize the losses on the loans sold to LoanCo. Why? Because the other owners of LoanCo wouldn't be willing to overpay for the debt acquired. They'd have to come up with some means of determining market value. Could they agree to inflate the value of all loans sold to LoanCo? They could in theory, but this wouldn't be to any one's advantage. Assume there were 5 banks forming LoanCo, and all 5 sold $10 billion par value in loans to LoanCo. Say that the loans should be worth 90 cents on the dollar, but they are actually sold at par. So from any one bank's perspective, I've sold my $10 billion in loans to LoanCo $1 billion above market value. But at the same time, LoanCo has over paid for the other $40 billion in loans by $4 billion. So I own 20% of a company overvalued by $5 billion. I'm no better off.

So I think that if LoanCo was formed by a group of banks mutually coming together out of their own volition, I see no problem. In fact, I think its brilliant. And the transfer of risk involved in such a maneuver would not be markedly different than other very prevalent risk diversifying strategies, such as self-insurance.

However, if the Fed forces them to come together, or if any other governmental force is involved, then my whole argument is thrown into the pit of Carkoon. I think many of the comments posted on DealJournal roundly criticizing the idea are apt, if the Fed got involved.

And as to the comment by the Ghost of Ken Lay ("Sounds like something I want to do"), remember that the Enron stuff was truly a closed system. Enron formed these off-balance sheet partnerships and Enron was de facto the only owner. So Enron could stuff losses in whatever pocket it wanted, because no one was watching. If a group of banks get together, they check and balance each other. I'm certain that Jamie Dimon won't eat losses just to help out Chuck Prince.