Cat Bonds for Everything

This is the galaxy brain version of my previous post.

Imagine that the government gives a small tax break to people who obtain income from "conforming leases," "conforming mortgages," and so forth. What is a conforming lease? A conforming lease is a lease that has a special clause whereby the government can impose a rent holiday for up to 3 months (or whatever) in specified circumstances.

So if you're a landlord, what you do is either sign a conforming lease and obtain a conforming mortgage, or you pay a little extra tax and get non-conforming leases and mortgages. And if you're a mortgage lender, you either buy conforming mortgages and issue conforming notes (saving a little on taxes) or you buy non-conforming mortgages and issue non-conforming notes. You get the idea.

Then when necessary, the government triggers its rights under the conforming contracts. Say a hurricane hits Miami. The government might immediately give tenants a 3-month break on rent (in addition to whatever other break they might be entitled to under Florida law). Likewise, their landlords get a 3-month break on their mortgages. And whoever holds the mortgages gets a 3-month break on its debt.

There may be logistical difficulties in tracing the contracts up the chain. Suddenly it matters to me, as a noteholder under a conforming bond indenture, whether my notes are secured by Florida mortgages or Texas mortgages. But that's the risk I take. The landlord certifies to the government that its certified lease been triggered, and then it doesn't have to pay its certified mortgage. The mortgage holder certifies to the government that x% of its certified mortgages have been triggered, and then it only has to pay (100 - x)% of its bond payment. The government can audit all of this.

Of course in a situation like the present pandemic, all conforming leases everywhere in the country would be triggered at once. Then in turn, pretty much every conforming mortgage would be triggered. The result would be a lot of missed payments on conforming bonds. You would have to have rules about who could hold those bonds and in what concentration. (E.g. a money market mutual fund obviously wouldn't be allowed to invest more than a tiny fraction of its assets in conforming bonds.) But basically you would have a pre-arranged system for allocating losses in catastrophic situations.

By the way, all of this has been done at small scale. This is what a catastrophe bond is. But catastrophe bonds are narrowly tailored instruments and can't be used to protect, for instance, ordinary tenants.

You could bootstrap off of this. The Treasury could issue bonds that actually pay extra when a catastrophe is called on conforming contracts. States would hold the bonds and would get an automatic infusion of cash when a catastrophe hits. There could be a whole formal system to invoke the bonds (like a declaration of emergency) and other legal arrangements (not just conforming contracts) could use an invocation of the system as a triggering mechanism.

This is not a perfect solution of course. It would be difficult to trigger the conforming leases and mortgages in a particularly targeted way. (For instance, some homeowners and renters might not be affected by the catastrophe at all, while others would need more than 3 months of relief.) But it would give the government a tool to help people at relatively little cost, effectively allocating the risk of catastrophe to investors compensated to bear it. (Ultimately I would expect conforming notes to be held by investors who either lay the risk off to insurance companies or simply accept the risk in exchange for a higher yield. Recall that this is somewhat subsidized by the tax treatment of conforming contracts.)

[Update: I guess you'd have to consider making all residential mortgages conforming, otherwise a lot of poor people will end up in non-conforming leases, defeating the purpose. Commercial leases, I don't know, I can see it both ways.]