It Burns! It Burns!

I emailed this to Planet Money:

I’ve heard the argument that the heyday of the airline industry came in part because the government fixed ticket prices. As a result, airlines had nothing else to do but compete based on quality. Airline deregulation did away with all of that, and the general consensus is that this was a good thing — tickets became more affordable for all, airlines became masters at optimizing costs, routes, and providing variety.

That said, I’m intrigued with the idea of government fixing prices to force insurance companies to compete on quality. I’m free market enough to want insurance companies to compete, so I figure, why not a hybrid?

What if the government said something like “all insurance companies must offer a plan at $X/month that anybody can take” (where X is set low enough to expect most of the population to be able to afford it, perhaps a fixed % of CPI). It’s up to the insurance companies to say what exactly the plan covers.

It very well might be the case that no insurance company offers serious plans. But I suspect that the government could come up with *some* X that would be reasonably profitable for insurance companies. The government was going to do that work anyway in the form of a public option. The difference here is that the we let the free market dictate the actual benefits.

There’s a potential feedback loop here — if an insurance company offers a plan at X better than anybody else, more people will sign up for it, which should theoretically bring down the liability variance, making the plan more profitable, etc…

Is there an example, besides the airline industry, of price fixing leading to higher quality?

I had a conversation with a Schwab representative about what should happen to my investments if Schwab were to go under. I figured the answer would be one of two possibilities:

1. You lose everything.
2. You keep everything.

The answer is neither. According to this rep, the government insures up to $500k of your investments.

To make the discussion more concrete — imagine that you’ve got $1,000,000 (what an imagination!), and you put it all into a CD (not very imaginative). This is basically the safest investment you could possibly make short of stashing cash underneath your mattress.

If Schwab goes out of business, the government will insure that you still have $500,000. It’s unclear to me if they insure a $500k CD, or if they just hand you $500k in cash. Anyway, that’s unimportant.

My question is: what is the cost of insuring the rest of the $500k? In other words, how do I gain if Schwab craters?

One solution is to buy put options. If Schwab stock drops to near zero, you want to be able to sell it to someone at a higher price and buy it at the near zero price.

As of this writing, the last put option at a strike price of $7.50 expiring Jan 21, 2011 (let’s call it 1 year from now) sold for 40 cents. If you wanted to insure $500k, you’d have to buy about 667 of these contracts. Assuming that you’d be able to find counter parties for all those shares, this would cost you about $266.40, which is less than 0.02 percent of your portfolio per year. Or, roughly equivalent to Vanguard fees. Not bad.

Then again, I might be doing my math wrong. I’m not terribly familiar with options.

This is, for all practical purposes, a theoretical exercise. If Schwab were to crater, I fully expect that they would sell off their deposits to another bank. Schwab is also known to be a conservative and well capitalized bank.

But, if you are paranoid enough to get the options… make sure you buy them through a different brokerage.

I want to write a Wii game where your mii is playing a Wii.