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Generational Dynamics Web Log for 8-Feb-08
Bond insurer 'bailout' appears near crisis point

Web Log - February, 2008

Bond insurer 'bailout' appears near crisis point

Federal and New York state regulators feud over who'll get credit for "saving the market," according to reporting by CNBC's Charlie Gasparino.

The problem of the "bond insurers" (also called "monolines") has been simmering for months, but because of its complexity I've only mentioned it a time or two, particularly in "The collapse of the bond insurers, ACA, Ambac and MBIA."

The bond insurance firms are part of the alchemy that financial engineers used to transform low-rated, highly risky CDOs and other structured securities into top-rate "risk-free" AAA rated securities. If you're an investment bank issuing questionable bonds, then you buy insurance from an insurer who promises to pay off the bonds if the issuer defaults. That way the bonds are "doubly-protected" -- either the bond will pay off or the insurance will pay off -- thus magically earning an AAA rating.

(For those interested in the math behind bond insurers and other structured finance games, see "A primer on financial engineering and structured finance.")

However, the bond insurers lose a lot of their magic power if their own ratings get lowered, and that's what's being threatened by the ratings agencies, Standard & Poor's, Moody's Investors Service and Fitch Ratings.

There's a great fear of a devastating chain reaction if the bond insurers lose their AAA ratings. If so, then all the bonds that they've insured also lose their AAA ratings. There are two main categories of bonds that would be affected:

$2.4 trillion in CDOs and other mortgage-backed securities that are turning out to be worthless or near-worthless. Many of these securities are still retaining AAA ratings because of the bond insurance. But if the bond insurers lose their ratings, then a lot more of these CDOs will lose their rates, and banks will be forced to write them down.

$2 trillion in muncipal bonds. These are issued by city and town governments. They're normally pretty safe from default because the city or town can tax its citizens if necessary to pay them off. Still, many of them have AAA ratings only because of bond insurance. Many mutual funds and money market funds and other "safe" funds are backed by municipal bonds, but if the munis are downgraded, then the mutual funds and money market funds will have to start selling them off.

In both of these cases, the resulting sales and downgrades will have a domino effect on other investment funds and hedge funds, forcing additional selloffs and downgrades.

During the last couple of months, there's been a huge drama being played out in the financial world. Here are the actors:

The bond insurers. They say, "We're fine. We're great. Don't worry about us. Just leave us alone and go on with your life." MBIA has taken the additional steps of raising capital on its own to protect its rating.

The state regulators. New York Insurance Superintendent Eric Dinallo has been trying to organize a deal to get the large banks to bail out the bond insurers. Under the proposals being discussed, the banks would loan money to the insurers and would also purchase part ownership in the insurers. This could create a wonderful conflict of interest situation, where a bank is issuing bonds, the bank is insuring the bonds with a bond insurer, and the bank owns the insurer, so that the bank is insuring itself. What fun.

The federal regulators. The Treasury Dept. and the Federal Reserve are joining in the negotiations.

The banks. They're getting their arms twisted to participate in this bailout. They really can't afford it, after losing so much in writedowns.

The ratings agencies. Now here's where the real games are being played. They've been threatening to downgrade the ratings on the bond insurers for weeks, but it's always coming "next week." They're stalling because they don't want to be blamed for causing a chain reaction that would harm the markets. However, the ratings agencies have so little credibility left that they may have no choice other than to act soon.

It wasn't so long ago that all of these actors were well respected organizations, but no more. They've all lied and prevaricated and defrauded the public so many times, that they have almost no respect remaining. As I wrote recently, the moral to the Aesop's Fable "The boy who cried wolf" is "Nobody believes a liar, even when he's telling the truth." Nobody knows when any of these organizations are telling the truth anymore, or are just covering their asses.

So now we come to next scene of this dramatic real-time farce.

On Friday afternoon, CNBC's Charlie Gasparino reported the following:

He's spoken to many Wall Street bond trading professionals and "sophisticated people in the bond market," and "I can't find a single person who thinks that these bailouts are going to work." He adds, "The whole thing could blow up any time now."

The ratings agencies have reached a tacit agreement with Dinallo's office to hold off on downgrading the insurers' ratings to see if a bailout agreement can be reached. However, according to Gasparino, that tacit agreement expires within the NEXT WEEK. (This paragraph was corrected on Feb 10)

People in Dinallo's office are telling him that they're "cautiously optimistic" that the whole thing will be settled next week.

It's possible that only a partial bailout will succeed -- namely, only municipal bonds will remain insured, and could retain their AAA rating. CDOs and other shaky bonds will lose their insurance, and would have their own ratings downgrading.

Incredibly, according to Gasparino, there is a turf war developing between the State and Federal regulators over who will get credit for "saving the market" if there's a deal.

Just as incredibly, Gasparino concludes from this development that it's a sign that the bailout is succeeding. "One of the ways you know this thing is going to happen is that they're starting to fight over credit," he says.

Well, who knows? Maybe the regulators have something in their bag of tricks that will lead to some agreement. But there's another, much more likely explanation.

It's much more likely that the State and Fed regulators are both convinced that the bailout will be a spectacular failure, and the supposed "fight over credit" is really a disguised "fight over blame." What each side is saying is: "Let's do this my way, or it will fail." That way, each side can blame the other for failure.

How bad will it be if the bond insurers lose their AAA ratings? There have been a wide range of opinions expressed.

According to a Wall Street Journal article,

"The financial crisis plaguing municipal-bond insurers has some people wondering what the world would look like without them. The answer: maybe not as bad as you would think. ... Municipal bonds don't default much. Municipal bonds with a double-B rating from credit-rating services have a cumulative average 10-year default rate of 1.74% since 1970. That is much lower than double-B-rated corporate bonds, which have a 29.93% 10-year cumulative default rate during the same period, according to research compiled by research firm Municipal Market Advisors."

This has led a number of analysts to conclude that municipal bonds don't really need insurance, and that they'll get along fine without insurance, if there's no bond insurer bailout.

But analysts aren't nearly so sanguine for the other part of the market, the structured finance securities like CDOs.

Josef Ackermann, chief executive of Deutsche Bank, said that bond insurer downgrades could have a big knock-on effect: "It could be a tsunami-like event comparable to sub-prime."

From the point of view of Generational Dynamics, we're overdue for a generational panic and crash, the first since 1929. What's really amazing is how investor attitudes have changed in the last year. A year ago, when the stock market bubble was still growing, the markets would go up almost every day, whether the news was bad or good. Tens of trillions of dollars of interlocking securities were built up on the assumption that the market would keep going up. Now the market has been on a general down trend, ever since December, with the market going down almost every day, whether the news is good or bad. This past week was the worst week for Wall Street since 2003. At some point a "tipping point" will be reached. It will trigger a domino effect that will cause multiple fund failures and forced selling. It's impossible to predict when that will occur, or whether bond insurers' ratings downgrades will have anything to do with it, but if the market continues its steady fall, then it should happen in the near future. (8-Feb-08) Permanent Link
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Generational Dynamics Web Log for 8-Feb-08 Bond insurer 'bailout' appears near crisis point

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Generational Dynamics Web Log for 8-Feb-08
Bond insurer 'bailout' appears near crisis point