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Generational Dynamics Web Log for 26-Feb-08
Investors euphoric as bond insurers' AAA ratings are re-affirmed

Web Log - February, 2008

Investors euphoric as bond insurers' AAA ratings are re-affirmed

You could've knocked me over with a feather.

Unlock this door

Unlock this door

Boomers reading this web site may recall hearing the following on television many times during their youth: "You unlock this door with the key of imagination. Beyond it is another dimension. A dimension of sound. A dimension of sight. A dimension of mind. You're moving into a land of both shadow and substance of things and ideas. You've just crossed over into the Twilight Zone."

On Monday, S&P Ratings re-affirmed the AAA rating of "monoline" bond insurers MBIA Inc and Ambac Financial Group. Investors became so euphoric that they pushed the stock market up 189 points in the Dow Industrials.

I went to the S&P web site, and found the statement explaining their reasoning. It contains this text on MBIA:

"The ratings on MBIA Insurance Corp. ... were affirmed and removed from CreditWatch Negative; the outlook was changed to negative. In our view, MBIA's success in accessing $2.6 billion of additional claims-paying resources is a strong statement of management's ability to address the concerns relating to the capital adequacy of the company. It is also a strong statement by investors of their understanding of MBIA's franchise value and business practices. To further improve the company's claims-paying resources, management is pursuing alternatives to reshaping the insured portfolio through reinsurance transactions. We believe management is likely to succeed in implementing their reinsurance strategy.

However, the reversion back to a negative outlook is warranted in light of the absolute size of stress scenario losses relative to the adjusted capital cushion, as well as the uncertainty surrounding a possible reconfiguration of the company. In our view, several factors--the viability of the resulting corporate structure, investor acceptance, the effect on the company's franchise value, and the potential for disadvantaging any group of policyholders with regard to the availability of claims-paying resources--will require further assessment."

This is a pretty mealy-mouthed statement. They're saying (my paraphrase):

"MBIA obtained $2.6 billion of financing, which they can use to pay out claims on the tens of billions of dollars in CDOs that it insures, based on some assumptions that we've put together. If that isn't enough money, we think that MBIA can get some more money, so we're going to let them keep their AAA rating. But we're not sure that MBIA will really be able to get enough more money, so we're saying they have a 'negative outlook.' So we're covered, no matter what happens. Ha, ha."

We have to look at motivations here. S&P, along with other bond ratings agencies, took fat fees from bond issuers in return for giving AAA ratings on the CDOs, and did so long after it was clear that these CDOs were seriously flawed. They essentially lied for months. There's no reason to assume that they wouldn't lie now, if they felt that lying would be to their advantage.

MBIA, along with other bond insurers, took fat fees from bond issuers in return for insuring CDOs in order to give them AAA ratings, and did so long after it was clear that these CDOs were seriously flawed. They essentially lied for months. There's no reason to assume that they wouldn't lie now, if they felt that lying would be to their advantage.

(For those interested in the math behind the creation of CDOs from mortgage-backed securities, and how they get AAA ratings from "monoline" bond insurers, see "A primer on financial engineering and structured finance.")

We're now in the middle of a huge political battle, headed by New York Insurance Superintendent Eric Dinallo, to arrange a bailout of the bond insurers. This bailout involves money from the banks whose CDOs are in danger of losing their insurance and a signoff from the ratings agencies that they won't downgrade the insurers' AAA ratings.

If the bailout doesn't work, then it's widely believed that the stock markets will fall sharply, and whoever didn't cooperate in Dinallo's scheme would receive all the blame.

So the banks are willing to spend a few billion on financing MBIA and the others, because they're going to lose at least that much anyway, writing down CDOs in their portfolios. And the ratings agencies are willing to sign on, because otherwise they'll be blamed.

Everyone has major conflicts of interest, and no one has any credibility.

But let's look at this in another way.

Suppose that you own a house, and you have a homeowner's insurance policy that protects you against things like fires and robberies and other stuff that homeowner's policies are supposed to cover.

And suppose that your house is worth $200,000. (Let's assume these are normal times, and there's no deflating housing bubble, so the $200,000 is a real number.)

OK. One day you read in the newspaper that your insurance company is in some financial trouble, and they've lost their AAA rating.

So now your house is worth only $50,000.

Huh??? Is your house worth $200K or $50K? Why should your insurance company's problem mean that your home's value has fallen by 75%? That makes no sense at all.

But that's what we're talking about with these bond insurers. This is all part of the magic and alchemy that was dreamed up by the Generation-X genius "financial engineers" who set all this stuff up.

Let's use round numbers. There are, say, $60 billion of at-risk CDOs in the portfolios of various banks. They're all AAA rated, because a bond insurer has insured them against default.

Suddenly the bond insurer's rating goes down. The CDOs are now worth only $15 billion.

Huh??? Are these CDOs worth $60 billion or $15 billion? How can they fall in value by 75% just because the bond insurer loses its rating?

So now, someone gives the bond insurer $3 billion in credit. By magic, the CDOs go from $15 billion in value back to $60 billion in value.

You're entering the Twilight Zone

You're entering the Twilight Zone

DOO do DOO do
DOO do DOO do

Let's look at one more aspect of this, by going back to the $200,000 house that's worth only $50,000 when the insurance company gets into financial trouble. How could that ever be possible? (This and subsequent paragraphs were added on Feb 26.)

There's only one way it could be possible: The only reason your house was ever worth $200K is that you expect it to burn down, so that you can collect the insurance. Your house is worth four times as much if it burns down than if it stays up.

Translate that reasoning into the CDO case, and you see what's going on. You have $60 billion in CDOs, but they're worth only $15 billion when your bond insurance company gets into trouble. How could that ever be possible?

There's only one way it could be possible: The only reason that the CDOs were ever worth $60 billion is because you expect them to default, and the owners can collect the insurance.

Taking that reasoning a step further, if the industry is expecting $500 billion in additional CDO writedowns that can be avoided only if the bond insurers retain their AAA ratings, that can only mean one thing: That the $500 billion is going to come from payouts by the bond insurers. There's no other possibility.

When S&P reaffirmed MBIA's rating on Monday, they didn't follow that reasoning. Instead, they assumed that only a small fraction of the CDOs would default. That's why S&P's action is essentially fraudulent. But these financial institutions have been committing fraud with CDOs for a long time now, and so this is nothing new. The only really new thing is that the government, in the form of New York Insurance Superintendent Eric Dinallo, is fully involved in the fraud.

I've quoted the passage below before, but it's worth doing again. This is from John Kenneth Galbraith in his 1954 book, The Great Crash - 1929:

"A bubble can easily be punctured. But to incise it with a needle so that it subsides gradually is a task of no small delicacy. Among those who sensed what was happening in early 1929, there was some hope but no confidence that the boom could be made to subside. The real choice was between an immediate and deliberately engineered collapse and a more serious disaster later on. Someone would certainly be blamed for the ultimate collapse when it came. There was no question whatever as to who would be blamed should the boom be deliberately deflated. (For nearly a decade the Federal Reserve authorities had been denying their responsibility for the deflation of 1920-21.) The eventual disaster also had the inestimable advantage of allowing a few more days, weeks, months of life. One may doubt if at any time in early 1929 the problem was ever framed in terms of quite such stark alternatives. But however disguised or evaded, these were the choices which haunted every serious conference on what to do about the market." (p. 25)

Galbraith's paragraph describe's precisely what's going on now with Dinallo's working sessions, and in meeting rooms in banks around the world.

I've estimated that the probability of a major financial crisis (generational stock market panic and crash) in any given week from now on is about 3%. The probability of a crisis some time in the next 52 weeks is 75%, according to this estimate. (26-Feb-08) Permanent Link
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Generational Dynamics Web Log for 26-Feb-08 Investors euphoric as bond insurers' AAA ratings are re-affirmed

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Generational Dynamics Web Log for 26-Feb-08
Investors euphoric as bond insurers' AAA ratings are re-affirmed