Question about bond insurance?

Discussion in 'Politics & Religion' started by swtrader, Feb 22, 2008.

  1. what exactly, are the premiums paid for?

    is it a broker's fee, for transfering the risk to the taxpayer?

    not sure I understand
     
  2. February 21, 2008 -- THE Port Authority and other public borrowers are paying steeply higher interest on some debt because Wall Street screwed up. And Gov. Spitzer and state regulators can make the mess worse.

    The problem started because an obscure set of financiers known as bond insurers took a business many deem to be a public trust - insuring municipal bonds like the Port Authority's - and squandered it by also insuring bonds backed by shaky mortgages.

    In recent weeks, that has forced municipalities to start paying "penalty" interest rates on some variable-rate debt through little fault of their own.

    For decades, a few firms most people never heard of - MBIA, Ambac, FGIC and more - have acted like co-signers for local and state governments and public authorities that want cheap debt to build schools and fix roads.

    These municipalities generally have decent credit without the co-signer. But they don't have credit's "gold standard": a triple-A rating. Why not? It's similar to personal credit: Someone with millions in the bank has a better chance of paying his credit card on time, and so can get a better rate than the guy who just holds down a steady job.

    And investors in municipal bonds or in muni-bond funds - many of them upper-middle-class retirees - don't want to think about risk at all. They want to know their money is safe. To assure them, public borrowers have gone to the people who have that AAA-rated credit, by virtue of huge capital reserves and sterling reputations: MBIA and the other bond insurers. They pay the insurers upfront so that they can "borrow" the insurers' own AAA ratings.

    But this happy system is dissolving into misery - because bond insurers were also insuring the riskiest mortgages, so now have to pay investors in mortgage bonds when the mortgage borrowers don't.

    And the ratings agencies that give the bond insurers their AAA ratings (along with investors in the muni bonds themselves) are wondering if the bond insurers can pay all those likely claims.

    Even if the insurers have the cash, they may not have enough money (or reputation) left to keep those all-important AAA ratings. FGIC has already lost its rating, and the markets are already behaving as if other muni-bond insurers will lose theirs, too. That's why the PA wound up paying a 20 percent "penalty" interest rate (up from 4 percent) on some bonds.

    State and local leaders across the country (and investors in their muni bonds) complain that they're being punished for something that's not their fault. Yes, there's always a risk to issuing bonds whose interest rates "reset" frequently - but one can hardly blame municipalities for not foreseeing this strange situation.

    Spitzer and his insurance regulator, Eric Dinallo, think they have a solution. If big banks don't immediately pump billions into the bond insurers to make the market happy (or if the insurers don't capitulate to billionaire Warren Buffett's offer to simply buy out their muni-bond insurance business at a dear price), Spitzer and Dinallo say, they'll use their regulatory powers to let the insurers break up - that is, split their business in two, with "good" muni bonds in one company and "bad" mortgage bonds in the other.

    But there are a few problems with that.

    First, the state has a conflict of interest. It's a regulator, but also stands to lose money as an issuer of insured muni bonds. New York and its authorities have nearly a fifth of their outstanding debt in about $4 billion of "insured" bonds whose interest rates reset frequently - all of which could face millions in higher rates in even short-term turmoil.

    So splitting the bond insurers into "good" and "bad" firms may make investors wonder if the state is thinking of itself, rather than thinking of all insurance clients as a regulator should. And some investors will likely sue.

    After all, it's unlikely that the "bad" insurance company would survive after a split. That is, the firm that gets the mortgage bonds won't be able to pay out on its claims. People and institutions that bought subprime mortgages only because they, like muni bonds, came guaranteed with a AAA rating, will lose.

    This is why Spitzer thinks he can strong-arm banks into putting up a few billion: If they don't, they stand to lose more on their own insured bonds if an insurer goes under.

    But Spitzer can't make good his threat without a fight. And continued uncertainty (from lawsuits) means continued turmoil for muni bonds.

    In fact, insurers who made such terrible judgments that they're in danger of losing their best asset - their AAA rating - should fail. Regulators saving such companies now will cause even bigger problems down the road: Future insurers will figure they can count on a get-out-of-jail-free card if they run into trouble - and so would be more likely to take foolish risks. Instead of saving the insurers, the state should prepare for failures.

    What of municipalities who've already paid for insurance that now seems worthless? Regulators can play an informational role here. They can send letters and hold conference calls and town meetings to convince muni-bond holders and their advisers that the loss of the AAA rating doesn't have to be a crisis: Their bonds are still good, and paying principal and interest. (Buffett's offer to take over the bonds should comfort them, too: He doesn't think they're a bad risk.)

    Markets are already catching up to this fact, anyway. Hedge funds and others are stepping in to buy those adjustable-rate municipal bonds that are paying higher interest rates than usual, because it's easy money. When enough investors do so, the interest rates will fall. And as muni-bond investors get their payments, they'll stop worrying about the lost triple-A ratings.

    As for towns and cities that want AAA ratings on future bonds? Buffett has started a new municipal-bond insurer. But New York, as a huge issuer of municipal bonds, rather than a regulator, should focus on explaining to its own investors why such insurance may be unnecessary.

    The state could start explaining to county and town officials how showing (via clear financial disclosures to investors) that they can pay back their own bonds could be just as good as insurance.

    Buffett isn't infallible. Investors who put all their eggs in one basket may find themselves in trouble again someday. They'd do better to consider the risks of the cities, states and towns in which they invest - rather than count on some third party to save them in a crisis. As today's turmoil shows, nothing is risk-free.

    This business might put itself out of business - without Spitzer's help.