Bond Insurer Break-Up: Beware Unintended Consequences

All this talk of a government-driven break-up of bond insurers into their municipal and non-municipal (read: structured mortgage securities) components leaves me scratching my head. Why are so few calling bullsh*t on New York State insurance superintendent Mr. Dinallo and his strong-armed tactics?

This is not the government urging a solution, this is more akin to the government holding a gun to the head of bond insurers and saying "Restructure - or else..." And it is just not that simple due to the complex webs of financing arrangements among the bond insurers, the banks and the buyers and sellers of credit protection on both the firms themselves and the securities they've backed. His actions may well have unintended consequences that far exceed any benefits that might be created, largely by calming down issuers of and investors in municipal debt obligations.

But given the low historical default rates on such paper, are all of these financial machinations really worthwhile? There is much data to argue that the municipal bond insurance industry shouldn't exist to begin with, given these default rates. If municipalities have to issue at slightly higher rates in the absence of insurance, isn't this a cleaner long-run way to fund itself?

As we all know buying insurance is an NPV-negative enterprise for the buyer; all is is really doing is taking unwanted "tail risk" off the table. But can't we withstand a few defaults in order to strip the friction of insurance out of the industry? All this money paid out to bond insurers over the last 30 years is largely a tax on issuing bonds that don't really need the enhancement to begin with. So what's all the fuss?

While the discussion around the a good bank/bad bank approach to the structured investment vehicle [SIV] problem of the banks was largely negative, it was a far more straight-forward, market-driven solution to a difficult problem than Mr. Dinallo's urgings. And as the Super-SIV approach became more real, the banks decided to take care of the problem themselves. A win/win without paying the frictional costs of establishing such a structure. Mr. Dinallo's solution would be maximally disruptive for a minimum of benefits. Maybe I'm just missing it.

But I can see the government-driven bond insurance restructuring program getting mired in a protracted court battle among entrenched interests on all sides. However, instead of simply reporting on the bond insurance industry break-up I'd like to see some more critical analysis of its cost and benefits. Because taking this step is a big deal and sets a very worrisome precedent. There is urging and facilitation and then there is coercion, and Mr. Dinallo's steps are falling dangerously close to the latter.

Comments

[Chris White:]

The NY govt probably just wants to try and separate what is arguably toxic, from what is secured against someone's taxes, even if those are real estate based. Don't they hold muni bonds as well as insure them? Wouldn't it be much cleaner if the revenues from healthy taxes were not used to provide transfusions to the toxic stuff? They might also want to do something with the structure before the CDO mess becomes a public issue like sub-primes did, don't you think? Looks like it might be a whole lot bigger and messier. Some tails get to be like that if they're not cleaned up often enough.

2008 Feb 17 07:04 PM

[300mph:]

I think you are absolutely right on this issue. It now appears to me to be a case conflict of interest that the State of NY is trying to rig the game in their favor at the expense of other insured instruments.

2008 Feb 18 11:05 AM

[Rong:]

My understanding is that General Obligation Bonds have a good record of paying off. There is a point at which funds from property taxes will dry up because of mortgage default and shrunken real estate values.

2008 Feb 18 01:01 PM

[pharma:]

All these discussions by politicians about the best way to screw monoline insurance companies are very dangerous.

The world entire financial system is very unstable and there is no time to lose. The situation continue to deteriorate with every single day. There is no room for a grand standing at this time.

In my view, the federal government must ensure stability and solvency of major monolines as well as major commercial banks. The next step will be to ensure clarity and transparency of the financial system with most financial derivative must be eliminated.

Only after stabilizing the financial system, the other issues can be addressed. The nonsense of how to prevent a recession must be stopped. Real-estate foreclosures and a recession can not be stopped and/or prevented. Let free market mechanisms take place of it.

Unfortunately, it is an election years. It will be very difficult to find a consensus on how to fix the situation. Consequently, the overall financial and economic situation will continue rapidly deteriorate.

2008 Feb 18 10:35 PM

[.crazylegs..:]

"But can't we withstand a few defaults in order to strip the friction of insurance out of the industry? All this money paid out to bond insurers over the last 30 years is largely a tax on issuing bonds that don't really need the enhancement to begin with."

If the cost of the insurance wrapper is less than the amount the municipality saves in interest paid with versus without the insurance, this is a clear benefit to the municipality. It is not friction if an A rated issuer can get a AAA insurance wrapper and pay less to fund themselves on a net basis.

There is a place for the muni bond insurers if they stick to their core business. These guys got into trouble only when they wrapped their insurance around structures they could not peer through and understand exactly who the borrowers were to correctly price those risks.

2008 Feb 19 01:33 PM

[Alex_G:]

"There is much data to argue that the municipal bond insurance industry shouldn't exist to begin with, given these default rates. If municipalities have to issue at slightly higher rates in the absence of insurance, isn't this a cleaner long-run way to fund itself?"

When a municipality buys insurance for it's issue, it is in effect being rated by the insurer, which is far cheaper than being rated by the rating services. They save 2 ways, one w/ a lower interest rate and the other by not paying S&P and Moodys.

2008 Feb 19 05:13 PM