Bond Insurer Break-Up: Beware Unintended Consequences

Includes: AMBC, MBI
by: Roger Ehrenberg

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.