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Why A Low Loss Rate Needs a Good "Population"


Some years ago, at a meeting for MBIA, the company boasted of its "no loss" underwriting. They claimed that they could achieve this because their officers performed "surveillance" on a quarterly basis, and those of bank lenders didn't. That wasn't quite the case, but like a lot of other false claims, it had a grain of truth.

What was true was that quarterly surveillance was adequate (at the time), because the company's original population of municipal borrowers was a relatively tame one. Defaults in this "space" were very much the exception, and not at all the rule. So it was possible to prevent loss by monitoring for the occasional exception, and taking appropriate remedial action (enforcing covenants, seizing collateral, etc.) before things got out of hand.

In the current era of junk finance, that began with the junk bonds of the 1980s, the whole point was to create "populations" that were fundamentally riskier than earlier ones. Bonds issued in leveraged buyouts (LBOs), were closed to defaulting AT THE TIME OF ISSUE. Likewise, the past decade's "subprime" loans issued with "teaser" rates, were basically in default WHEN WRITTEN. Such loans depended on "subsequent" events (rising house prices or company valuations) to bail them out.

In such populations, and those of CDOs that MBIA backed, defaults were practically the RULE (or if you prefer, the "default condition") rather than the exception. In such a situation, "surveillance could not prevent the effect of defaults, because there were too many of them, which in turn derived from the fact that they were "statistically inevitable" (to use an expression taught to me by former partner at Houston's Arthur Andersen office).

Warren Buffett pointed out another factor. Junk bonds that resulted from companies that had fallen on hard times typically had managers that were "embarrassed" by this fact. It was the "embarrassment," as much as anything else, that led such managers to pull their companies out of junk status. On the other hand, the management of a company that BEGAN with junk status, typically had no shame, which is to say that "embarrassment" was not a factor in their later recovery.