Editore"s Note
Tilting at Windmills

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January 18, 2008
By: Kevin Drum

BOND INSURANCE....Last night I was reading a story in the Wall Street Journal about the travails of "struggling bond insurer" ACA, and although the basic story was one I'd read about before, it got me thinking that I didn't really understand why there was any such thing as bond insurance to begin with. After all, the whole point of rating bonds in the first place is to price the risk of default into the bond itself. I suppose insurance could make sense in a case where a party was buying only one bond and genuinely needed protection against a catastrophic event, but anyone with a portfolio of bonds — investment banks, say — simply wouldn't need it. Their risk would be diversified enough that no single default would be disastrous, and the overall default rate of their portfolio would already be reflected in the prices they paid for the individual bonds.

But the credit default swap market amounts to $45 trillion, according to the Journal. So what gives? I guess this paragraph tells the story:

Investment banks paid ACA annual fees for bearing the risk in their debt securities. This shielded them from the impact of market-price fluctuations, so the banks didn't have to reflect such fluctuations in their earnings reports.

In addition, a low-rated bond insured by an A-rated insurance company suddenly becomes A-rated itself. Wrap all this stuff into CDOs and other structured finance vehicles, and before long everything is A-rated and off the earnings report. Prizes for everyone!

The swap market got so big because lots of people who didn't own any bonds themselves were buying and selling swaps for other people's bonds purely as a form of gambling on interest rates and other derivatives. However, apparently the prime motivation for the ur-swaps was to allow creative CFOs to play games with their balance sheets. Somehow, this stuff always seems to get back to unregulated bright boys in their unregulated back rooms, doesn't it?

Kevin Drum 12:29 PM Permalink | Trackbacks | Comments (34)

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Look, George Bush has a plan to fix everything. So just stop hating America already.

Posted by: Conservatroll on January 18, 2008 at 12:34 PM | PERMALINK

> Investment banks paid ACA annual fees for bearing
> the risk in their debt securities.

There the marker right there: as soon as you see phrases such as "bearing the risk" or "transfer of risk" you know that the situation is right for a disaster. The word "risk" gets thrown around until people who have no idea what it means think that they do, and the dictionary definition of everyday risk is utterly forgotten. Then - boom - the real risk comes home and someone gets hurt badly no matter how much "risk" they "transferred".


Posted by: Cranky Observer on January 18, 2008 at 12:40 PM | PERMALINK

Kevin Drum >"...unregulated back rooms..."

Ah yes, those same smoke filled back rooms you mentioned the other day. Funny how it all comes back to that isn`t it.

"The power of accurate observation is commonly called cynicism by those who have not got it." - George Bernard Shaw

Posted by: daCascadian on January 18, 2008 at 12:51 PM | PERMALINK

Kevin reads the Wall Street Journal? I'm shocked, just absolutely shocked.

Posted by: optical weenie on January 18, 2008 at 1:00 PM | PERMALINK

unregulated??? clearly, you've never worked in a bank or any form of banking related enterprise, or in finance more generally, or any kind of business. Or the real world outside politics more generally still, I suppose...

Posted by: on January 18, 2008 at 1:09 PM | PERMALINK

Actually, a lot of muni bonds are held directly in individual accounts (rather than through mutual funds). Also, buyers tend to hold concentrated portfolios (e.g., NYC bonds) to get the maximum tax benefit. This means that these buyers are not fully diversified, and so insurance is a way to get around this.

Your point about insured (or 'wrapped') bonds being held at cost rather than at market value is an important area that isn't being well explored in the press right now. If these bonds lose their 'wrappers' a lot of insurance-related investment products are going to become unglued.

Posted by: Rich on January 18, 2008 at 1:12 PM | PERMALINK

Pay me $50 a month and I will tell everyone your debt rating is just fine!

Posted by: Matt on January 18, 2008 at 1:24 PM | PERMALINK

I remember back in 2002 or 2003 Paul Krugman was widely derided for having written something to the effect that in 5 or 10 years -- whatever it was -- the Enron debacle was going to be remembered as a bigger deal than even September 11. Now that people (and the markets) are coming to realize that everything has basically been run like Enron, and they're losing their homes and jobs because of it, I'm wondering if perhaps Krugman wasn't more prescient than we think. We are all Enron employees now.

Posted by: jonas on January 18, 2008 at 1:28 PM | PERMALINK

My spouse is CFO at a small university that issued some bonds. They were able to insure their bonds, which resulted in a higher bond rating and a lower interest rate. It was a pretty straight forward financial decision, do you pay a higher interest rate on the bond debt or do you pay the bond insurance premiums. The concept in and of itself is not bad, but leads to abuse when the bond rating people have a conflict of interest and the regulators are asleep at the switch.

Posted by: fafner1 on January 18, 2008 at 1:29 PM | PERMALINK

Fascinating story. I wonder why they don't have a futures market in this area. It would help get rid of counterparty risk (great term, should be used for relationships).

Posted by: Bob M on January 18, 2008 at 1:29 PM | PERMALINK

This actually explains things a bit. It seems to me that the idea behind creating regulatory authority was to prevent another 1929 style disaster; here we have the financial markets finding ways to recreate 1929 style balloons outside of the current regulatory apparatus. Perhaps some well-informed person can explain to us whether the Bush administration could have tightened the reins on these practices and chose not to.

Posted by: Bob G on January 18, 2008 at 1:29 PM | PERMALINK

I don't have any inside information. I have read on this blog before that Bush intended to let mortgages go out in any form, so the administration could claim more home ownership. It is an 'ownership society' don'tcha know.

Of course, now we know this, like everything with Bush, is a fraud intended to steal from the poor and give to the rich. His whole life as an adult has been this way.

Posted by: MarkH on January 18, 2008 at 1:44 PM | PERMALINK

Most of these risk swaps are NOT insurance. MBIA and Ambac are real insurers of bonds, who report to regulators. ACA is not an insurer, but an unregulated and absurdly undercapitalized risk broker/speculator. Generally, ACA and others like them are the ones who are running the oldest established craps game in New York.

Posted by: freelunch on January 18, 2008 at 1:53 PM | PERMALINK

Of course, Kemp is full of bullshit in his column when he claims, multiple times in various ways, that markets always work.

He's so dumb that he doesn't even realize that when he says "But the reality is that markets do work," he's undercutting the premise of his whole column, the premise that there's a need for government intervention.

Idiot. Illogical idiot.

Posted by: SocraticGadfly on January 18, 2008 at 1:54 PM | PERMALINK

It's fairly straight forward. Surely, to deserve their credit rating, they should be in a position to post the margin, even if they don't have to ... so make everyone post margin, and get rid of the loophole.

Posted by: royalblue_tom on January 18, 2008 at 2:01 PM | PERMALINK

This video explains counter-party risk in the CDS market.

Posted by: milo on January 18, 2008 at 2:31 PM | PERMALINK

Just what rating company is giving ACA an "A" rating? It seems to me that, if ACA is insuring CDOs many of which are worthless, its rating should be much lower than "A" unless it is charging very high fees for the insurance. It actually seems to be a scheme to hide bad risk obligations..

Posted by: raj on January 18, 2008 at 2:33 PM | PERMALINK


You were wondering why there might be a thing called bond insurance? It is a way to lower the interest rate you might have to pay to borrow money. Without such insurance, the total extra interest you might have to pay will be more than the premium for the insurance- you are paying a smaller amount to a third party to accept a portion of the risk your lender is taking by lending you money.

Posted by: Yancey Ward on January 18, 2008 at 3:25 PM | PERMALINK

Drum is having an alarmingly infantile/populist day: first the complaint about how individuals are treated differently than business entities in bankruptcy (duh, individuals are treated differently from business entities in many contexts, because they ARE different), and now the complaint about sinister financiers in secret back rooms (I hope they're not in cahoots with the Trilateral Commission, or the Zionist World Government, or whatever). Really this type of commentary is uncharacteristic for this site.

Posted by: y81 on January 18, 2008 at 4:03 PM | PERMALINK

> My spouse is CFO at a small university that
> issued some bonds. They were able to insure
> their bonds, which resulted in a higher bond
> rating and a lower interest rate.

Right, but taxing jurisdiction bonds are not usually wrapped up into 327 layers of more "sophisticated" instruments, then "stripped" and "flipped" and discombobulated; they generally go straight into mutual funds and rich widows' portfolios. And there is very little danger that a large percentage of taxing jurisdiction bonds will default at the same time (absent a Depression), whereas there is /and always was/ a chance that a large percentage of mortgage-backed bonds could go bad at the same time - meaning that the "strips and flips" had correlated risk.


Posted by: Cranky Observer on January 18, 2008 at 4:28 PM | PERMALINK

and now the complaint about sinister financiers in secret back rooms

I think you misread this, y81. Kevin said "unregulated bright boys in their unregulated back rooms" -- with obvious emphasis on "unregulated". And "bright boys" translates, I think, to "inexperienced, and in need of regulation" more than to "sinister".

Everyone seems to agree now that more regulation was/is needed. Except for the die-hard libertarians who believe that the invisible hand of the free market can solve all problems. Evidently, a helping government hand is also needed.

Posted by: JS on January 18, 2008 at 4:52 PM | PERMALINK

Let's give it up for the guy holding a gun to y81's head, forcing him to read post after post of Drum's infantile populism . . .

Posted by: Clap Louder on January 18, 2008 at 5:03 PM | PERMALINK

$45 Trillion???? Holy crap. If even a tiny part of that goes bad, man, that is really bad.

I'm beginning to understand why the Ancient Hebrews had a Jubilee every fifty years or so. After a while, everybody is in so much debt to everyone else that it makes sense to wipe the whole slate clean. Not that it makes sense for a modern economy, but I get the underlying principle. As for us today, we just have to suffer through the inevitable unraveling.

Posted by: nathan on January 18, 2008 at 5:04 PM | PERMALINK

Actually, Clap Louder, I often like to read things even when I don't agree with them. Usually, Kevin Drum makes me think. But this post doesn't.

If someone seriously wants to understand the capital markets and the role of bond insurance and credit default swaps, there are a number of treatises and university courses available. If someone thinks that the finance industry isn't sufficiently regulated, that person doesn't know what they are talking about. If someone wants to complain about financiers in back rooms, that person is being rather infantile.

Posted by: y81 on January 18, 2008 at 6:27 PM | PERMALINK

I should know more than I do, but I think there is another explanation of the existence of bond insurance -- evading prudential regulation. Banks are not allowed to gamble as much as they choose but are subject to capital requirements. These restrictions are typically binding. They do not fully reflect diversification of risk. I sure don't understand them. I think this knowledge, which I lack, is valuable as it seems to be systematically deleted from google books previews of just enough to make you buy the book.

I suspect that bond insurance allowed banks to bear more risk than they would otherwise be allowed to bear. Relaxing capital requirements can be hugely profitable. One way in which Long Term Capital Management made money was swaps which allowed ordinary investors to bear the risk of default of 10 year lira bonds issued by London banks and banks to bear the risk of default by the Italian treasury. Ordinary investors (including me) had less faith in the Italian treasury. Italian BTP's were, to European regulators, super safe (couldn't single out a European country by name as a bad credit risk). This created an anomoly worth hundreds of millions of dollars a year.

If banks are allowed to invest in bonds that will default when the housing bubble bursts so long as they buy insurance from corporations which will go broke when the housing bubble bursts, they will. I think they were allowed and they did.

Ditto for pension funds.

Posted by: Robert Waldmann on January 18, 2008 at 7:02 PM | PERMALINK

Attention, attention !

Troll y81 please contact your handler for new instructions immediately.


Troll y81 please contact your handler for new instructions immediately.


"A nation of sheep will beget a government of wolves." – Edward R. Murrow

Posted by: daCascadian on January 18, 2008 at 7:32 PM | PERMALINK

So y81, in your opinion what is the cause of the current crisis and what (if anything) can be done to avoid future repetitions of it?

Posted by: JS on January 18, 2008 at 7:50 PM | PERMALINK

Even sillier, supposedly not a few of the bond insurance companies went out and virtuously invested (so as to prepare for potential problems) in "highly rated instruments" that, when you trace the trail back...

....were the same bonds they were insuring against a default of.

Posted by: grumpy realist on January 18, 2008 at 8:05 PM | PERMALINK

A great way to start a brand-new Depression.

1929 stock market would be proud.

Posted by: James on January 19, 2008 at 2:17 AM | PERMALINK

There are good reasons for bond insurance-- e.g., pension plans that require AAA ratings for their investments but don't want to get all their bonds from one source-- but the super-duper-geniuses behind the various sliced and diced CDOs needed to support the fairy tale of low risk and high return for their securities. Too bad for municipalities that need money for infrastructure, but dog barks, caravan goes on, etc.

Posted by: MattF on January 19, 2008 at 8:53 AM | PERMALINK

When I worked, briefly, at the SEC in 1975, there was an active controversy over the fact that various mutual funds wanted to tout in their prospectuses that they had bond insurance for their portfolios, but they didn't want to assign a valuation to the insurance, as we on the SEC staff wanted. Given that New York City stood on the brink of default, bond insurance was a serious matter. A bonding company rep stated at a meeting at the SEC that his company had sufficient reserves to handle all claims for an NYC bond default.

Posted by: William Bennett on January 19, 2008 at 1:19 PM | PERMALINK

JS, as many others will tell you, the cause of current capital markets problems is that there has been a global re-pricing of risk (i.e., credit spreads have widened dramatically) over the past 12 months. What to do about it? Until such time, if any, as I see lots of working people losing their jobs as a result, I wouldn't do anything. If the problem remains confined, as it is for right now, to investment bankers losing their bonuses, and stocks being down 10% or so, I would be opposed to any measures to prevent a recurrence, because I don't like investment bankers and don't care if they lose their bonuses one year out of every 10 or 20. If the current problems have the same effect (i.e., almost none) on the real economy as the financial crises of 1987 and 1998, then I don't think it's a problem. Thank goodness we're not on the gold standard, as we were in the 19th century, when financial panics inevitably produced crises in the real economy.

Posted by: y81 on January 19, 2008 at 9:04 PM | PERMALINK

OK -- I appreciate the perspective. But a lot of people in the financial world seem to think that this can turn into a runaway crisis that could cause serious trouble to the economy, and that we are in uncharted territory. Nobody knows right now where this will stop, or how. If I understand you, you are saying that (central) corrective action should be taken only if this crisis actually explodes. Isn't it enough that we skidded so close to the cliff to change something about our driving even if we don't fall off this time?

Posted by: JS on January 20, 2008 at 2:38 AM | PERMALINK


Posted by: ISHMAel back on February 29, 2008 at 7:17 AM | PERMALINK



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