Drilling Down

We see the first signs of bail-out proposals for the US bond insurers (monoliners), and that of course is inevitable. If only because at face value, it seems to make sense.

After all, it was only last week that some of the ratings agencies indicated that they would be satisfied with capital injections of some $1 billion, in order for Ambac (and consequently all the bonds it insures) to keep the coveted AAA status. Obviously, other parties did the math too, and reckoned that this was a cheap bargain for restoring law and order in the sector, which tries hard to hold together $2.4 trillion in insurance for bonds, plus who knows how much for other paper.

A closer look, however, will show whoever tries this trick that what makes it seem like such a good deal, is exactly what kills it. Ambac is leveraged 143 times, and MBIA 147 times. This means that even if far less than 1 percent of their outstanding commitments go south and sour, they will, in theory, have emptied their covering coffers, which for Ambac hold less than $7 billion (which is why the $1 billion injection looks so appetizing!!), if memory serves. Ponzi works great on the way up, but not so after. This deal looks cheap, but looks deceive.

It will still be tried though, even if it’s a bad deal: the money needed on the table will come from the public purse, and that’s mighty easy to spend, always. Just to be on the safe side, they’ll raise $15 billion this time, by throwing in some private capital. Don’t forget that for the banks this is an excellent investment: they stand to lose more, by an order of magnitude, if the monoliners’ ratings fall below AAA for real and for good. The value of the bonds will drop off a cliff if that happens. Some people now start blaming the shifting (as in: more severe) focus of the ratings agencies for the monoline mayhem, but that's like saying the cart is supposed to push the horse.

Still, the biggest problem for the monoliners may well not even be in their core business. In the past few years, they, like few others, were "lifted up" by the party spirit, and started insuring and covering all sorts of securities as well. What enabled them to do this was partly the counterparty cover of banks such as CIBC and Barclay’s (and many -so far more or less hidden- others).

The most astonishing model here: bank buys or sells commercial paper, which is insured (either by same bank, or by another issuer) through the bond insurer. The next step is that same bank becomes the counterparty (in this case guarantor, or you could say insurer) for the paper, so the bank is the (end-) insurer for the paper that it just bought insurance for. That's a hard one to beat, brought to you by the 1998 repeal of Glass-Steagall by the US Congress.

Lastly, the main victims of the downfall of the bond insurers will be municipalities, counties and states. I’ve said it several times: they face a triple whammy slamdunk, which will drive many to the brink of the abyss. First, their tax revenue plummets when property taxes decrease through lower housing values. Second, the vast majority of them have reserves invested, often through third parties, in shaky shoddy not-so-securities. Now, number three comes a-calling: issuing bonds will become much more expensive (or less lucrative, if you will), if not downright impossible for many, if insurance at AAA level cannot be acquired.

These lower levels of government depend, for a very large part of their day-to day-finance dealings, on issuing and rolling over bonds. If that becomes a dead end, there will be no more capital to maintain infrastructure, let alone build new. Not only does that mean potholes and school closings, it will lead to a lot of unemployment in communities as well.

So yes, the stakes are high, and the temptations obvious. But if you’d ask the decision makers, off the record, if they feel confident in reviving the industry, the ones in the know would all shake their heads and wander off, possibly babbling incoherently, a condition sustained shock is known to inflict on human beings.