More on Bond Insurers, Insurance, and Swaps

Back on the last day of 2007, I wrote this post on AMBAC and MBIA. In that post, I concluded with,

"But mortgage insurance is far riskier. Compared to a municipality's ability to tax and raise fees, a mortgage is typically repaid from the borrower's far more risky and volatile personal income stream.

One has to wonder at the wisdom of AMBAC and MBIA jumping into the mushrooming world of mortgage-backed instrument guarantees. I'd be willing to bet that, compared with the sleepier, slower-growing world of municipal obligations, the burgeoning volumes of CDOs with mortgages underpinning them became too tempting for the two municipal bond insurance firms.

It probably seemed relatively simple to them to hire some experienced mortgage bond analysts, leverage their existing operations into the new sector, and watch the new income invigorate their stock prices.

Instead, both AMBAC and MBIA are ending the year down more than 60%.

It seems that financial excess wasn't limited to just the borrowers and lenders. Even the insurers got into the act. No wonder Warren Buffett has chosen this opportune time to enter the municipal bond insurance business- while the two major competitors are reeling from losses in unrelated market segments."

Now, after the weekend's downgrading of the fixed income insurers by rating agencies, and the Monday US financial markets holiday, investors panicked.

I recall when I first learned the mechanics of fixed-variable rate interest-bearing loan swaps. If I'm not mistaken, it was early in my tenure at Chase Manhattan Bank. Those were simple enough. One party wanted a floating-rate loan, and another wanted fixed. Obviously, they differed on outlook on the rate environment going forward. Essentially, each paid the other party's interest obligation each period.

Even here, it occurred to me that there were conditions under which a party might find their counterparty, who had opted for the variable rate payment, unable to make payments if rates rose too high.

When I learned about credit derivative swaps, I recall being very sceptical that these were reliable. The Wall Street Journal featured an article detailing the mechanics of such swaps last Friday in an article entitled, "Default Fears Unnerve Markets."

The piece describes credit swaps as,

"At the center of these concerns is a vast, barely regulated market in which banks, hedge funds and others trade insurance against debt defaults. This isn't like life insurance or homeowners' insurance, which states regulate closely. It consists of financial contracts called credit-default swaps, in which one party, for a price, assumes the risk that a bond or loan will go bad. This market is vast: about $45 trillion, a number comparable to all of the deposits in banks around the world.

Not everyone who buys one of these contracts has bonds to insure; because the value of an insurance contract rises or falls with perceptions of risk, some players buy them just to speculate. In much the way gamblers make side bets on football games, a financial institution, hedge fund or other player can make unlimited bets on whether corporate loans or mortgage-backed securities will either strengthen or go sour.

If they default, everyone is supposed to settle up with each other, the way gamblers settle up with their bookies after a game. Even if there isn't a default, if the market value of the debt changes, parties in a swap may be required to make large payments to each other.

This being Wall Street, the investors often use heavy borrowing to magnify their wagers."

This is clear enough, but poses the risk I immediately noticed- counterparty risk. In the world of financial instrument trading, there's a bright line dividing exchanges and over-the-counter, or 'bespoke' instruments. The latter require members to have collateral and/or credit sufficient to settle their outstanding obligations. This is policed by the exchange, resulting in low counterparty risk. When Wall Street brokers trade with each other, for their customers, everyone feels comfortable that the brokers are able to settle their trades. This works backward, in that the brokers require similar asset levels from their customers, because the former aren't in the business of taking that type of risk, although they will lend on margin, at rapacious rates.

In the over-the-counter market, of which credit swaps are one, there's no central location or crossing point for the instruments. In olden days, before computer screens, it was also called a 'telephone' market. POSIT and other "crossing networks" are modern-day equivalents. Bids and quotes are posted, but it's just a very efficient way of presenting, in one 'place,' a myriad of independent bids and asks on various custom instruments. As such, there's no guarantee of counterparty viability.

So, as long as nobody actually defaults, the game seems reasonably benign. Prices vary with risk assessments of the borrowers, but no contractual payoffs are involved, which might tax an issuer of a swap.

However, as the summer's credit crunch continued into the fall, according to the Journal piece,

"With many bond values falling and defaults rising, especially in the mortgage arena, some institutions involved in these trades are weakened. This has investors and regulators worried that, through such swaps, some market players could spread their own problems to the wider financial system.

"You are essentially counting on the reliability of strangers" to pay up on their contracts, notes Warren Buffett, the Omaha billionaire. In some cases, he says, market players can't determine whether their trading partners have the ability to pay in times of severe market stress.

The issue is raising broader concern among regulators and investors over what Wall Street calls "counterparty risk," the danger that one party in a trade can't pay its losses. A recent survey by Greenwich Associates found that 26% of investors were worried about counterparty risk, nearly double those who said so in a poll last March."

This side-bet casino ran with minimal supervision. But, in truth, even better regulation couldn't have mitigated the worries when a few thinly-capitalized insurance firms whose main business had been stable, solid municipal bond insurance, levered their balance sheets with these bets.

As I wrote in my prior linked post, it's a vastly different world to insure payment of mortgages from insuring a taxing authority's ability to repay its bonds.

That credit swap buyers ignored the difference, and the lack of balance sheet muscle of AMBAC, MBIA and ACA to actually absorb the full extent of their obligations was simply stupid business. Legal, but unwise.

And, of course, just like "portfolio insurance" in 1987, what seems fine in the abstract, isolated case of loss, works far differently when everyone defaults at once. Or seems to. The fallacy of composition comes into play, guarantors/counterparties, a/k/a the insurers, become overstretched, and the whole mess descends into default.

As the Journal noted, it's much more complex than an exchange,

"Sometimes it isn't clear who owes what. A tiny hedge fund sold a swap to a unit of Wachovia Corp. this spring and faced repeated demands for more collateral as the subprime market slid. The fund, CDO Plus Master Fund Ltd., says in a suit in New York federal court that it insured a $10 million security, but Wachovia eventually demanded more than $10 million of collateral -- even as the security's value dwindled. Wachovia called the suit "without merit."

Last fall, with the market for low-end subprime mortgages collapsing, investors worried about firms with exposure to them. Analysts zeroed in on ACA and other bond insurers that had assumed the risk on many such securities.

ACA appeared to be in the most precarious position, because its capital of $425 million seemed minuscule compared with the $69 billion of credit protection it had provided on corporate and mortgage debt. ACA had added about $20 billion of that exposure between April and September."

Now the state of New York is reputedly organizing some sort of private capital rescue of the swaps/bonds insurers. Even Jack Welch noted on CNBC the other morning that Warren Buffett's entry into the basic muni insurance business demonstrates it is a private, capital market solution, not a government bailout.

And Rick Santelli noted earlier this week that the one thing that will totally unglue financial markets is if those swaps insurers are allowed to fail.

All true. But they miss the fundamental point of the whole morass. MBIA, AMBAC and ACA launched themselves into unwise businesses with inadequate capital. Their counterparties blithely assumed obligations would simply be paid when due.

It reminds me of a story about auto insurance. I used to play squash with a guy from AIG. A few years back, AIG began underwriting auto insurance in my state. I asked Joe, the AIG guy, what he thought of it. The AIG price quotes for comparable insurance were much lower than the limited options available.

Joe laughed and said that neither he, nor any AIG employee whom he know, would touch an AIG auto policy. When I asked why, he explained that AIG makes much of its money by being stingy on payouts for claims. This tendency, he further explained, extends to auto insurance, too.

Since AIG employees were intimately familiar with the firm's culture regarding payment of claims, they all steered clear of the firm's auto insurance, at any price.

Usually, when something seems too good to be true, it is. The easy availability of credit swap insurance from the three firms must have seemed 'too good to be true.'

It was. The firms aren't properly capitalized to underwrite the huge risks related to subprime mortgage securities. When those securities stop paying, the premiums which the insurers have collected, and invested, aren't going to be sufficient to fulfill their policy obligations.

What I have to wonder is, what in God's name were the buyers of this 'insurance' thinking? Weren't they typically middle- to senior-level managers at well-regarded investment, commercial banks and asset management firms? Didn't they realize that insurance is only as good as the ability of the insurer to actually pay?

Evidently not. Or perhaps everyone simply assumed the worst case would never occur. Much like those using portfolio insurance.

I accept that a lot of inept fixed-income investment, via subprime mortgages, CDOs and swaps, have finally affected equity markets. I'm reasonably confident that, given some time, the larger effects of these problems on the equity markets will recede, leaving fixed-income investors with the large, enduring losses.

The question is, what would be a fair and effective manner in which to contain the damage to, and avoid the insolvency of the insurers?

Some have argued for a variant of the old, 1980s "good bank, bad bank" mortgage loan solution. The municipal businesses of AMBAC, MBIA and, if there is any, ACA, would be packaged up with sufficient capital, and spun out. The remainder would exist to handle non-municipal claims.

That seems reasonable and appropriate. After that, anyone who loses insurance protection due to their counterparty, the insurer's, inability to pay deserves what happens.