The rest of the story

This morning's post was up to my usual high standards, timely, informative and richly amusing. But in keeping it pithy, I left out a little background information which would have helped to set the scene.

Have you ever heard of Municipal Bond Insurance? Don't feel bad. If you had it probably would have gone in one ear and out the other.

Say the water department in some little town in some unimportant state wants to build a new filtration plant for ten million dollars, they can issue tax free bonds (usually referred to as muni's, short for municipals)to raise the money. That is, the interest earnings are tax free to the buyer of the bonds. To give you an idea how that works I stole the following explanation somewhere:

"...Lets assume you are receiving a yield of 4% from a municipal bond and you want to understand the equivalent yield that you would need to receive from a treasury bond to compensate for the tax advantage that the munis offer. For the sake of the calculation, let's also assume you are in a 28% tax bracket. The calculation would be written as so:

Taxable equivalent Yield = .04/(1-.28) = .0555 = 5.56%"

So since the muni's equivalent yield is higher, this tax free status allows state and local authorities and agencies to finance projects more cheaply. Sounds good so far.

Well, for the issuer to get the lowest interest rate on these bonds, a rating agency like Fitch, S&P or Moodies' has to award them a AAA rating. To get their AAA rating the water department can buy insurance that if they default on the bond the insurer will pay off the bondholders That's easier on everyone involved than having the rating agency come out to the little town in the unimportant state and do a thorough audit of the water departments projected revenue stream and it's credit worthiness. Plus the insurance is cheap, I think it's been just a little over one percent of the insured amount. So everybody's happy.

The big insurers reported profits in recent years as nearly 50% of revenue. They began to feel so good about their abilities they decided to branch out and expand further into insuring - you guessed it - CDO's, That's right "Collateralized Debt Obligations" those big bundles of junk bonds and sub prime mortgages. Why would they do such a thing? Hubris and Greed. The Hubris: We're making so much money we must be really smart. The Greed: The CDO market is getting bigger than the Muni market and we can charge higher premiums.

The borrowers began to go south, and the rating agencies belatedly realized the insurers have inadequate reserves to cover the losses they were facing. Remember a couple months ago I wrote about counter party risk. Well, this is it. "I brought a lot of junk so I bought some insurance. Now I should be fine - unless my insurance is junk too". So the rating agencies issued a credit warning to the biggest insurers, and one agency lowered an insurer's rating to AA from AAA. Realistically these insurers should have their ratings lowered into the B or C range, but therein lies the rub. If the insurers ratings drop then the ratings on all the bonds they insure should also drop, and all the insurance companies, mutual funds, and pension funds that are required to invest only in "investment grade" securities (BBB or better: AAA AA A or BBB not BB or lower)would have to divest themselves of these bonds. Divest as in sell, but who would buy and for how much? Answer: I don't know but for a lot less than they were purchased for. So big losses are in the cards for the financial companies that pretended that they were investing only in risk free securities.

And then, of course, you've got the hedge funds. They'd buy crappy investments with triple A ratings, and use the crappy investments as collateral to borrow more money to buy more crappy investments, and then do it again, and again. They're so highly leveraged that a small drop in the market value of these crappy securities will have a multi fold impact on their liquidity. As the value of their collateral securing all those loans goes down they'll get margin calls and have to come up with more collateral, and they can't deliver. Pretty soon everybody will be selling everything except the furniture in their swanky digs which will have been repossessed.

So even though most of us could live our whole lives without thinking once about Municipal Bond Insurance, it will prove to be one more nail in the coffin of the economy that the Bushes, Clintons and Greenspan have shaped for us - but their friends at Goldman Sachs will probably be OK.

Anyway that's the kind of thing that's got Bernanke so nervous that he has one finger on the panic button at all times.