A consortium of banks is considering injecting US$3 billion into Ambac, the
monoline insurer that relies on its AAA rating to insure, amongst others,
municipal bonds and collateralized debt obligations (CDOs). What appears as a
rescue plan and may appease the markets short-term, may plant the seeds for
disaster.
Monoline insurers used to be in the business of insuring municipal bonds. For a
small fee to the insurers, municipalities were able to attach an AAA rating to
their bond offerings, significantly lowering their borrowing cost. The market
was so attractive that a short-term market was created where long-term debt was
packaged into "auction rate securities" (ARS). These are a kind of
commercial
paper attractive to, amongst others, money market funds and treasury
departments of large corporations. Municipal bond funds are also large buyers
of insured municipal debt.
Then two developments caused the insurers to veer from their path: as public
companies, monoline insurers were looking for new income streams. Not only
that, rating agencies told these insurers that they were not very diversified,
and that they might have to have a second look at the credit ratings if they
did not broaden their insurance coverage to, say, securitized mortgage
products. Rating agencies were eager to see the market of debt derivatives
expand, so that they could facilitate a market by providing credit ratings to
structured products.
There was one further market that was developed to close the circle of
financial sophistication: credit default swaps were created. Think of a credit
default swap as a put option that will pay you if a company or a security
fails.
With a perceived foolproof arsenal of financial tools, banks felt encouraged to
carry a lot of complex financial products on their balance sheets. By buying
insured securities, or by protecting against the default of an issuer, the
banks reasoned, they could show stellar balance sheets. Banks are in the
business of lending money; to do so, they require reserves. That arsenal of
financial tools, however, is at risk of turning into a collection of toxic
waste if the securities held are not as secure as they seem to be or if the
credit default swaps are not worth the paper they are written on.
One risk that few talked about until recently is counterparty risk. Your
insurance is only as good as your insurance company. Your credit default swap
is only as good as the party you contract with to setup the agreement.
And that's where we are: the banks are scared that a significant part of their
reserves may be downgraded. In practice, the market trades these securities as
if they had been downgraded; but for the purpose of preserving capital ratios,
an AAA rating on paper continues to satisfy the banks' top regulator, the
Federal Reserve (Fed). Selling these securities is not a preferred option for
the banks, as many are - even in good times - illiquid; and in the current
environment, a fire sale would cause serious harm to the banks holding the
securities.
However, banks are on an increasingly shaky foundation. Add a few ingredients
to set the stage for more volatility in financial markets. Maybe most vocal
have been the municipalities that have seen the cost of borrowing surge as the
ARS market has vanished. Municipalities have to learn the same lesson as
holders of mortgage-backed commercial paper: the buyers of short-term
securities tend to be risk-averse investors. They like the extra bit of
interest they get from exotic instruments, but as soon as they realize that the
securities they have been buying are risky, they walk away.
Money markets fund have no interest in holding risky securities; many were
foolish to buy these securities in the past, but those days are gone and won't
return. Municipalities, however, are political beasts. In their view, monoline
insurers have betrayed them by risking their credit rating through recklessly
veering into riskier lines of business; they believe that insurers have a
contractual duty to try to preserve their credit ratings. And they have a
point; not only do they have a point, the municipalities exert influence over
attorneys-general and over insurance licensing, amongst others.
When CEOs are threatened with jail time - and we are not suggesting that this
has been done yet, nor that fraud has been made public to date that would
warrant that - they listen to the requests of municipalities. Hence the calls
to have these insurers split up into their traditional and their riskier
businesses. Such calls are difficult to implement as the holders of insurance
on mortgage products also have rights.
Just as it took years to separate the tobacco liability from integrated food
and tobacco conglomerates, it takes more than a few tough words from a
regulator to split monoline insurers. Note that municipalities will get through
this, but their cost of borrowing will likely go up, and they will have to
revert to long-term financing options for their obligations.
The one proposal that would work is Warren Buffett's proposal to re-insure $800
billion worth of municipal debt. However, the terms of his proposal are not
deemed attractive by the monoline insurers - they would de facto give most of
their revenue stream to Buffett's recently created municipal bond insurer,
while causing their remaining business to collapse.
The problem is that one cannot force the monoline insurers into action until
there's a crisis (read: downgrade by rating agencies); however, the ripple
effects of a crisis are exactly what various stakeholders try to avoid.
In this environment, many have been praising the proposed "bailout", a capital
injection of $3 billion by a consortium of banks. The complexity of the issues
at hand is blinding banks, regulators and rating agencies alike. An investment
of banks into the insurers concentrates risk further rather than spreading it.
Banks are closer to being their own counterparty to their credit default swaps.
Banks may technically be able to provide the appearance of independence by
keeping their stake below certain thresholds. But given that the entire
industry has very similar issues, this is a rather weak smokescreen. Indeed, we
consider it a pathetic waste of bank shareholders' money.
Banks may buy some time if they can convince the rating agencies to go along,
but all involved better pray that the housing market and the economy do not
deteriorate further, as otherwise another wave of securities may fail and yet
another "bailout" may be required. We used to criticize Japanese shareholder
crossholdings, building a house of cards that eventually had to collapse. US
financial institutions are laying the foundation for the same mistakes.
The irony in all this is that there are solutions to this crisis: prices have
to come down and banks have to be recapitalized. Housing prices have to come
down, risk premiums have to go up. Banks have to look for additional,
substantial capital infusions. At this stage, however, there's little interest
in the tough medicine. Adding significant capital would likely cause further
downward pressure on share prices of financial institutions, something few
desire. And no policymaker has an interest in lower housing prices, as that
will cause further ripple effects.
Instead, the Federal Reserve is fighting the credit contraction with all of its
force. Unfortunately for the Fed, it is a tough battle to win. The more the Fed
tries, the more side-effects we may see, such as higher commodity prices,
higher inflation as well as a substantially weaker dollar.
Axel Merk is the portfolio manager of the Merk Hard Currency Fund, a
no-load mutual fund that invests in a basket of hard currencies from countries
with strong monetary policies assembled to protect against the depreciation of
the US dollar relative to other currencies.
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