Can it ever be so simple as the goodies and the baddies?
On the one hand, the latest Dinallo-inspired plan to save the bond insurers (or at least part of them) seems to be gathering steam. First FGIC was considering the much-heralded “good bank/bad bank” plan that would see the relatively safe business of guaranteeing municipal bonds hived off from a toxic debt insurance rump.
Now it’s one of the two largest that has embraced the good/bad creed. Ambac, reports the WSJ, is in discussions to split itself up so that the municipal bonds backed by the monoline retain their high credit ratings.
Beware this supposed panacea. The “good bank/bad bank” split is designed to save municipal bonds - and their many and various uses across the US. But why should those who’ll end up in the “bad bank” stand by and let this roll on?
Why is no one pushing back against the New York state insurance superintendent’s strong-armed tactics, asks Roger Ehrenberg? The risks to such a seemingly simple split are complex to the point of being inestimable. While the benefits - in terms of safeguarding muni bond insurance - are also unclear.
But given the low historical default rates on such paper, are all of these financial machinations really worthwhile? There is much data to argue that the municipal bond insurance industry shouldn’t exist to begin with, given these default rates. If municipalities have to issue at slightly higher rates in the absence of insurance, isn’t this a cleaner long-run way to fund itself?
In other words, are we going to a whole lot of trouble to maintain an industry that isn’t needed in the first place. But problems in the auction-rate market suggests that some investors are uncomfortable with the threat hanging over the bond insurers, and therefore the municipal borrowers’ credit.
David Merkel at Aleph is unsympathetic. Most of the municipalities with the failed auctions are creditworthy entities that don’t need bond insurance, he argues. Auction rate structures deliver low long-term financing rates when things are calm. The more sophisticated investors should have known that this wouldn’t hold when short term liquidity dried up, or in times of even moderate stress. The smaller borrowers should have been so advised by their banks. You can’t have long term financing and low rates with certainty.
Merkel has also wondered how the state insurance commissioners intend to get away with favouring one class of claimant over the other - namely the municipalities over those in hock to the “bad bank”, ie the banks with CDO hedging arrangements in place.
The appeal of a split is that it would sever the municipal bond business from the structured credit business, as it is the monolines which act as the channel between the two. But, as Bank of America on Monday commented, “the fact that one group of policy holders’ exposures has imperiled the policies of the other does not mean they should foreit the value of their claims altogether.”
The banks in talks to prop up FGIC were, reportedly, taken by surprise by its plans to split itself. And a split would potentially leave billions of dollars of credit default swaps in doubt, as their underlying credit gets sliced into two, very different, portions. Merkel writes:
If I were one of the banks, I would sue the State of New York, and quickly, because NY is moving more quickly than they ought to. There is no NY crisis here, and the politicians and bureaucrats of New York should behave as gentlemen, and not thugs.
