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Monoline Insurance and Financial Fear   (Protagoras, January 28, 2008)

This interesting comment on the monolines is from Mauldin's widely read email letter.

"Here's a quick primer on how they work. Let's say you are a small municipality and want to borrow $10,000,000 for a bond offering to build a road or a water treatment plant. If you went to the market with your credit rating, it would be a low rating and the cost of the money would be high. But if you get one of the seven monoline insurers to guarantee your bond, then you get whatever their credit rating is. The fees for such insurance are lower than the savings you get on the bond, so everyone wins."
It cannot work like this, can it? This is not how markets work, they arbitrage the hell out of this stuff until the savings vanish, and you pay the same rate for the same risk no matter how packaged. The going rate on a risk must be a certain amount, that is the economic chance of default. How this risk is paid for, whether to the bond issuer or the insurer cannot change it. The issuer either pays the full interest rate to compensate everyone in the chain for the risk or not, and the size of and cost of the risk does not change based on how the payments are parcelled out.

In the above account, what allegedly happens is that the bond issuer offers the holder a certain rate, which is let say for example 6%. However, the holder declines to buy it, because the necessary rate to compensate for the real risk of default is 8%. The argument is that the insurer guarantees the risk to a level where 6% is the economically right interest rate, and only charges 1% to do it. This leaves the issuer with a spare 1%.

Now how does this magic happen? The issuer has the identical risk to what he had before, one where 8% is the correct rate. So if the monoline without modifying the risk guarantees it two points up, the monoline can make no money over time. Because the monoline will have overheads and shareholder profits, which will eat up some of the premium, not to mention that there is an extra 1 percentage point that is economically required from someone, but is a cost that the monoline is mysteriously avoiding incurring or passing on to the issuer.

You can see looking at it this way that the monoline model is economically hopeless over time. There may be long periods of good times when it is safe to insure these bonds to these levels, and you may seem to be making money. But it is like hurricane insurance in the good years. When they strike, you go bust. For the bondholder the reverse applies: the real risk of default is not at the 6% level, and no amount of pretending will make it that.

So why does anyone think otherwise, if its so obvious? Because of the collusion of the rating agencies, which means the Government, in the scheme. You cannot usually get away with a shell game across large swathes of a financial market without having Government collusion at some level, and in this case we have it because of the special position of the rating agencies which is given them by the Government.

What will happen? It seems increasingly likely that Ambac and MBIA will be out of business as going concerns within months. Whether they are out of business as entities or not, they will cease writing insurance that anyone wants to buy. Their stock market collapse means its impossible to raise capital on any scale. MBIA's bonds are reflecting, according to J P Morgan reported in Bloomberg, a 71% risk of default.

Have you ever seen a company survive a swoon like the one appearing in the Ambac charts? When they are gone, something novel happens. Bond issuers start having to pay the real interest rate their risky status demands. They find it unaffordable. They can't raise money or roll it over, and more of them than expected default.

It is clear then that what's coming towards us is a sort of tidal wave of debt default and writeoffs and also of inability or unwillingness to lend. What exactly it means is less clear. I don't yet see if its deflationary or inflationary in its final ramifications after all the players have reacted in their various unpredictable ways to these events. But as far into the future as one can see, which is not far, it is not good news.

And as the implications of the scale of this percolate through the population, we can expect to see the beginnings of real financial fear, for the first time probably in two generations.

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