Friday, January 18, 2008

The high cost of insurance, portfolio and otherwise

Guambat isn't saying that the situation facing the markets at the moment is the functional equivalent of the 1987 tempest (which was a zigzag in what has shaped up to be a long, long bull run, not any kind of 1929 crash).

Who knows?, it could get worse. Or it might not. (Guambat, who had never owned nor traded a stock or any derivative thereof once asked a senior partner in a prominent Sydney brokerage what her view of the market was, and she very carefully and laboriously explained how it could go up ... or down ... or sidewise. Guambat has never been able to fault that explanation. As a lawyer, he had to give the answer top marks.)

Anyhow, back to 1987, that bit of turbulence was attributed to portfolio insurance gone awry. This time around it is pretty much the same saga; only this time the portfolio risk is monoline insurance, otherwise coming to a headline near you as "counterparty risk".

You see, not everyone was as smart as John Paulson, even those on the same contrarian side of the trade. Some of the folks on the contrary side of credit instrument "insurance" hedges just can't seem to take a trick these days and, consequently, may be ushered out of business.

Too bad for them, you say? Well yes and no.

You see, the thing that held the noses of some very big banks above water in the recent reporting season was the accounting notion that many of their unrealized losses where unrealized because they realized early on that they needed insurance to cover the very dicey nature of those "assets" on their books. And it was that insurance that kept them from going down for the third time.

Now just suppose that the insurance company that was supposedly holding them afloat is already underwater and hanging on to their trousers. In that case, they're both on their last legs.

Guambat again must turn to the professionals for the confessionals:

FT Alphaville has two quickies on the subject which raise the alert. Gwen Robinson notes "Fears that the credit crunch might be entering a grim new phase grew Thursday as investors lost confidence in the insurers that guarantee payments on billions of dollars in bonds" and she paraphrases how Lex frames the issue:
the prospect of a second leg of big charges for Merrill if the monoline situation worsens. Other banks will also have to reflect the gathering storm over bond insurers, when positions are next marked to market. In the meantime, fear over counterparty risk, on all manner of trades, is likely to grow.

Bloomberg puts more meat on the story:
MBIA Inc. and Ambac Financial Group Inc., the two biggest bond insurers, have a more than 70 percent chance of going bankrupt, credit-default swaps show.

Moody's Investors Service threatened to cut the AAA credit ratings of their insurance units.

The bond insurers place their AAA stamp on $2.4 trillion of debt sold by thousands of municipalities across the country, as well as subprime-mortgage securities. Losing those rankings may cost borrowers and investors as much as $200 billion, according to data compiled by Bloomberg.
And Yves Smith of Naked Capitalism compares the Financial Times take with the WSJ take on the story, asking, "How Far Down is Down, Exactly?"
The Financial Times and the Wall Street Journal both address one of the major causes of the mini-panic: a new focus on counterparty risk.

there is a case to be made (and I am surprised no one has argued it) that this is an unregulated insurance market, but going down that avenue might have created massive turf wars between Federal banking and securities regulators versus state insurance authorities.

The biggest problem with the lack of jurisdiction is that it isn't at all clear who if anybody has the authority to address any problems that occur. A downgrade of MBIA or Ambac will have vastly worse consequences than the bankruptcy of Countrywide would have. Yet there is widespread belief that the government played a hand in the staged purchase of Countrywide by Bank of America, possibly to forestall the losses to the Federal Home Loan Bank system. But no regulator (save perhaps New York's superintendant of insurance, Eric Dinallo) seems to be on top of this situation.

The best we can reasonably hope for is that the likes of Berkshire Hathaway and AIG shore up part of the monoline's portfolios, either by purchasing them or more likely via reinsurance.

Guambat is sure he has recently read other casandras' fears and foreboding on the subject of late, but can't find them to give credit and "network" their views. Just as well. It was too much credit going round that got us here.

PS: Guambat had not ready Barry Ritholtz' post when he wrote above "otherwise coming to a headline near you as "counterparty risk"." In fact, he's pretty sure Barry's post was not up when he put his own up. But Barry has used a similar expression in his more lucid take on the "counterparty risk" story:
Get used to hearing that phrase: Counter-Party Risk. You will be hearing a lot of it in the coming year.

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