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Death of Mortgage Bond Insurers May Be Greatly Exaggerated

Hans, you are certainly right that the credit rating agencies goofed in giving their highest credit rating to mortgage-backed securities before these new instruments met the test of the market. Now, there is a credit slowdown after the trading market for these securities has frozen up. There were more defaults on mortgages than anticipated, and many investors don't trust the valuation methods the securities firms or the credit rating agencies used in the selling of these securities. But what this means for bond insurers is unclear. This is because of the nature of the problem. The primary risk the credit markets are facing are not those of massive defaults (unless the politicians -- from Hank Paulson to Hillary Clinton -- successfully persuades everyone to default with further mandatory or "voluntary" freezes in interest rates), but of liquidity. Money-center banks that had anticipated selling the mortgage-backed securities after holding them for a very short time are now having to hold on to these instrument for longer, meaning the can't lend out money for other ventures. The "losses" banks are reporting are better characterized as estimates of what banks could lose with the downgrading of these securities. (And the SEC accounting mandates -- which require banks to take paper losses almost certainly larger than what they will actually incur -- are contributing to the liquidity problem themselves. More on this later.) The upshot is banks have to boost their capital reserves just in case, and hence, the infusions of capital from things like preferred stock offerings and sales of passive investment stakes to sovereign wealth funds. But these are not, for the most part, the issues faced by the banks' insurers. They primarily insure against default, not liquidity. And as Eli Lehrer and I have shown, we're nowhere near the risk of massive defaults, when looked at in proportion to the overall mortgage market. Although there have been signficant increases in foreclosure, the percentage of homes in foreclosure is still around 1 percent. Eli has written further why, even if there is an overall downturn in the economy, catastrophic rises in loan defaults are unlikely (again, unless the government steps in with perverse incentives to "save" the housing market, which prevent things like refinancing). And with bond insurers, the real danger is that a stampede to declare them on "life support," may trigger a government bailout even as many in the industry say it's not needed or wanted. Reading through the Bloomberg article you linked to on bond insurer MBIA, it is clear that the "in the doghouse" comments from the firm's CEO have been taken out of context. What CEO Gary Dunton said on a conference call on January 31 was that the firm was "in the doghouse, earning our way back," because of what he called unwarranted negative perceptions. He then blamed "fear mongering" and "distortion" for this bad perception, and reiterated that MBIA is well capitalized. "The world's largest bond insurer has more than enough capital to keep its AAA credit rating," the article paraphrased Dunton as saying. Of course, others -- particularly hedge funds shorting MBIA and other insurers -- see it differently from Dunton. But the bond insurers also have plenty of supporters in the financial world, and they see the current situation as a great buying opportunity. As the Bloomberg article noted, "Dunton's comments helped alleviate concerns that the company would lose its top ranking, driving MBIA up 11 percent in New York Stock Exchange trading and fueling a rally in the Standard & Poor's 500 Index." Also, the private equity firm Warburg Pincus recently purchased $500 million of new MBIA shares to infuse the company with capital. On the policy side, it's not our job to take sides in fights in the financial world or to predict who is right. That's the job of the market, and what is our job is to see that the market can process information flows freely. However, we should try to put the sensational factoids and screaming headlines in perspective, so that politicians aren't stampeded into rushing through unwise and counterproductive policies such as Sarbanes-Oxley, which you I and even many Democrats now regard as a foolish response to the corporate accounting scandals (and which certainly, despite billions in costs, did nothing to prevent these new accounting controversies) One of the lessons I think many market players will take is they can no longer rely as much on the credit rating agencies. This is not a bad thing. A rating for any type of product is no substitute for an investor's own due diligence, no matter how stellar the rating agency is purported to be.