The Wall Street Journal-20080213-Business World- Warren the Munificent
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Business World: Warren the Munificent
Full Text (873 words)No offense to Warren Buffett: All predators should be as gifted in cloaking themselves in a folksy demeanor. He yesterday offered to sell a bunch of troubled municipal bond insurers backup insurance for their municipal bond pools. He no doubt is charging an arm and a leg for insurance of that which hardly needs insurance, because he can.
Municipal bonds seldom if ever default. But the existing insurers who stand behind such bonds now are in trouble thanks to the other dodgy subprime business they dabbled in. Hence Mr. Buffett's opportunity, the announcement of which was implausibly credited with lifting the Dow 200 points at its peak yesterday. How much fun he must be having. And it's good to see someone besides Abu Dhabi taking advantage of the bargains revealed in the credit meltdowns of the developed world.
Let's pause, however, to consider how some crazy rules helped inadvertently bring him his present opportunity -- and put the world seemingly on the brink of financial chaos.
In the abstract, of course, neither bond insurers nor bond raters should exist. The market ought to be able to assess and price bond issues efficiently itself, leaving no profit opportunity for raters and insurers.
But this overlooks "information costs." In effect, a triple-A insurer turns every bond issuer into a triple-A issuer, and does it more cheaply than the bond issuer could do it for himself. Thousands of towns and cities don't have to spend time and money advertising their bona fides to investors. Investors don't have to pore over credit reports on thousands of towns and cities.
Hooray for an efficient market solution. Or it would be an efficient market solution if participation by all parties were voluntary, therefore conditioned by appropriate skepticism. Unfortunately the kink in the great chain of being here is supplied by various government rules that require many large pension funds and other institutions to hold only bonds that receive an "investment grade" rating.
Current upshot: If the rating agencies downgrade the bond insurers, they effectively downgrade thousands of municipal bonds, meaning many holders no longer would be legally eligible to hold them. That's where we are today.
We're not so sure the result would be the financial catastrophe that some forecast. The market might well recognize the value of the downgraded bonds despite any downgrades. But some believe a downgrading of the insurers would beget forced selling, a collapse in muni prices, and insolvency for many institutions and perhaps for towns and cities that couldn't roll over their outstanding debts.
Eric Dinallo, New York's insurance superintendent, is worried enough that he's trying to organize a Wall Street bailout of the bond insurers. Federal officials are worried enough that they are cheering him on. The stock market is worried enough that it lurches up and down on every rumor of his progress or lack of same.
Enter Mr. Buffett, who offers to solve the problem in his own way, no doubt hoping regulators will quietly pressure the big bond insurers to acquiesce in his proposal to take their bread-and-butter muni business away from them, leaving them to sink into the mire along with their remaining subprime bets.
How much money is at stake? Mr. Buffett says his head-in-the-bed offer to the three biggest bond insurers covers some $800 billion in municipal issues.
We should quickly note that he's not offering to solve the problem for many banks that own mortgage-backed securities also insured by the bond insurers -- but these banks have already shown themselves capable of facing up to their losses. Whether they do so indirectly by recapitalizing the insurers or by taking charges on their own books may not be a pregnant distinction. Besides, there's always Abu Dhabi.
But let's spare a moment for what's really the core problem here: "underwriting," and government's contribution to the undermining thereof.
"Underwriting" means careful assessment of credit risk by lenders who have money at stake. When it comes to many of the biggest funds, however, government rules encourage them to defer to the judgment of rating agencies. Further complicating matters are rules requiring banks and other institutions to value their holdings at daily market prices -- even if the market price is temporarily zero for an income- producing asset that continues to produce income.
Somehow we have to get back to a world where people are directly responsible for the risks they take, and where they are using real judgment rather than following cookie-cutter rules, then turning to government to save the day because, after all, government is author of the rules. The current system also put the raters in an impossible position. Now they have to worry that any downgrade that forces some institutions to sell their holdings may drive other clients into insolvency, a dynamic that motivates all concerned to adopt an attitude of make-believe.
As we and many others have pointed out, banks are unique among business enterprises in their ability to bring low entire economies. To date, the latest test of this theorem has not provoked the global recession that many fear. But unless government figures out how not to be responsible for so much risk taking, sooner or later the boomerang will catch us in the face.
