Barney Frank, master of complex derivative products

Tim Cavanaugh | May 18, 2009

The National League of Cities has asked for a $5 billion Treasury Department loan in order to set up a municipal bond insurer that would dwarf other players in the private muni insurance market. Say hello to IMBAC, the Issuers Mutual Bond Assurance Co., which would aim to provide insurance against default for cities with poor bond ratings.

The main private players in the muni insurance market (née 1971) have mostly been laid low by the mortgage-backed-securities pox, and don'tcha know the League has discovered that profit was the word of their undoing: "Fifteen shareholder-owned municipal bond insurers have failed because of the intense pressure to produce 15 percent to 25 percent annual returns for their shareholders," says the League's preliminary business plan.

A while back, Rep. Barney Frank (D-Massachusetts) proposed a federal muni bond insurer along these lines, envisioning an entity that provides attractive premiums to at-risk municipalities while costing "zero" to the taxpayer. The Wall Street Journal noted that while it's true they have had historically low rates of default, city governments are entering uncharted waters of debt — with ballast, in many cases, provided by growing and non-negotiable bills stemming from pensions and other obligations. Further increasing the risk of muni defaults is the existence of the insurance itself, which turns bond default from an apocalyptic to a merely regrettable scenario.

Warren Buffett has eased Berkshire Hathaway into the muni insurance business, charging much higher rates than other insurers and using an extremely cautious approach. In the 2008 edition of his beloved investor letter [pdf], Buffett explored how muni insurance changes incentives, with a wacky wayback journey to the year...

1975 when New York City was on the edge of bankruptcy.

At the time its bonds - virtually all uninsured - were heavily held by the city's wealthier residents as well as by New York banks and other institutions. These local bondholders deeply desired to solve the city's fiscal problems. So before long, concessions and cooperation from a host of involved constituencies produced a solution. Without one, it was apparent to all that New York's citizens and businesses would have experienced widespread and severe financial losses from their bond holdings.

Now, imagine that all of the city's bonds had instead been insured by Berkshire. Would similar belt-tightening, tax increases, labor concessions, etc. have been forthcoming? Of course not. At a minimum, Berkshire would have been asked to "share" in the required sacrifices. And, considering our deep pockets, the required contribution would most certainly have been substantial.

Mish Shedlock calls IMBAC "pure insanity" from a government that has "no idea how to price risk" and "ought not be competing with private enterprise."

I think Frank deserves some credit for his financial ingenuity. Muni insurance is basically a credit-default-swap, which allows leveraged parties to take on more debt. Frank has seen the havoc overuse of CDS caused in the private market, but he chooses hope over fear. He is confident that in Federation hands these instruments can be harnessed for peaceful use.

Maybe if Treasury goes along with this plan, we could get some Department with a lot of free time (Homeland Security maybe?) to start writing insurance policies against the risk of default by muni bond insurers. What could possibly go wrong?

Comments

Jeff Balla|5.18.09 @ 9:54PM|#

Lawl, DHS writing insurance policies.

You couldn't pay me to sign a contract written by those weasels.

Deflationista|5.18.09 @ 10:17PM|#

Kudos for linking Mish.

|5.18.09 @ 10:20PM|#

If only Barney Frank's mommy had strangled him in his crib, instead of giving him a new ice cream cone every time he dropped one.

-jcr

Some Guy|5.18.09 @ 10:26PM|#

So I guess the difference between that idea and the current reality is at least we'd be collecting insurance premiums before we bailed out the irresponsible parties. Which I guess beats doing it for free.

Paul|5.18.09 @ 10:47PM|#

I mean, what could possibly go wrong?

|5.19.09 @ 1:09AM|#

The worst part about this plan;

- The $5 billion in initial capital is INTEREST FREE

- They will not have to pay taxes

So fundamentally they will have an enormous competitive advantage. Not sharing 35% of profits with the federal government and paying no money to get their capital. What will surely ensure is they will have the ability to price much more aggressively, driving the remaining players out of the market.

|5.19.09 @ 2:00AM|#

He is confident that in Federation hands these instruments can be harnessed for peaceful use.

Star Trek on the brain, Cavanaugh?

I've got it! Dilithium crystals will save the economy/planet!

Bruce Majors|5.19.09 @ 7:26AM|#

You really should post a Bernie Madoff/Barney Frank separated at birth photo.

And you know, Barney is one of the few Demwits with business experience. He oversaw boyfriend Steve Gobi's gay whorehouse after all.

|5.19.09 @ 7:47AM|#

Bruce-

That is an insult to Bernie.

Fluffy|5.19.09 @ 7:50AM|#

while it's true they have had historically low rates of default, city governments are entering uncharted waters of debt

Not only that, but that data point is a real problem, comparable to the Milken data that showed low default rates for junk bonds and the data that showed low default rates for early issues of subprime mortgages.

That data only exists because municipalities have faced a critical market for debt issuance.

Once Frank gets everyone to drink the Kool-aid to believe that muni debt is inherently safe, issuance will soar, risk control procedures will become lax, and there will be a muni debt bubble party for a while, until the whole thing crashes to earth. Just like the 80's and just like the 00's.

|5.19.09 @ 8:24AM|#

I hope I'm just missing your sarcasm in the second paragraph (with regards to the "league"), but just in case its serious:

"The main private players in the muni insurance market (née 1971) have mostly been laid low by the mortgage-backed-securities pox..."

True

"...Fifteen shareholder-owned municipal bond insurers have failed because of the intense pressure to produce 15 percent to 25 percent annual returns for their shareholders,"

False

You should have quit with the first part, these guys were hammered because there were very few (if any) pure muni insurance shops and many got hammered with RMBS and (now) CMBS losses. Also, for a free-markiteer blaming shareholders for "demanding" returns, seems a bit over-simplistic.

Fluffy|5.19.09 @ 8:30AM|#

You not only missed sarcasm, you apparently also missed the quotation marks.

|5.19.09 @ 8:52AM|#

Bruce-

That is an insult to Gay Whorehouse managers.

|5.19.09 @ 10:54AM|#

A while back, Rep. Barney Frank (D-Massachusetts) proposed a federal muni bond insurer along these lines, envisioning an entity that provides attractive premiums to at-risk municipalities while costing "zero" to the taxpayer.

What, no pony?

Tell me again why people keep saying Barney Frank knows how this stuff works.

|5.19.09 @ 11:20AM|#

envisioning an entity that provides attractive premiums to at-risk municipalities while costing "zero" to the taxpayer.

Its a fucking perpetual motion machine, is what it is.

Look, either they price risk appropriately (so it costs the taxpayer zero) in which case their premiums will be high, or the keep premiums low and effectively shift risk to the taxpayer. You can't have it both ways.

Which raises the question. Is Barney Frank

(a) criminally insane,
(b) unbelievably stupid, and/or
(c) incredibly venal and corrupt?

robc|5.19.09 @ 11:20AM|#

Fluffy,

I award Mango Punch the "Reading is Fundamental literacy award" for today.

RIF!!!

robc|5.19.09 @ 11:23AM|#

RC Dean,

Cant he be all three?

|5.19.09 @ 12:58PM|#

Which raises the question. Is Barney Frank

(a) criminally insane,
(b) unbelievably stupid, and/or
(c) incredibly venal and corrupt?

Are there any politicians who have risen to any prominence that don't end up raisng those questions?

I exaggerate, of course, but as I scant the Congressional leaders from both paties I just keep asking WTF? Or to quote PJ O'Rourke on an earlier congressional clustefuck, "What the fucking fuck?"

Invisible Finger|5.19.09 @ 3:07PM|#

Barney Frank - sodomizing the taxpayer.

|5.19.09 @ 11:52PM|#

Re: Isaac Bartram

Why not all of the above? Thanks to where his protected district, unless we find a dead boy or live girl in his bed, he's going to be re-elected forever.