Barney Frank, master of complex derivative products

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?