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The Bond Insurance Crisis;
Or, My Fig Leaf Is Falling

Jan. 23, 2008 (EIRNS)—First it was the sub-prime crisis, then it was the SIVs, and now it is the bond insurers that are the problem, according to the financial press. The line is that if the bond insurers fail, the ratings on the bonds they insure will be reduced, forcing pension funds and other institutions to sell their holdings, causing a crash in the market for the municipal bonds, CDOs, and other paper insured by these companies. That's a scary scenario, designed to make you feel that if we don't bail out the bond insurers, the whole system will collapse.

There's good news and bad news here. The good news is that the scenario presented above is not really true, but the bad news is that the situation is actually much worse.

Let's start with some basic cause and effect. It is not the collapse of the bond insurers that is jeopardizing the bond markets, but the collapse of the bond markets that is killing the bond insurers. Were the bond market sound, we wouldn't be hearing about bond insurance because it wouldn't be an issue. So the scenario being painted has it backwards. Bond insurance, like its larger credit derivatives sibling, is actually an accounting trick designed to help the financial markets portray all the worthless securities they are buying, selling, and holding as having value. When you think about it, the whole concept of such insurance goes out the door in a systemic crisis, since both the instruments being insured and the institutions providing the insurance are part of the same system, and when the system goes, it all goes down together.

So why have insurance at all? Take the case of the now infamous sub-prime mortgage loans which are pooled into groups, against which mortgage-backed securities are issued. The mortgage-backed securities are theoretically backed by the mortgages in the pool, but they really aren't. Then the mortgage-backed securities are divided into tranches, with a hefty slice being rated AAA by the ratings companies, even though they are nominally based upon junk-rated loans. The middle tranches of the mortgage-backed securities are then often combined with tranches from other mortgage-backed securities and other forms of debt into entities called collateralized debt obligations, or CDOs. These CDOs are divided into tranches, including a hefty slice rated AAA, and sometimes the middle tranches of the CDOs are combined into yet another abomination, called a CDO-Squared. The top tranche of the CDO-Squared is divided into tranches... You get the idea. What you have is a whole string of financial instruments, some of which are given the coveted AAA rating, even though they are all based upon junk-rated mortgages and a process which basically concentrates crap. Everybody on Wall Street knows the credit ratings on this junk are frauds, designed to keep the system going, but some of the potential buyers — say, your pension fund — are nervous, so the bankers came up with the idea to buy insurance on the bonds. The idea is for the bond insurer to have an AAA rating, and in effect rent that rating out to the mortgage-backed securities, CDOs, and similar securities. That means that the top tranche of a junk-backed CDO-Squared can not only have an AAA rating, but can also be insured by an AAA-rated bond insurer. What could possibly go wrong?

With the belt of an AAA rating and the suspenders of AAA-rated insurance in place, these abominations were sold all over the world, to mutual funds, pension funds, hedge funds, banks, corporations, to anyone foolish enough to buy them. Now they are blowing up, and the AAA ratings have been shown to be nothing but an illusion.

The problem is not the bond insurers, but the system. The system itself has failed, and that is what all the scenarios are trying to hide.