Saturday, January 19, 2008

Kevin Drum asks a very good observation about finance.

"I didn't really understand why there was any such thing as bond insurance to begin with. "

He points to an explanation in The Wall Street Journal

Investment banks paid ACA annual fees for bearing the risk in their debt securities. This shielded them from the impact of market-price fluctuations, so the banks didn't have to reflect such fluctuations in their earnings reports.

I suspect that there may have been another reason related to prudential regulations.

I should know more than I do, but I think there is another explanation of the existence of bond insurance -- evading prudential regulation. Banks are not allowed to gamble as much as they choose but are subject to capital requirements. These restrictions are typically binding. They do not fully reflect diversification of risk. I sure don't understand them. I think this knowledge, which I lack, is valuable as it seems to be systematically deleted from google books previews of just enough to make you buy the book.

I suspect that bond insurance allowed banks to bear more risk than they would otherwise be allowed to bear. Relaxing capital requirements can be hugely profitable. One way in which Long Term Capital Management made money was swaps which allowed ordinary investors to bear the risk of default of 10 year lira bonds issued by London banks and banks to bear the risk of default by the Italian treasury. Ordinary investors (including me) had less faith in the Italian treasury. Italian BTP's were, to European regulators, super safe (couldn't single out a European country by name as a bad credit risk). This created an anomoly worth hundreds of millions of dollars a year.

If banks are allowed to invest in bonds that will default when the housing bubble bursts so long as they buy insurance from corporations which will go broke when the housing bubble bursts, they will. I think they were allowed and they did.

Ditto for pension funds.

1 comment:

JR said...

Interesting post.

To me it seems like all the cities that had hyper-appreciation of real estate values from 2000 through 2005 are now really taking some major value declines.

Here in San Diego, I subscribe to: This San Diego real estate publishes a real tell-it-like-it-is blog. His 12-31-07 post Real Estate Market Predictions for San Diego in 2008 is a realistic idea about what this year will hold for not only San Diego, but, all the cities that had hyper-inflation.