Eliot Spitzer and the Mortgage Insurance Crisis

The Wall Street Journal, that most indispensable of newspapers, has this editorial suggesting that the credit crisis may be reaching bottom, noting that Warren Buffett seems keen to begin buying choice assets at rock-bottom prices and noting that Elliot Spitzer, the governor of New York and former Attorney General of the same is now demanding a breakup of the mortgage insurers.

The recent posturing by both men is a lesson in investment strategy. Buffett is demonstrating that liquidity is the most important weapon an investor has. Many times in his annual letters to shareholders over the past several years, he has noted that Berkshire holds enormous cash reserves and that it does so at minimal rates of return. He describes this situation as “no fun” since every investor wants to bag the big, return accelerating prize. But he has also presciently noted that it is often difficult to raise cash when you need it most and so Berkshire chooses to raise it at favourable rates when it is possible to do so, in order to ensure that the funds are available when needed (to pay super-cat insurance claims and still make major purchases). The bond insurance business is a classic example of an industry with players who appear to be undercapitalized (though comparing the company equity with the face value of the bonds they insure is hardly as significant as the press makes it appear – even defaults will not result in total losses in most cases). Buffett is offering them liquidity to ensure that they can meet payments (and avoid a credit downgrade in the short term) in return for collecting large premia on assets unlikely to default.

It is important to understand that Buffett is not offering to take the troublesome mortgage backed paper, but rather the quite solid municipal bond paper, of the hands of the insurance firms. These are assets likely to keep earning steady premia for years for these companies. But, if you cannot wait for those premia to come in because you need cash now, you may have no choice but to sell. This unfortunately is like having to sell the family heirloom to the pawnshop to meet the rent. While it puts off the day of reckoning, possibly forever, it more often leads to insolvency.

This is why it is so disheartening to see Eliot Spitzer recommend the breakup of the insurers in this way (unless they could recapitalize). Notionally, what Spitzer is suggesting is a prophylactic for the municipal bond holders (and issuers). Since they, through no fault of their own (they were trafficking not in shaky mortgages supported by questionable assets and incomes, but in solid municipal projects supported by reliable municipal taxes) they may lose protection because they chose the wrong insurer. Insurers actually favour a breakup which would allow the healthy municipal business to be insulated from the unhealthy mortgage business. But, as Cecilie Glutcher from Bloomerg quotes Tom Mercer of Musashi Capital, this is “like going to the casino and keeping only the winning bets”.

In fact, this is the worst possible outcome for bond insurance. It defeats the very CONCEPT of insurance. As we know, insurance is based on the empirical evidence that it is easier to predict outcomes for an entire population than for an individual member of that population. Since the risk (as measured by the standard deviation of the outcome) faced by the individual (early death, dismemberment, etc) is higher than that of the population, it is possible to make money arbitraging the difference. This is called underwriting. Everyone wins.

Furthermore, there is another well-known principle in investing, which is diversification. Diversification of risk tends to reduce the overall risks of a portfolio, even when the risks show some correlation. Thus, even if mortgage trouble is correlated with municipal default (because both mortgage collateral and municipal taxes are tied to real estate values) holding both types of mortgages should improve the quality of the balance sheet of the insurer. Insisting that an insurer would be better off taking on only one kind of risk is the same stupid anti-business/anti-management/anti-capitalist views that insisted that banks couldn’t have multiple branches, lest they become monetary overlords.

As I have noted before, this is exactly the sort of foolishness that led to the banking crisis of the 1930s. Spitzer thinks that if insurers of municipal bonds can be forced to only take this sort of business, which has historically been prone to high levels of repayment, that he can preserve cheap borrowing for cities and states. But he makes these insurers substantially more prone to risks unique to municipal borrowers (such as meeting large pension obligations). Worse, he prevents the beneficial diversification effects for mortgages and commercial paper that provide the source of the tax revenue that the cities need. Making real estate financing harder to obtain in the midst of a major downturn will lead to lower assessed values and the need to raise tax rates in order to meet budget shortfalls.

Not a pretty picture at all.

Certainly, the bond insurers need to find a solution. The most like is a recapitalization by large investors – hedge funds, private equity or possible state pension funds (now that would be ironic). The solution is not to weaken them, but rather to strengthen them.