The bond insurers have all rocketed today on the expectation that a bailout from the banks will be announced any time now. But this has hardly tempered the words of their critics. Everyone from Bill Ackman to Warren Buffett has criticized bond insurers for guaranteeing complex derivatives whose underlying risk they seem not to have understood. Even the core business of the insurers—guaranteeing municipal bonds—has come under fire.
In this month’s Portfolio, writer Jesse Eisinger argues that bond insurance is a racket, basically a tax-payer rip-off carried out by the collusion of bond insurers, Wall Street firms and credit rating agencies. It s a pretty extraordinary claim, for which Eisinger offers no real evidence other than the allegations of a Attorney General who hopes to be the next Eliot Spitzer and a claim that the ratings agencies consistently assign municipal bonds ratings that are too low.


Here’s how Eisinger thinks the racket works. Municipalities seeking to raise money issue bonds which are rated by credit rating agencies. The agencies give them ratings that are too low. Lower ratings means higher interest payment costs. To avoid these costs, the municipalities turn to bond insurance to bolster their ratings. The ratings agencies are all too happy to help out the bond insurers by delivering low ratings because the insurers are some of their best customers.
The argument hinges on the idea that municipal bonds are under-rated. Eisinger’s evidence for this is that according to Moody’s research, almost every municipal bond would get a higher rating is they were rated with the same criteria used to rate corporate bonds. “About two-thirds would probably be triple-A if they were rated with the same criteria used to rate corporate bonds,” he writes. “The obvious conclusion is that Moody’s, as the most influential of the credit-rating agencies, should simply start lifting its ratings on municipalities.”
But, of course, that conclusion is far from obvious. We’d only want to require the same criteria for corporate bonds and muni bonds if we discovered that measuring them by different criteria created some serious market failure. But markets aren’t as stupid as that. Markets are very much aware that muni bonds rarely default, regardless of the rating. This is why muni bond investors accept lower yields—they know they are getting less risk. Similarly rated corporate and muni bonds are not similarly priced—the munis have lower yields that reflect their lower risk. The only way to conclude that the muni bonds are rated too low is to ignore pricing differences. (Yes, I’m aware that pricing differences are typically assigned to tax differentials but I think this analysis overstates tax benefits and understates risk differences.)
Imagine if this were not the case. If munis were consistently rated too low and the market somehow overlooked this error, there would be huge opportunities for risk-free return in the market. We would expect arbitrageurs to very quickly make these opportunities vanish. The bond markets are not a place where these types of errors persist for long.
The mistake in the analysis is to treat ratings as if they were some kind of Platonic ideas, unchanging and perfectible. In reality, they are hermeneutic devices that are well-understood by the market players who use them. They exist to reduce information costs and commodify products but do not tell us everything we need to know about investment assets. This is well known and reflected in the pricing of these assets. In fact, rating munis according to the same criteria as corporate bonds would reduce the amount of information available to the market by obscuring differences in the risks of different municipalities. If two-thirds of munis were rated triple-A, investors would lack guidance about real differences between the issuers.
The truth is that different types of debt are rated on different scales, and the market is very well aware of this. Muni are rated on a scale that compares them to other munis, not corporate bonds. Corporate bonds, in turn, were obviously rated on a different scale than CDOs, and the market reflected its awareness of this by requiring higher yields for highly rated CDOs than it did for highly rated corporate bonds. The scandal of different criteria that leads Eisinger to call muni insurance a racket is so well known that its not a scandal at all.
Would You Buy a Bridge From Warren Buffett? [Portfolio]

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Comments (22)

  1. Posted by guest | February 25, 2008 at 5:03 PM

    muni bond investors accept lower yields because those yields are tax-exempt

  2. Posted by John Carney | February 25, 2008 at 5:21 PM

    To believe that it’s all tax-exemption, you have to believe that the market fails to price the lower risk of munis. I’m not willing to buy that level of inefficiency in the market without evidence to support it.

  3. Posted by guest | February 25, 2008 at 6:14 PM

    JC,
    The Masters of the Universe completely understand Muni’s? However, they didn’t understand the risk associated with a 2 Trillion dollar CDO market?
    So which is it? They obviously nailed the CDO market… Seriously, why would/should we expect them to get Muni’s at this stage?
    Our choices are a)brilliant masters or b) a chimp with a degree from HBS*…
    *It’s looking like HBS has graduated more then one chimp who knows how to screw up a perfectly good gig.

  4. Posted by guest | February 25, 2008 at 6:21 PM

    Wow. I missed this article because I stopped reading the WSJ in favor of the Financial Times. I agree with young Jesse. I know this because I wrote the same article on our blog http://www.monkeybusinessblog.com on February 21st! Not to mention we put out a video, essentially saying the same thing 1/6/08. Little bastard!

  5. Posted by Anonymous | February 25, 2008 at 6:57 PM
  6. Posted by diablo | February 25, 2008 at 7:04 PM

    Sorry Carney. What about default risk? That’s really what’s this about.
    With a record of 41 municipal defaults since 1970, is there any match in the corporate world or the derivatives muddler for that type of record? I’ve read about other smart hedge fund people saying the same thing as Eisenger, the whole thing is a racket.

  7. Posted by guest | February 25, 2008 at 7:34 PM

    @ Anon,
    Moody’s gives the following quote on page six…
    “…In fact, the 10-year cumulative default rate for all investment grade Moody’s-rated municipal bond issuers, excluding GO and water/sewer revenue bonds, stands at 0.2883%, which is lower than the 0.0.5208% rate for Aaa-rated corporate bonds. Indeed,…”
    Indeed, it appears that Moody’s uses a new form of math. I suggest this was not the kind of link you would want to point to. In their 58 page report, in the first real use of putting a key thought in bold, they can’t even get the basic math right. In fact,…
    It is sloppiness in professionalism, like this Moody’s article, that is damaging everything today. I suggest we look deeper for an answer then Moody’s… they are closer to chimps being paid to type, then real masters of the universe.

  8. Posted by Anonymous | February 25, 2008 at 7:43 PM

    great catch on the typo.
    Moody’s has always acknowledged that they use diffent scales for Muni vs. corporate. If you had any experience in the muni world, you’d know that.
    ‘then real masters of the universe’.
    fucking retard.

  9. Posted by guest | February 25, 2008 at 8:02 PM

    Nice slam 7:43! Why does Moody’s use a dual rating system? Do you agree with it? Honestly, I just want to understand it.

  10. Posted by guest | February 25, 2008 at 8:26 PM

    @7:43, I worked at the largest Muni bond house in the 90′s, we held 5% of all outstanding issues at the time… what where you doing then?

  11. Posted by diablo | February 25, 2008 at 8:34 PM

    The dual rating system is at the core of the scam. Everybody knows that.

  12. Posted by guest | February 25, 2008 at 9:22 PM

    If the dual rating system is public knowledge, all market participants know about it, are you saying all 1000 (or whatever) members of the MSRB are in collusion?
    That seems kind of nutty.

  13. Posted by diablo | February 25, 2008 at 10:18 PM

    to guest @ 9:22 PM
    Everybody in the business knows about the dual rating system, not necessarily the investors, especially the high tax bracket investors who purchase muni bonds or funds purely for their tax-exempt benefit.
    In the final analysis, 50% of the bonds are insured by monolines. So at least 50% of the bonds are AAA just because of the monoline wrapper. Retail investors don’t know that. An issuer with a AAA rated bond does not have to go for insurance. The fewer the AAA ratings the issuer gets from the ratings agencies, the most likely they’ll go for the insurance to save on interest costs for the lower rated bonds. But the fact remains that the default risk of municipal bonds is extremely low. The insurance industry concedes that point.
    Regarding the MSRB, last time I checked there were broker-dealers and banks in that organization. We are talking about rating agencies and monolines so good luck finding them in the roster of the MSRB. Those agencies and the monolines have very little reputation/credibility left.

  14. Posted by guest | February 25, 2008 at 10:27 PM

    The system was structured so that a small profitable “carry” could be assigned to each issue in a small boring market. They basically never defaulted and the product was sold to the client as A paper unless they paid to have it marked up as “insured” which is what made the paper AAA.
    So, an organization that deserved AAA in reality had to issue paper @ A, or pay the street a payment to issue AAA paper. If you cant see that, your pretty blind.
    The mono lines insuring this sector should never have been allowed to leave their niche. They had the golden goose laying eggs. They decided to chase SIV products and its crapped all over them.
    The reality is greed kills and right now the rating agencies should be downgrading the monolines, but we cant take the hit, because the cash is not in the till to make the payments on this scale.
    The carry that the system has relied on for ever, cant carry this problem and now it is being unmasked for what it is. A street based mismarking of risk to generate a fee. Huge surprise eh…
    There are mutual funds that only hold insured muni’s, the chance they held any paper that would default is pretty limited to start with just by holding muni’s only, but by marketing a product that was “insured” they could get a market that seeked the safest possible investment that was also tax free.
    So now we have insured AAA muni bonds… The level of redundancy in the above is silly, but in some cases it wont be enough if this recession kicks in.
    Nothing like a good old fashion stress test to see where the cockroaches are…

  15. Posted by guest | February 26, 2008 at 8:38 AM

    Yes, by the same token (measuring by default rate) financial corporate bonds have been systematically under-rated as the default rates are materially below those of other corporates. Moody’s attempted to rectify this situation in 2006 by implementing its Joint Default Analysis, which resulted in oddities like Icelandic banks being rated AAA before Moody’s had to dial it back a notch. S&P, then, could also be said to systematically under-rate financials if default rates are the scope of your analysis.

  16. Posted by guest | February 26, 2008 at 9:42 AM

    So who is in on this conspiracy?
    The Monolines and the rating agencies?
    Do the monolines pay the rating agencies to underrate the paper?
    If the b/ds aren’t in on this, doesn’t the secondary market sort out this racket?
    Do you people beleive Neil Armstrong ever set foot on the moon?

  17. Posted by HurtByAmeriquest | February 26, 2008 at 9:56 AM

    The rating company gets paid for good ratings, Right?
    How much does an AAA+ cost?

  18. Posted by 36th Chamber | February 26, 2008 at 9:58 AM

    8:38 – my understanding is that ratings are an indication of risk of default. If that’s the case then aren’t default rates the best measure of accuracy? If that’s not the case then what are ratings meant to do?

  19. Posted by guest | February 26, 2008 at 9:59 AM

    The scam isn’t in the ratings, its in the whole notion of muni bond insurance which at bottom is redundant. The facts are that there has been very few (43?) muni defaults in over 35 years because the municipal entity or government will raise the money to make the debt service payments on revenue or general obligation bonds. The low default risk is why muni yields are generally low. So basically, the bond insurers are getting free money by underwriting these insurance policies knowing that they will seldom be called on to bail out the issuers. Maybe they thought that the CDO market would be the same since the bonds are backed by mortgages, housing prices are going up, etc., etc.

  20. Posted by diablo | February 26, 2008 at 4:40 PM
  21. Posted by guest | February 26, 2008 at 6:01 PM

    one thing to remember in comparing coporate debt to muni is that muni issuers DO have the liability of Unfunded Public Employee Health Care Benefits. Most coporations in the US dont have such pension liabilities. The ones that do (e.g. companies with unions such as autos) are/have been in serious financial trouble.
    Furthermore, with the passing of GASB 45 and the need for municipals to properly account for this ongoing liability and expense, who knows what the financial picture of munis will be. Yes, historically they have experienced low defaults but I think it would be premature to say munis should have a rating approach similar to corporates. The rating agencies made the mistake a few years ago of saying that abs default rates were lower than that of munis and coporates…and based this notion on less than 10 years of performance data. Now, we have batches of downgrades in rmbs and who knows what’s next for other asset classes based on poor performance.
    In short, don’t be in a rush to lump fixed income sectors together. The future has yet to be written.

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