Last year, tens of millions of people bought life insurance for scheduled flights of airlines in the United States. Not one of those insured passengers died in a crash — and this was not just a coincidence, at least not to many of the people who bought the insurance.

Of course, buying an insurance policy does nothing to hold planes aloft, strengthen airplane mechanics or sober up pilots.* But studies by psychologists reveal that this kind of magical thinking is widespread. The reason the shrinks give for this is interesting: “Because calamities are so vivid and easily brought to mind, we tend to overestimate their probability when we intuitively judge what will happen if we tempt fate,” Tierney writes.
Individual retail investors make up most of the buyers in the municipal bond market and, for the most post, they do not actively trade the bonds. It’s not too much of a leap to suspect that this class of investor might be particularly prone to the kind of magical thinking that enriches the flight insurance industry. If the bonds are insured, they won’t default, the thinking goes.
Actually, when it comes to muni bonds, this line of thought is a little less superstitious than the kind that goes into buying many other types of insurance. Bond insurers actively work with issuers to help prevent defaults, and provide monitoring functions that can catch problems before they metastasize. They don’t do this out of a charitable instinct, of course. They do it to minimize the risk of paying out on bond insurance policies.
To the extent, however, that at least part of the demand by muni investors for bond insurance is fueled by the same psychology that fuels other insurance, there should be profit opportunities for investing in uninsured muni bonds. We’d expect those to be underpriced relative to insured comparable assets. The main problem, however, is that realizing the profit is likely to be slow-going. With nothing to trigger a dissipation of investor magical thinking, you’ll have to realize the gains over the entire life of the bond.
Appeasing the Gods, With Insurance [New York Times]

WSJ Marketbeat announced “Ambac Bailout Imminent! Maybe! Possibly!”
Then we learn that the deal was dead, and that Ambac needs to raise $1.5 billion dollars. Thus, all of those rumors and CNBC appear to have been patently false.
But here’s the question that keeps coming up: Who are the people leaking this information? And, is this legal? Now, we have learned that all of these attempts at manipulating the market were based on rumors that proved to be false.

Like so many other errant theories about the world, the Eisinger Thesis (as we’ll call it) starts with a grain of truth. Municipal bonds do get lower ratings than their chances of defaulting would earn them if they were corporate bonds. The ratings agencies acknowledge that munis are rated relative to other munis, and will even provide ratings for munis on the corporate scale if asked. Few municipalities do request this, however, because investors in municipal bonds are interested in risk comparisons between different members of the muni asset class and not so much in comparisons to corporate bonds .
But from this grain of truth, the Eisinger Thesis attempts to build an imaginary sandcastle of scandal, mispricing and collusion. What’s so implausible about the Eisinger Thesis is that it requires us to believe that the markets are radically inefficient when it comes to pricing municipal bonds. It asks us to believe that bond investors are unaware of very public facts—including the use of different ratings scales and the fact that the ten year cumulative default rate of muni bonds rated Baa is less than that of AAA rated corporate bonds. Only by assuming that investors are ignorant of these facts can Eisinger conclude that muni bonds are mispriced.
You can see the absurdity of this. Even if the unwashed were a ignorant as Eisinger believes, surely the publication of this alleged mispricing in a prominent business magazine should help alleviate the predicament. How notorious does a widespread error have to be before we can conclude that it is well known enough to be taken into account by the markets?
We’ll give the last word, however, to James Bianco, the president of Bianco Research and himself a famed contrarian. He agrees that the Eisinger Thesis depends on the belief that markets are radically inefficient for muni pricing. He departs from us only by embracing that belief.
“The market has been mispricing munis for decades based on the assignments of the rating agencies. If the market was properly pricing munis, bond insurance would not exist. It exists because this market is highly inefficient,” he writes.
Can it be that we’ve gone so far over the edge of contrarianism that we’re contrary to the contrarians? Does that make us spokesmen for the conventional wisdom? If DealBreaker is conventional wisdom, things are far worse than we feared.

According to Eisinger, the racket begins with the ratings agencies. At the heart of his argument is that claim that they issue ratings for muni bonds that are consistently too low. This forces municipalities to buy bond insurance, which raises their ratings and lowers their interest costs. In short, the ratings agencies and the bond insurers are in cahoots.
Yesterday we pointed out that this would require us to believe that the bond market consistently misprices munis, overestimating the muni risks due to the bum ratings. Of course, such consistent mispricing is implausible. If munis with poor ratings had yields higher than risk warranted, the market would quickly correct this. Witness what happened to the auction-rate securities market when some bonds on reasonably safe securities were paying coupons as high as 20%. Demand for these shot up, and the excess yield was quickly eliminated. The fact that the agencies use different scales for corporate and muni ratings might create some noise, but the signal of excess returns would be heard loud and clear.
What’s more, munis tend to have lower yields than similarly rated corporate bonds precisely because investors know that they are rated on a different scale. Investors are not confused by the ratings. The perception, for instance, that ‘A’ rated corporate bonds have greater associated risk than ‘A’ rated municipal bonds is widespread and has the added advantage of being accurate. Fitch and Moody’s are very clear that they rate muni bonds relative to other munis, and that munis have much lower default rates than similarly rated corporate bonds.
To put it differently, if Eisinger was correct, the bond insurance racket is even more extensive than he suspects. It not only involves ratings agencies and insurers. It includes bond investors, who must be deliberately avoiding the excess returns that would be available if bond issuers were really overpaying because they get lower ratings than they deserve. One thing we know for sure is that investors are not confused by the ratings—the perception, for instance, that ‘A’ rated corporate bonds have greater associated risk than ‘A’ rated municipal bonds is widespread and has the added advantage of being accurate.
Today both Felix Salmon, who writes the Market Movers blog for Portfolio.com, and Jesse Eisinger have responded. Felix insists that the difference in yields between corporate bonds and munis is only a product of their tax-advantages, and not at all a result of risk assessment. He doesn’t give any evidence for this beyond his own certainty that this is the way things are. The academic literature on the subject is decidedly mixed. Some studies have found that yield spreads can be explained by risk differences; some find they cannot. The bond traders we speak to insist that credit risk—as well as other risks—do indeed play a strong role in muni pricing.
Eisinger’s response makes clear that he regards muni bonds as essentially free of default risk. But this is just incorrect. Out of the three-hundred and seventy-five and half billion dollars worth of muni bonds issued between 1977 and 1998, bonds worth $24.9 billion defaulted, according to an influential 1999 study by Fitch. That means around 6.6% of muni debt defaulted, which is hardly trivial. Of course, the actual “default rate” is lower if you count by the number of issuances defaulting rather than the dollar volume and that number is inflated because it includes a lot of private activity bonds, basically corporate bonds that enjoy tax-free status because they have municipal sponsors. But even if we just include investment grade munis, there’s still something like a 0.5% historical default rate. On average, muni bondholders recover 68% of the par value of their defaulted bonds—which is better than the average for corporate bonds but, again, not trivial. And things have been even worse during especially bad economic times. During the 1873 Depression more than 24 percent of the outstanding municipal debt defaulted.
Eisinger is extremely impressed with the power municipalities have to raise taxes to pay off their loans, and seems distressed that investors and rating agencies don’t share this view. But there are lots of reasons investors may lack confidence in municipalities. Local governments often aren’t subject to very rigorous financial disclosure rules, investors may distrust the political and they may lack the financial acumen to anticipate future financial crises.
Like so much else that is misunderstood in financial markets, the issue really comes down to pricing. To turn a phrase on its head, people who think they know the value of everything, very often don’t know the price of anything.

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]