Freitag, April 17, 2009

If You're Not Part Of The Solution...

...then you're part of the problem.

There's a man out there who is definitely part of the problem, and he is dedicated to making things worse. He simply doesn't comprehend economics, and is increasingly dangerous: not dangerous to his opponents, but dangerous to everyone.

His name?

Barney Frank.

Mr. Frank believes state and local governments are paying too much when they issue debt because rating agencies don't give them the ratings Mr. Frank feels they deserve. So last year he pushed a bill to effectively force Standard &Poor's, Moody's and Fitch to raise their ratings on municipal bonds, but the legislation got sidetracked amid the financial turmoil. Now Mr. Frank is back, bigger than ever.

Mr. Frank's problem is that he fails to understand that you can't change the world to make it fit your expectations. He tried that with the subprimes, we know how that turned out: he is trying now to do it with risks.

He'd like to create what he calls an FDIC-like federal insurance program for municipal bonds. Jurisdictions issuing debt would pay premiums into the insurance fund, and in return the federal government would guarantee the debt against default. Private companies already insure municipal bonds -- companies such as MBIA, Ambac and Berkshire Hathaway. And you may recall that last year the big bond insurers caused considerable angst when their exposure to mortgage-related debt called into question their ability to meet their muni-bond obligations. MBIA, in response, recently fenced off its muni-bond business from its other obligations.

What's the problem with that, my liberal friends might say? We're just leveling the field, allowing local governments to compete "fairly". The problem is that there's a reason why state and local governments "overpay" for their insurance: they are, fundamentally, a higher risk.

If Mr. Frank really believes that state and local governments have been forced to overpay for this insurance, one has to assume his federal program would charge lower premiums and so undercut its private-sector competitors. The government can charge low premiums without putting taxpayers on the hook, he argues, because the risk of default is so low.

Just like the default rate for subprime mortgages was so low, right? Mr. Frank is trying to legislate away risk: that is what is insanity.

Or is it? The payment history of municipal bonds seems to support Mr. Frank. But then the triple-A ratings assigned to many mortgage-backed securities were also based on backward-looking models that failed to anticipate today's housing bust. The muni-bond performance record is also mostly the history of uninsured bonds. But the very existence of insurance can change the behavior of the policyholder or beneficiary -- watch Barbara Stanwyck and Fred MacMurray in the 1944 classic "Double Indemnity." If a state or locality knows someone else will make bondholders whole, they are far more likely to default than an uninsured issuer would be.

Bingo. This is Mr. Frank's attempt to help states and localities that have run up huge pension and health-care obligations that they cannot afford, which will destroy their finances. But rather than cut back on the obligations - which is the only economically and financially sensible thing to do - he wants to make the taxpayer in general liable, and remove the risk from the state and local entities who made the promises. In other words, the removal of risk from the equation, most fundamentally: political risk for those who made these promises. Who are, to be certain, virtually all Democrats. Mr. Frank wants to have the US taxpayer foot the bill for the incompetence of his party, and that is all this is aimed at: saving the Democratic Party from its apparent innate incompetence and stupidity when it comes to factors financial and economic.

Many states and localities have run up huge pension and health-care obligations to retirees that will come due over the next few decades. And many of those obligations were underfunded even before the bottom fell out of the stock market. When those bills hit, cities will have to choose among raising taxes, cutting benefits or stiffing bondholders. In some states, such as New York, retiree benefits are constitutionally protected, and taxes are already chokingly high. So stiffing the bond insurers will look pretty attractive.

Muni bonds are tax-free, which were considered to make them attractive enough when they were aimed at paying for investments. But now, if they are being used to pay operative costs, the obvious risk that they will not be paid back - with what? - makes them highly unattractive. So Mr. Frank wants to eliminate the risks involved by shifting the risks to the US taxpayer.

None other than Warren Buffett devoted several pages in his latest Berkshire Hathaway shareholder letter to precisely this kind of risk: "When faced with large revenue shortfalls, communities that have all of their bonds insured will be more prone to develop 'solutions' less favorable to bondholders than those communities that have uninsured bonds held by local banks and residents."

This is right: the fetish with insuring everything means, at the end of the day, that there is no risk for those communities, or more exactly, no risk for the administrators and elected officials of those communities. By removing their risk, they have no incentive to be responsible: they're being invited to be irresponsible.

He continues: "Losses in the tax-exempt arena, when they come, are also likely to be highly correlated among issuers. If a few communities stiff their creditors and get away with it, the chance that others will follow in their footsteps will grow. What mayor or city council is going to choose pain to local citizens in the form of major tax increases over pain to a far-away bond insurer?" This goes double if the insurer is Uncle Sugar.

Snow ball effect: Mr. Buffett is absolutely correct.

Mr. Buffett concludes: "Insuring tax-exempts, therefore, has the look today of a dangerous business -- one with similarities, in fact, to the insuring of natural catastrophes. In both cases, a string of loss-free years can be followed by a devastating experience that more than wipes out all earlier profits."

It's not just a bad idea: it's stupid.

The difference, in this case, is that bond insurance, and especially federal bond insurance, would have helped create the "natural" catastrophe by encouraging jurisdictions to rack up obligations that taxpayers would be forced to make good on down the road. As for Mr. Frank's contention that muni-bond insurance is too expensive, Berkshire Hathaway is charging two and three times historical rates -- and Mr. Buffett is still worried.

Let me state this plainly: you can't legislate risk away. You can insure risk, but ultimately, once the insurer understands what he is doing, that risk insurance will eat your profits away entirely, removing all incentive to insure against all possible problems.

One Fannie Mae debacle ought to be enough for any career, but Mr. Frank wants taxpayers to double down on his political guarantees. There are currently some $1.7 trillion in municipal bonds held by the public, and Barney thinks we can insure them at "zero cost." Considering the source, and the potential size of the bill, someone in Congress needs to sound the alarm.

If anything, Congressman Barney Frank is the best argument for term limits that this nation has seen since Franklin Delano Roosevelt. Of course, at this point Congress may just think "So what? That's only a couple of trillion".

Dangerous times. If you're not part of the solution...

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