Dutch Boy, Finger and Dam, Inc.

What are we to make of the possibility that several banks will try to inject $3 billion into one of the ailing monoline insurers? The news involves AMBAC, which insures $524 billion of bonds, including municipal and structured finance issues. I have some observations:

The effort is all about appearances instead of reality, i.e. preserving the AAA rating for the monolines so that banks' own portfolios of insured securities can still be used at elevated prices for regulatory capital purposes. In today's virtual reality banking it's the nameplate fictitious AAA that matters, instead of the factual reality that exists in the marketplace. In other words, if a CDO has a AAA rating, a bank can still employ mark-to-model methods and calculate a very high virtual price for its balance sheet, instead of having to use a lower factual price (i.e. what someone will pay for it right now).

We can get a sense for this from the Fed's guidelines for acceptable collateral at the Discount Window, which clearly favor AAA-rated issues for CDOs, CLOs and such structured instruments. The same collateral rules also apply to the Fed's current TAF (Term Auction Facility) operations, which have become quite vital in meeting banks' liquidity needs. It is important to note that..."If the margined value of a winning Participant's available collateral were to fall below the amount of TAF Advance awarded to it in the Auction at any time before, on, or after, Settlement Date and before Maturity Date, the Participant would need to pledge additional collateral to cover the shortfall...". In other words, the Fed would issue a margin call.

Let's follow through a bit..

Assume a bank has collateralized its TAF loan with a five year, 5% AAA-insured CDO. Given current rates (5-year Treasury at 2.83%), this bond would be expected to trade significantly above par - if the AAA-insured rating was, in fact, real. Since the CDO doesn't really trade in the secondary market, the mark-to-model fiction is being maintained through the AAA rating and the Fed takes it as collateral at par (minus the haircut).

Now, if the AAA rating were to be cut down to AA or A in a monoline downgrade, the game would be up. The mark-to-model algorithm would have to take into account the alternative credit insurance market (e.g. CDS prices), resulting in much lower prices for the CDO and thus margin calls from the Fed. Pretty ugly.. But this would only be the beginning of the trouble, because in such a downgrade scenario other dominoes start falling, too.

1. There are many investment pools that can only invest in AAA securities: e.g. many pension, mutual and money market funds. As soon as the AAA ratings are gone they would be forced to sell - imagine the crush at the gates as everyone tries to get out at once.
2. Bank regulatory capital would be affected, since AAA-insured securities have a much smaller reserve requirement than lower-rated ones.

Not to mince words, banks and regulators want the AAA fiction maintained at all costs. But it is fiction, so reality will ultimately catch up. The AMBAC plan (if it comes to fruition) is only a delaying tactic, meant to maintain the fiction long enough for reality to change back to positive, instead of abysmal. Think Dutch boy, finger and dam... The hope is that the credit storm will end before the whole dam collapses and drowns a large number of the financial system population.

Hope dies last, of course, and the delaying plan may yet work - so who am I to question it? It is just that my experience has shown that in matters financial it is best to deal with reality as it exists today, instead of playing Annie (The sun'll come out tomorrow, Bet your bottom dollar that tomorrow there'll be sun!).

Reality is that there is too much debt versus earned income in the US and many other western countries. There aren't any painless ways out of this fix (certainly not monetary ones), and the pain to correct it must be shared by all: investors must accept some capital losses and significantly lower real rates of return going forward, corporations must accept lower profit margins by boosting wages and salaries (i.e. increase earned income for workers), and individuals must realize that low taxes are a thing of the past.

We got into this mess as separate entities - persons, corporations, countries - each selfishly and separately looking to maximize individual gain. The way out must perforce involve commonality in understanding the problem and cohesion in finding solutions.