For several weeks at "A Dash" we have tried to highlight the importance of the bond insurance companies. It is difficult for the market to rally without any strength in financial stocks. Since the financials have insurance (credit default swaps) with the monoline insurers, all of these companies will be forced to take write-downs in various positions if the credit ratings of the insurers is reduced.
Background
This story is mostly about recognizing expertise. Wall Street analysts and pundits are not very good at this. Almost by definition, punditry means having an opinion about everything and getting media exposure.
The Key Expertise. Pundits tend to dismiss any expertise that they personally lack. If this related to repairing their car or a home appliance, they would quickly be proven wrong (as we were when trying to do these things on our own!) When it comes to government action in solving problems, the Street Pundits are just as ineffective, but the proof takes longer.
These are the main problems:
- Pundits and media do not have public policy experts on their staff. As a result, they rely upon many commentators with an agenda -- a pre-conceived market opinion.
- Pundits talk about what they believe government should do, a normative approach. We believe that they should instead look at the motivations and missions of the various government actors, an empirical approach. This would have helped them do a better job of predicting behavior: why the Fed took aggressive action, why political actors with disparate views came together to pass a stimulus package, and why insurance commissioners worked to create a package to help the bond insurers.
- Pundits get attention for problems, and much less for solutions. This has contributed to an overwhelming media blitz on issues -- something that has lasted for months.
- Pundits expect fast and comprehensive solutions. That is not the way government works, but it does not mean that public policy will fail. There is no concept that is more important to the investor.
Here is the question for a thoughtful investor. Does your chosen pundit have the relevant expertise? If a scientist on stem cells told you that a plan would not work, that would have meaning. If a physicist challenged the cold fusion concept, you might well listen. When economists opine on the effects of fiscal stimulus, we should listen.
When someone with absolutely no experience in a field tells you that intelligent people, spending their careers on the subject, have no clue -- well, that is time to see a red flag.
Bond Insurer Examples
The key concept for bond insurers is the systemic effect. If the credit ratings for a couple of companies decline, there is another round of write-downs triggered by FAS 157. We have written extensively, and with little notice, on this subject. This is a well-intentioned policy that has an unintended consequence. Securities that trade in highly illiquid markets must be marked to these prices. Securities marked to a model, no matter how strong or relevant the model might be, are viewed with suspicion--more write-downs expected. We are delighted to note that Doug Kass has also noted this issue, suggesting, after careful analysis, the following:
If my observations are correct, a mistaken pricing of debt is serving to constrain bank lending, slow the economy and has produced artificially low stock prices (especially of a financial sector-kind) as investors could be overreacting to the huge financial writedowns at some of the world's largest financial institutions.
These are complex issues. Individual investors and traders alike look to major journalists to highlight what is relevant. Here are two examples from mainstream media bloggers whom we respect and read throughout the day.
Colin Barr at Fortune's Daily Briefing told us on Friday that the bailout plan would dilute investors at the bond insurers. Today's afternoon article pointed out the stakes for other companies, while mentioning the effect on other financial stocks. We agree with everything written, but it is, somehow, unsatisfying. The big story was not the effect on these two companies, but the implication for the market.
David Gaffen chose to highlight a collection of the usual suspects. He quotes Jim Bianco, “If the fate of the financial system only needs $3 billion to get ‘fixed,’ why did it take eight banks a month to negotiate coughing up $300 million each?”
There is an answer to this, the subject of a future article. Simply put, it is a collective action problem, a classic situation calling for government involvement. It is a somewhat difficult problem because each stakeholder has a different level of interest, and the various insurers have different relationships with the stakeholder. The government agency is acting to protect the policy holders -- those who purchased the credit default swaps-- but it is tricky since they were parties to creating these opaque instruments. Bianco -- a savvy guy who does a lot of great work -- has unrealistic expectations for the speed of the solution.
Gaffen next talks about the notional exposure of the bond insurers. This is simply not fair. No insurance company has assets matching the entire notional exposure of what they insure. It is misleading to make these comparisons. The bond insurers must pony up the stream of payments, not cover the entire notional amount. If the underlying concept is sound, covering the stream of payments is enough.
So what about the underlying risk? On this point Gaffen quotes Michael Shedlock as follows:
“Oh sure, the market may rally a bit, especially if Moody’s, Fitch, and the S&P keep their collective heads buried in the sand and reaffirm the AAA ratings on a mere $2 billion infusion, but long term the problem cannot go away until the entire package of CDOs guaranteed by the monolines is properly marked to market at a value close to zero,” writes Mike Shedlock of Sitka Pacific Capital, on his blog.
We are very curious about why David Gaffen thinks that Shedlock knows more about bond ratings than the experts at the various agencies. The average reader assumes that David Gaffen makes a judgment about his sources. We would enjoy his work even more if the range of sources quoted showed more discernment and balance. For now, let us leave it at that.
Conclusion
Any intelligent investor, reading the principal mainstream sources and the most popular investment blogs would have been scared silly on Thursday. If this issue were not enough, investors could worry about alleged "stagflation", our next subject for analysis.
Meanwhile, we have been trying to highlight the various fundamental and technical signals, as we did last Thursday.
Investors who got on board in the last hour of trading Friday enjoyed some major returns, highlighted by Bespoke Investment Group. These are the stocks that have been depressed by the bond insurer obsession.
Bespoke has shown a game plan for investors. We think that there is still plenty of time. In a market with low forward P/E ratios, one should not worry about missing a single leg up, even a really good one.
