Greece, Default and Insurable Interests

You'll be reading more in coming weeks about credit-default swaps on Greek debt. The Fed seems to be interested (finally) and the do-nothings on Capitol Hill might decide to pretend they're doing something.

I've been raging over the danger of credit default swaps for years. A credit default swap is an insurance contract, only it doesn't have the word "insurance" in it. Therefore, it's not regulated like insurance. You might enter into a credit default swap against, say, General Motors bonds. If GM defaults on those bonds, the swap pays you the notional amount of the contract. This is a sensible tool if you own $10 million of these bonds. You worry about default, but you don't want to sell the bonds. So, you buy insurance against loss. Same as you do for your house or your car.

However, a central and bedrock principle of the insurance world is that, in order to buy insurance against some calamity, you have to be at risk of that calamity. I can buy insurance against my own house burning down, but I can't buy insurance against yours. This would create a moral hazard, in that I sit around hoping your house burns down. Who knows...if I were a nefarious type, I might even devise sinister methods to increase the odds that your house burns down. I might figure out ways to impede the fire trucks from getting to your house quickly. I cannot buy insurance unless I have an insurable interest.

The requirement of an insurable interest ensures that no more insurance is outstanding than the potential losses from the event. If a storm causes $1 million in damage, no more than $1 million will need to change hands. It would be profoundly destabilizing to have more money change hands than the losses from casualty events. We'd have the equivalent of people out in the streets stopping fire trucks from getting to fires simply so those people could realize a profit. We cannot have a system wherein certain participants hope that bad things happen to other people. Whenever a lot of (wealthy, influential) people hope that something happens, it generally tends to happen.

The existence of this moral hazard, and the need to outlaw it, was figured out hundreds of years ago. Lloyd's of London has had this policy in effect during its nearly 400 year existence. It is not a new notion that requires new concepts of regulation.

Credit default swaps are a end-run around the requirement that one have an insurable interest. Big banks, hedge funds and other speculators at one point ran the outstanding volume of credit default swaps into the trillions of dollars, against mere billions in potential losses. This is because the contracts can be bought by investors who don't even own any of the subject bonds. This no more a tenable outcome in the financial markets as it is in the casualty insurance market.

There is a very simple piece of regulation that will fix this problem: Credit default contracts need to be called what they are: insurance. And insurance can only be purchased by those at risk of the involved loss. It's really a rather simple concept that has served us well for hundreds of years. But, as usual, the lobbyists will fight back and true reform will probably remain elusive.

A Long Hot Summer for Muni Bonds

It all seems too quiet right now...but it's going to heat up. The state and local government budgeting process is going to get rolling soon, and the picture is bleak. The sheer size of the budget gaps faced by cities, counties, school districts and the state itself is downright overwhelming. Articles are already appearing that hint at potential bankruptcy filings.

In the face of this, muni bonds are still trading at very high prices -- meaning very low yields. We were offered some 1-year bonds yesterday at a yield of 0.40%.

As regular readers know, we are tactical investors. That means that we spend a lot of time waiting for opportunities -- opportunities to move into cheap assets or to move out of expensive ones. Right now, muni bonds are expensive...and we are waiting. While we are quite reluctant to get into the predicting game, we do sometimes play the expecting game. And we expect that the mid-summer budget distaster will reach a crescendo at some point and investors will flee muni bonds the way they fled Fannie Mae and Greek bonds.

If that fleeing occurs, we will buy bonds by the fistfull. As we have written before, some muni bonds are genuinely at some risk of default. But, many types of bonds are "money-good" even under a bankruptcy proceeding. Municipal bankruptcies aren't like corporate proceedings...courts don't dissolve the entity, sell the pieces, and distribute the cash to bondholders. School districts, cities and the like can't "go out of business." They don't have "equity" to give to creditors upon a default.

I read a recent rating agency report that confirmed the AAA credit rating on the general obligation bonds of my favorite California small town. This high credit rating is much deserved, and the report touted at some length our town's prudent fiscal management. But, here's the catch: The credit quality of those bonds has almost nothing to do with the town's prudent fiscal management.

The City Council doesn't "appropriate" the bond payments -- fitting them into a budget of many choices. No -- the bond payments come directly off the property tax bills that are printed, mailed and collected by the county tax collector. Should, heaven forbid, our dear town find itself in bankruptcy, the bonds payments will continue to flow from property owners, right on past city hall, and straight to the county's money pool, from where it will be sent to the paying agent for the bonds.

These are the types of bonds that would get beaten down along with other, more risky, types of muni bonds. And we will be standing by in the heat of July ready to fill our portfolios with misunderstood and high-yielding bonds. We saw the same opportunity in late 2008 and we took advantage of it then.