BOND INSURANCE….Last night I was reading a story in the Wall Street Journal about the travails of “struggling bond insurer” ACA, and although the basic story was one I’d read about before, it got me thinking that I didn’t really understand why there was any such thing as bond insurance to begin with. After all, the whole point of rating bonds in the first place is to price the risk of default into the bond itself. I suppose insurance could make sense in a case where a party was buying only one bond and genuinely needed protection against a catastrophic event, but anyone with a portfolio of bonds — investment banks, say — simply wouldn’t need it. Their risk would be diversified enough that no single default would be disastrous, and the overall default rate of their portfolio would already be reflected in the prices they paid for the individual bonds.
But the credit default swap market amounts to $45 trillion, according to the Journal. So what gives? I guess this paragraph tells the story:
Investment banks paid ACA annual fees for bearing the risk in their debt securities. This shielded them from the impact of market-price fluctuations, so the banks didn’t have to reflect such fluctuations in their earnings reports.
In addition, a low-rated bond insured by an A-rated insurance company suddenly becomes A-rated itself. Wrap all this stuff into CDOs and other structured finance vehicles, and before long everything is A-rated and off the earnings report. Prizes for everyone!
The swap market got so big because lots of people who didn’t own any bonds themselves were buying and selling swaps for other people’s bonds purely as a form of gambling on interest rates and other derivatives. However, apparently the prime motivation for the ur-swaps was to allow creative CFOs to play games with their balance sheets. Somehow, this stuff always seems to get back to unregulated bright boys in their unregulated back rooms, doesn’t it?