Bailing Out Bond Insurers: It’s Big, Really Big
Today’s dramatic market turnaround was due largely to the leaks, rumors, and eventual news stories about a meeting convened by New York Insurance Department Superintendent Eric Dinallo. Wisconsin, which has a very active insurance industry, was also represented by Commissioner Sean Dilweg.
Some vague early stories dribbled out from hard news agencies with a stronger Bloomberg story a bit later. Subscribers to RealMoney Silver could have paid for their subscription by following the Doug Kass commentary, which came out in time to catch about 40 points in the S&P.
Why So Important?
To appreciate the news, one has to realize that many of the media explanations for early selling were wrong. The talking heads were speculating about the Fed and the meaning of the inter-meeting rate cut. The real problem was an expanding concern about the companies insuring bonds. If these companies fail, the credit ratings of many bonds are imperiled, and we get another round of write-downs from financial institutions.
Because this news hit the bulls-eye for market worries, it had an immediate impact.
How to Judge a Bailout
The beauty of the news today is that it requires no government action, and no taxpayer money. It is reminiscent of the Long Term Capital Management rescue, where the New York Fed provided a meeting room for the financial firms most affected. After discussion, they went around the table and all of the firms (except Bear Stearns) contributed to the rescue. The process, described well by Roger Lowenstein in his book, When Genius Failed: The Rise and Fall of Long-Term Capital Management, did not really save the original investors in the hedge fund, but it rescued the financial system from the falling dominoes that come with counter-party risk in the derivatives market.
Please note the key distinction. Measures that require legislation take time. Those that help financial institutions cooperate work much more quickly.
We expected some kind of action to shore up these insurers, because the stakes are so high. It is a "too big to fail problem." We are surprised (and delighted) by the speed of insurance regulators in taking action. It is part of our viewpoint that a solution to current problems is going to take more than just fiscal stimulus or interest rate cuts. There are several different aspects to the problem, and each requires a solution. This means that many different agencies of government must act.
It is relatively easy for government to take popular steps like tax cuts to many individuals and businesses. We expect such a program, and we think it will help. So will the Fed’s interest cutting moves.
But these are not targeted solutions. The Fed’s TAF approach was targeted, and it has worked well.
What is Still Needed
There are two steps remaining that will be more difficult.
First, we need attention to the jumbo loan market. In many parts of the country housing prices are high enough that average mortgages exceed the $417,000 limit on Fannie and Freddie. The Administration is holding out for a comprehensive reform of the GSE’s before supporting an increase in the limit, something that requires legislation. The House has passed a bill, but the Senate has been very slow. The Washington Post editorial on this subject hits the mark:
Last May, the House of Representatives
passed a bill that would remedy this situation. The legislation would
replace OFHEO with a new, independent Federal Housing Finance Agency,
which would regulate not only Fannie and Freddie but also the 12
regional Federal Home Loan Banks.
The Senate, however, has done exactly nothing since then. Its inaction
has been due in part to differences on other points of the bill between
Republicans and Democrats — and in part to the fact that the Senate
Banking Committee chairman, Christopher J. Dodd (D-Conn.), was pursuing his long-shot presidential campaign. In recent weeks, both President Bush and Rep. Barney Frank
(D-Mass.), who shepherded the House bill, have called on the Senate to
get busy. It’s not often that George W. Bush and Barney Frank agree on
anything. In this case, they are both right.
Second, we need to get some valid pricing and trading in existing debt obligations (CDO’s) which have been marked to market at distressed prices. This may require some buyer of last resort, either governmentally or privately. There is a continuing demand for extra yield, but it needs to be correctly priced and rated accurately by agencies. This was a good idea that was poorly implemented, and it will return. How long will it take?
These two steps are needed for qualified buyers to have access to mortgages, firming up demand for housing, and helping existing borrowers to work out their loans. Some think this process will take several years. We disagree. It will happen more quickly, but it will require more innovative actions of the sort we saw today in the bond insurance market.
Implications for Investors and Traders
The news today coincided with various technical interpretations of testing support and a double bottom. Our own Gong Model finished the day with the hammer cocked — finally! This means that the Gong will ring as stocks recover. The ringing of the Gong is a very unusual and meaningful indicator. It provides an intermediate-term buy signal, suggesting significantly higher prices within a few months.
Today’s news is good enough that potential buyers may see a combination of technical and fundamental factors supporting action. Obviously, many did today. Our view is that this is more than just a "bear market rally" or trading bounce.
Problems remain, but several of the key steps to maintain economic growth have already been taken.