Saturday, February 23, 2008



The stock market turned around abruptly yesterday on news that a private bailout was being arranged for Ambac. The experts assure us that Ambac is at the heart of the current financial difficulties we are facing and thus that solving Ambac’s (along with FGIC’s and the other bond insurers’) problems would put us back on the path to nirvana. Hence the rally in stocks on news of the bailout.

Leave aside that this will probably not prove to be an entirely private operation; though details are scarce on the bailout, everyone agrees that New York Eric Dinallo was a major player in the dealing that led to the plan, and the U.S. Treasury was involved, reports say, only to assure that the arrangement involved no taxpayer money. (A realist (er, sorry, a cynic) might add the words “for now” to that prior sentence, but I digress.) What else is wrong with this embryonic bailout plan?

This might be simplistic thinking, but I have long held that if a little more simplistic thinking, rather than the highly sophisticated financial sophistry in which the Wall Street deep thinkers appear to revel, had been employed in the recent past, we might not be in the financial soup in which we are currently swimming. So here goes:

Again, while details are scare, it looks like the deal will involve various banks’, investment banks’, and other financial institutions’ investing $2.5 billion in equity and $500mm in debt in Ambac. Some credible analysts estimate that Wall Street firms could have as much as $40 billion in exposure if the bond insurers endure further downgrades. Note that that $40 billion in losses could result if all the insurers get downgraded. So, in order to adjust for Ambac’s share of the bond insurance market, which I admittedly don’t know, let’s just say that it would take three times as much capital, say $9b, to bail out all the insurers along the lines of the inchoate Ambac plan. That number could be smaller, but probably wouldn’t be much larger.

So, for a $9b investment, the investment banks and other financial denizens can avoid $40 billion in losses. Who wouldn’t do such a deal all day? I understand the concept of leverage at least as well as most people, but wasn’t it leverage, real and notional, that got us into this trouble in the first place? How will a generous dollop of more aggressive leverage save us from a problem that had its origins in excessive leverage? This deal sounds sounds too good to be true from the perspectives of both the banks and the economy as a whole, and, at the risk of again sounding too simplistic in this era of sophistication for the sake of sophistication, it probably is. Yes, I know that the plan supposedly works because it will be sufficient for the rating agencies to restore Ambac’s and its cohorts’ AAA (or Aaa) ratings, but how much acuity have the rating agencies shown of late in these matters? A restructuring that leads to a rating upgrade will only, at best, postpone the problem.

The problems with which we are dealing arose because a lot of people made a lot of foolish financial decisions. In the case immediately at hand, as I’ve said before, debt analysis involves more than asking looking up a rating and/or asking “Is it insured?” In order for whatever vestiges of free enterprise that remain in our economy to function, those who made those poor financial decisions must be allowed to suffer the consequent financial pain. Financial wizardry (Some might say financial black magic.) aimed at avoiding this simplistic reality can only delay, and exacerbate, the damage that our economy will suffer.

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