Last Summer's Missed Opportunity

Posted by: Matthew Goldstein on January 29

With the Obama administration busy working on a new plan for bailing out the nation’s crumbling banking system, one can only wonder whether government policy makers missed an opportunity nearly a year ago to mitigate the damage from the financial crisis.

Flash back to a year ago February, before Bear Stearns collapsed into the waiting arms of JPMorgan Chase, when there was a lot of talk about bailing out the bond insurers—also known on Wall Street as the monolines. Former New York State Governor Eliot Spitzer was in the news almost every day it seemed, warning that the weakened state of bond insurers like MBIA and Ambac posed a big threat to the financial system. Then Spitzer shot himself in the foot by getting caught-up in a dalliance with a high-priced call girl and disappeared from the scene.

Almost as quickly, the problems facing the bond insurers receded as a pressing issue. There was a lot less urgent talk about the bond insurers and their need to raise fresh capital in order to avoid painful ratings downgrades. In fact, in the weeks immediately following the collapse of Bear, there was a false sense of security that the worst of the financial crisis was over. Of course, Lehman Brothers bankruptcy filing on Sept. 15 and the subsequent budget-busting government bailouts of AIG, Citigroup and Bank of America have rendered that little bit of optimism a distant memory.

But what if government officials had moved boldly following Bear’s collapse and nationalized the major bond insurers? A takeover of the bond insurers might have enabled the government to inject fresh capital into the firms and bolster their balance sheets. The government then could have put in a place a system that would have permitted the banks to take more orderly write-downs on the hundreds of billions of dollars in rotting securities that still clog their investment portfolios.

How would that have helped? The bond insurers, through the sale of credit default swaps, fueled the explosive growth of collateralized debt obligations, by permitting banks to theoretically hedge away their exposure to these and other exotic asset-backed securities. But the hedges were something of a charade. As CDOs kept plunging in value, the banks were forced to take bigger and bigger write-downs because the ability of the bond insurers to ultimately make good on those CDS contracts was seen as being in jeopardy. The monolines were exposed as being something of a paper tiger.

Sure, nationalization would have been controversial. And it would have generated a howl of protest from executives at the insurers, shareholders and free-market advocates. Yet if the government had taken over the monolines and gradually wound them down, it might have saved the nation’s banking system from a lot of the current turmoil and reduced the need for the government to spend upwards of $1 trillion to bail the banks out. The banks would still be feeling the pain from the recession, but at least one big headache may have been taken care.

Even today, some think the government still might be better off bolstering the bond insurers rather than doling out tens of billions of dollars in a bank by bank rescue plan. Risk management consultant Leslie Rahl, president of consulting firm Capital Market Risk Advisors, says if the government recapitalized the bond insurers and allowed them to regain their Triple A credit ratings, it might provide the biggest bang for the buck. That’s because it would enable a slew of banks that had purchased CDS, or bond insurance, to avoid taking future write-downs on the deterioration in the underlying insured assets. “On a pure dollar for dollar basis you may get more bang by propping up the monolines because you get a multiplier effect,’’ says Rahl.

All of this begs the question, of whether government policy makers could have done more during the summer of 2008 to stave-off the current financial crisis that has caused so much pain around the world.

Reader Comments

richard carter

January 29, 2009 03:46 PM

The subject of avoiding this catastrophe should fall on the subject of the subprime housing market which was the first domino in this whole mess. As it was becoming obvious that too many people had been put into mortgage vehicles that were basically unafforable the solution would have been for the government to mandate that the original terms of the loans would continue for five years or roll over into a new 30 year note at market rates. This would have given the industry and the government time to orderly and slowly deal with this crisis. This and similar options were proposed, but the banks and investment groups balked and were afraid they would lose profits. The funny thing is if they had not stood in the way they could have unrolled these bad investment instruments in an orderly fashion and stayed in business. Their greed is the only thing that stood in the way and without that first domino falling most of us would still have jobs.

R

January 29, 2009 11:12 PM

Did Spitzer pay you guys? You actually believe that this crisis could have been prevented as late as summer 2007? come on wake up (assuming u r not on Spitzer's payrolls)

JJH

January 30, 2009 10:00 AM

The monolines ABK and MBIA are too small to have had the kind of effect you describe. AIG is the entity that was big enough and AIG has been, in fact, pretty much nationalized at this point, call it what you will.

No questions have been "begged" - I have not stopped shooting the STOP sign because I never did in the first place!

All the best!

Thank you for your interest. This blog is no longer active.

 

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BusinessWeek's Adrienne Carter, Jessica Silver-Greenberg, and David Henry deconstruct the mysteries of high finance, Wall Street, and hedge funds for pros and ordinary investors. E-mail them directly if you've got tips about big deals, a hedge fund, or even securities industry gossip.

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