A little 'magic' won't fix debt insurers

By Bill Fleckenstein

Lately, there's been no shortage of chatter about one particular casualty of the credit bubble, the monoline insurers. As the news goes, they'll be split up into bad company/good company entities, and this "magic wand" will save the day.

It will not, for a reason best articulated by a reader of my daily column:

"What people really don't understand is that a Bad Co. and Good Co. solution is only a partial solution. This Reuters article is a perfect example. . . . An AAA Good Co. would solve most problems as they pertain to the municipal bond market.

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"What people overlook is that there also has to be an AAA rated Bad Co. Bad Co. is the gigantic pink elephant in the room that everyone either ignores or fails to recognize. Bad Co. is effectively the credit enhancement insurance company of the Pandora's Box of the financial community. Who in their right mind would put capital in that, given what is now known?

"Think about it. If all the stuff covered by 'mark to make believe' accounting loses its accounting treatment because it is no longer AAA rated, is there really going to be anyone around left to sue? Will there even be a banking system? I wish I was joking. It will take a printing press to capitalize Bad Co. to afford it a AAA rating."

For those who'd like to understand another facet of the complicated puzzle that they might not already be familiar with, please see a Feb. 17 New York Times story titled "Arcane Market Is Next to Face Big Credit Test." Gretchen Morgenson did herself proud in this comprehensive examination of some potential horrors that may befall the credit-default-swap market. She noted that documentation in this $45 trillion market appears to be somewhat optional.

As recently as December, 13% of the trades there were unconfirmed, which means, as Morgenson wrote: "One of the parties in the resale transaction was unidentified in trade documents and remained unknown 30 days later."

The gloom surrounding a swap with whom

That's a problem in and of itself, but it's compounded by the fact that these contracts are sometimes sold to others. "The original buyer may not know that a new, potentially weaker entity has taken over the obligation to pay the claim," Morgenson wrote. Consequently, when "investors who have purchased such swaps try to cash them in, they may have trouble tracking down who is supposed to pay their claim."

Of course, even if investors can find the new buyer, he may not be able to pay the claim. Furthermore, the credit-default-swap market may be affected if the good-company/bad-company idea were to be implemented, because splitting a company into two may affect the contract itself. According to a knowledgeable friend I call the "Lord of the Dark Matter," we may be on the verge of the biggest document failure ever. In some cases, there will be nothing on the other side.

As badly as everyone wants a simple solution to make all the problems go away -- so we can return to that much-beloved Goldilocks fantasy -- there is no magic fix to transport us to a place we, in fact, never were. Perhaps folks will sober up to this after the first-quarter-earnings period, when companies disclose (a) problems on their balance sheets, left in the wake of the credit debacle, and (b) problems on their income statements, caused by an economy weakened by the debacle's aftermath.

The Fed's credibility rating

This incredible disaster has been created by the Federal Reserve, which for the past 25 years has targeted interest rates under the ill-conceived belief that it could know the right interest rate to pick.

One good thing that may come out of this approaching debacle is that the Fed may be thoroughly discredited. If so, we will all be better off.