Municipal Bonds: Eisinger's Response to Carney

Jesse Eisinger is of course eternally grateful for my defense of his article against the imprecations of John Carney. But he has more to add:

I'm grateful that John took some time out from reporting on the toilet situation at Merrill Lynch to respond to my piece. Perhaps not surprisingly, I remain unconvinced.

Felix has ably dealt with most of Carney's objections. But I'll add some points to his. For one, I'd like to see the affirmative case for muni bond insurance. If the vast majority of muni bonds are backed by the implicit taxation power of the state - some municipalities cannot even legally default - then why do these bonds need insurance? They don't. End of story.

But let's deal with this magic of the marketplace line of argument. He writes: "If munis were consistently rated too low and the market somehow overlooked this error, there would be huge opportunities for risk-free return in the market." Ah, the miracles that our investing class can work!

Except that the mispricing is small - perhaps 0.2% a year, according to people I've spoken with -- and difficult to arbitrage. If, however, you multiply that by the size of the muni market ($2.5 trillion or so) you get $5 billion in extra annual costs to our taxpayers. That's a pretty big price to pay so that rating agencies don't have to travel all around the country inspecting roads and bridges and bond insurers can make a few bucks.

And in fact, there have been some highly rated, highly levered structured finance vehicles created to take advantage of the situation. Of course, they have gotten into trouble due to the mark-to-market distress in the current muni market.

Finally, I'll add one clarification to his last paragraph, which suggests a misunderstanding of the way the rating agencies' business works. The agencies explicitly say that there is ratings equivalence between corporates, sovereigns and structured finance. So a Triple A rating across all three is supposed to reflect the same default and/or loss assumptions. Munis, however, are rated on a separate scale. (Though, of course, the object is the same: to rate the chances for default and loss. That's the only reason a rating should be different, so I'm not sure what Carney is referring to when he worries that mapping to a corporate ratings scale would "[obscure] differences in the risks of different municipalities.")

So why are there two different scales? Why did Moody's do all that work over ten years to come up with the muni/corporate ratings equivalence and not move munis onto the regular scale? When I asked Moody's they said that the market likes to have fine distinctions in their muni ratings. Ok, so why does muni bond insurance need to exist, which makes every insured bond Triple A? Because, Moody's told me, the market likes the "commoditization" in the ratings that bond insurance brings. Hmmm. So which is it?

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