Women and children first

Yesterday's post on talk that two major bond insurers may each split themselves into separate companies -- one covering municipal bonds, the other riskier investments like collateralized debt obligations (CDOs) -- prompted one reader to ask why that would prolong the credit crunch. A good question, since the only reason we even get into stuff like that on InmanBlog is the potential impact on mortgage lending and housing markets.

Picture these big bond insurers as the Titanic. On board as paying passengers you have local governments who need bond insurers to back the municipal bonds they issue to fund big infrastructure projects like sewers and street improvements (and maybe even services, when the going gets tough). Let's call these passengers the women and children.

Also on board are investors who have purchased credit guarantees on CDOs, complicated investments that often contain slices of mortgage-backed securities and other debt. Losses on those CDOs have ripped a long gash in the bow of the Titanic, and unless the investors (including large banks) are willing risk even more resources to plug the leak and pump out the water that's rushing in, the whole ship could go down. We'll call these passengers the men (click "continue reading" for further discussion).

The owners of the Titanic -- and government regulators -- are getting worried that it may be impossible to save everybody. What if, in the event that things get really bad, they could put all the men in the leaky bow of the ship, and the women and children in the stern, and then split the ship in two?

The men could continue trying to repair the damage to the bow, while the women and children could continue sailing on in the undamaged stern (In other words, to step away from this slightly ridiculous analogy for a moment, local governments could continue issuing municipal bonds no matter how bad losses in CDOs get).

Just the threat of doing this could get the men working harder without even splitting the ship in half, because they have a better chance of bailing the water out if the women and children are around to help them man the pumps.

If the ship does get split in two and the bow loses headway or sinks, that's going to have an impact on mortgage lenders ashore, because the investors aboard the Titanic include banks that were counting on bond insurers to cover some of their CDO losses.

Today, Moody's Inevstors Service estimated that banks may have to boost their reserves by as much as $30 billion to cover additional CDO losses should things get ugly for bond insurers (see CNNMoney.com story) That's money that won't be available to make loans.

New York Gov. Eliot Spitzer has toned down his rhetoric about wanting to see the companies split up within days (see Reuters story), but federal lawmakers don't want to be seen as sitting on the sidelines. The House Financial Services Committee has just announced that it will hold hearings on March 5 to see what can be done to protect the ability of cities and states to continue issuing bonds.

“Municipal bonds are among the safest—second only to US Treasuries—in terms of losses to investors, and it will be of particular concern to this committee that they not be punished by the worsening credit market and overall economic picture,” Committee Chairman Barney Frank, D-Mass. said in a statement announcing the hearing.    

Given that declining home prices will put a major dent in many state and local government's tax rolls, all the talk about protecting the "women and children" may be more than posturing.

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