After noting the distinction between pro forma and GAAP earnings in a Tuesday post, we ran across "Death of a Bond Insurer," in which BusinessWeek's David Henry and Matthew Goldstein shed some light on the role of accounting rules in the bond insurance business. Read it if you dare:
Here's another secret behind the mortgage mess: It turns out that Wall Street generally didn't buy insurance on subprime bonds to protect against default. Instead, many big banks used the policies to play one set of accounting rules against another.
Why would banks buy insurance on AAA securities, especially from ACA, which had only an A rating? That would be akin to homeowners at the top of the hill purchasing flood insurance from a company at the side of a river. If a flood did happen, the insurer wouldn't be around to pay any claims.
The explanation lies in the complexities of accounting rules. Both banks and insurance companies report earnings to investors under what's known as generally accepted accounting principles (GAAP). But insurers also follow another set of guidelines, used by state insurance regulators and applied in key areas by credit-rating agencies.
In the case of CDO insurance--technically called credit default swaps--part of the appeal lies in the differences between the two accounting regimes. GAAP tends to require companies to value securities at prices in the market. Under those so-called mark-to-market rules, banks have to report losses on the investments each quarter even if they're only on paper. Insurance rules, by comparison, make firms only declare losses if it looks as if the bond is permanently damaged and they'll have to pay a claim.
Insurance turned out to be a sort of accounting arbitrage, allowing banks to take advantage of that different set of rules. By using it, they could offload the price risk to insurers' books to avoid suffering a hit to earnings if the bonds dropped in value. "Bond insurance was an accounting strategy," says former ACA chief Satz, now the founder of an online startup called BarterQuest. "It reduced banks' mark-to-market worries."
Welcome to the brave new world of structured finance.
David Henry and Matthew Goldstein, "Death of a Bond Insurer," BusinessWeek, April 3, 2008