When I was a corporate and mortgage bond manager, I would have to look through prospectuses, if the bonds weren’t vanilla in nature. There was a division of labor — credit analysts would opine on the likelihood of whether a company was “money good,” and portfolio managers would try to decide relative value, analyze structure issues, and figure out whether the bond fit client needs.

The structure part didn’t come up often, but when it did, you’d have to read through a prospectus between a quarter of an inch to an inch thick. There were rewards to doing that. Sometimes I learned that protections weren’t what they seemed… I remember looking at an Enron privately placed bond, and after looking at the complex structure, asking what would happen if Enron’s stock price fell so hard that they couldn’t issue preferred or common equity to redeem the notes. I was told that Enron was a very successful corporation, and that wouldn’t happen. We didn’t buy the deal, and we let some of our existing Enron bonds mature. The protections might be valuable in a minor crisis, but not in a major one. In a major crisis, they would be the equivalent of unsecured debt.

After Enron blew up (and we took losses on the smaller amount of bonds still held — that’s another story), all Enron-like deals began to founder in the market. Dominion Utilities had a bond, Dominion Fiber Ventures, that was an Enron-like structure. It was only 3% of their capital structure, though, so unlike Enron, it wouldn’t kill them. We quietly bought as much as we could, after I read the prospectus, saw the protections (must issue preferred stock to redeem bonds if downgraded and stock price is below a certain price for so much time), and saw that Dominion guaranteed the debt. Dominion’s stock price did fall below the threshold, and a downgrade might come, so Dominion negotiated with bondholders to redeem the debt. We had a 10%+ gain plus interest in less than a year.

My point here is that protective measures in bonds must be adequate for the size of the issue involved, and must be capable of handling a big crisis to truly be effective. With Dominion, the protections were adequate, with Enron, they weren’t. Protective systems can work when they only have to take care of 3% of the capital structure — they will be inadequate at 50%.

Let me point you to a few other areas where this can be a problem. General American went under when they had ratings triggers on their floating rate GICs, as did ARM Financial. All it took was a downgrade, and when the money market funds exercised their puts, they couldn’t meet the redemptions, and they were insolvent. For GA, it was 25% of their capital structure. Metlife bought them for less than 75% of their net assets, and paid off the claimants. Mutual Benefit died for similar reasons. (I was a small part of trying to eliminate such triggers in property-catastrophe insurance.)

Or consider the financial guarantors. What if many different types of insured debt got into trouble at once? We may be seeing that now. If it’s not enough to see structured products in trouble, what of municipalities with soft real estate markets, like Vallejo? The rating agency models give some benefit to lack of correlation in the business mix, but in a systemic crisis, there is greater correlation. Insured obligations are AAA (or if you speak Moody’s Aaa) so long as the system is not overwhelmed. In normal times financial guarantors are money-spinners. There are few defaults, and nothing that is concentrated.

Or consider the auction rate securities markets, with all of the failed auctions of late. The dealers bought bonds when it was to their advantage, or, at least, not a big disadvantage. But when a tidal wave came, they protected themselves and not their issuers. Municipalities are working to refinance the high cost debt that they now have. The end result is bad but not horrid, but it will lead to steep yields in the long end of the muni curve for a while. (Also student loans and closed-end muni funds…)

Finally, think of the variable rate demand note (obligation/bond) market (Hi, Liz, another good article!). It is similar to the auction rate securities market, except there are banks that guarantee (for a time, sometimes to maturity, but usually for more like a year or two) to repurchase notes at par, so long as the municipality is still solvent, and the guarantor is still solvent, and not severely downgraded. The escape clauses have not been triggered, so now the banks that guaranteed repurchase at par must buy the bonds. What happens if the bank runs out of liquidity to make the purchases? The bonds will trade decidedly below par in most cases, even at the maximum interest rate payable.

I could go on from here, and talk about other protective structures that fail in disaster scenarios (Florida Hurricane Catastrophe Fund?), but you get the idea. Truth is, almost ant protective structure will fail, given a large enough crisis. Strong as the GSEs are, even they could fail in a large enough crisis, though the US government would likely stand behind senior obligations.

The important thing for fixed income investors is to evaluate the level of crisis that any protective structure/covenant might protect against, and how likely that crisis might be. During a period when many aspects of the credit markets are under threat, it’s too late to begin the analysis. Best to analyze when things are calm, and then ask the question, “What if?…”