Bond Insurers: The Monster in the Closet

For months the world's financial markets have been roiled by the subprime mortgage contagion. According the implode-o-meter, 225 major U.S. lending operations have become insolvent, since the subprime crisis began. There has been a definite nervousness permeating the markets since the summer of 2007.

In an attempt to stem the tide of fear that has been washing over the markets, the U.S. Federal Reserve has been steadily cutting interest rates. Just eight days after an emergency 75 basis point easing, the Fed announced another 50 basis point cut. The markets rejoiced, the Dow blasted off to a triple digit gain, and then it gave all the gains back, and finished the day 37 points in the red. By the end of the trading day fear had re-established itself.

There have been many economic bogeymen stalking the markets since the summer of 2007: subprime mortgages, collateralized debt obligations (CDOs), and a rogue French trader to name just a few. One particularly nasty monster has been lurking in an obscure corner of the financial world's closet - the bond insurance industry.

Bond insurance is like any other insurance, the bond insurer promises to pay the owners of the bonds in the event of a default. Bond insurers guarantee about $ 2.4 trillion of investment grade paper around the globe.

For years, bonds were a pretty safe middle of the road investment, and insuring them was not a risky undertaking. As with most investments low risk equates to low profits.

In an effort to boost profits, bond insurers began to guarantee mortgage-backed bonds. Profits soared, but enough wasn't enough, and insurers exposed themselves to bonds backed by collateralized debt obligations (CDOs).

The growing fallout from defaulting subprime mortgages has triggered fears that mortgage backed bond defaults will rise. And rise they have. The two largest bond insurers, Ambac (ABK) and MBIA (MBI), wrote assets down by a combined $8.4 billion in the last quarter. This has caused credit rating agencies to begin downgrading many bond insurers, including Ambac, which has recently lost its coveted AAA credit rating.

Why are investors so freaked out by credit rating downgrades for the bond insurers? It's quite simple really. Bond insurers use their AAA credit ratings to allow themselves to guarantee lower rated debt. If the insurers lose their AAA badges, it will be next to impossible for them to gain new business. No new business means no new cash. This is bad news for companies that are busy shoveling out cash to cover bad paper written down by firms like Merrill Lynch (MER) and Citigroup (C).

Another reason that investors fear rating downgrades is that downgrades reduce the value of the bonds guaranteed by the insurer. Anybody holding these bonds, like hedge funds, pension plans, banks, and even Joe Retail investor would see their portfolios take a hit. According to Bloomberg, the loss of the AAA credit rating could cost investors $200 billion.

The credit rating downgrade is a systemic problem. Most pension funds are only permitted to hold only the highest rated securities. If securities receive a lower grade many pension funds will be forced to sell those securities. Anybody who's been in the market the last six months knows what happens to the value of a security in a mass sell-off.

According to most financial journals, and engineers of high finance, it's too soon to push the panic button. Bails out plans are in the works. New York's insurance regulator has asked a group of banks to buck up $15 billion to shore up Ambac and MBIA's credit ratings. Yes, it would seem it's time to circle the wagons, or cash strapped banks, if you like.

Will the banks come to the rescue? I'm sure they would love to, as they hold $ billions of the very bonds that will see significant write-downs if the insurers credit ratings are downgraded. Do they have the cash to bail out the bond insurers? I don't know.

I do know that when I go to sleep tonight on my bullion stuffed mattress, I will be keeping one eye on the monster in the closet.

Comments

[staceylaliberte]

Not sure if my timing on this article was good or bad. the markets blasted off on the news that Warren Buffet plans to bail out the bond insurers. Tomorrow may be a different story for the markets, once investors digest what Mr. Buffets offer actually entails. Mr. Buffet only wants to back their municipal bond portfolios, and not the mortgage backed toxic portfolios.Municipal bonds are not where the problem lies. The offer wont do anything to back up the bond insurers high risk debt. The offer has been rejected by at least one insurer. If this offer isn't accepted the credit rating agencies will eventually have to pull the AAA rating from some insurers.