This has been a crisis of risk in unexpected places. Think of collateralised-debt obligations (CDOs), structured investment vehicles (SIVs), and now a £4.9 billion ($7.1 billion) loss due to fraud at Société Générale. One particular nastiness has been festering in an obscure industry which, until recently, enjoyed pristine credit ratings: the “monoline” bond insurers. Their plummeting fortunes helped to spark the stock-market sell-off that prompted the Federal Reserve to act this week ahead of its scheduled meeting.
So perturbing was their plight that the prospect of a rescue caused a far bigger stock-market rally than the Fed’s biggest rate cut in a quarter of a century the day before. There may be no better example of how a dull province of finance, when snared by complex risks it barely understands, can become terrifyingly unboring.
Though themselves no giants, monolines have guaranteed a whopping $2.4 trillion of outstanding debt. The two largest, MBIA and Ambac, cut their teeth “wrapping” municipal bonds, in effect, renting their AAA rating to the securities for a fee. For a long time this business, though staid, was nicely profitable.
But, as competition grew, the monolines — with two honourable exceptions, FSA and Assured Guaranty — were seduced by the higher returns of structured finance, especially the stuff involving subprime mortgages. As mortgage delinquencies rose, so did paper losses. Ambac and MBIA wrote assets down by a combined $8.5 billion in the past quarter.
The monolines’ thin capital cushions, adequate when they wrote only safe municipal business, now look worryingly threadbare. Moody’s and Standard & Poor’s—the very rating agencies the monolines relied so heavily upon when piling into the mortgage business—are threatening downgrades unless they raise more equity. Ambac’s failure to do so last week prompted Fitch, another rating agency, to cut its debt by two notches, to AA.
This has spooked investors for several reasons. First, heavily downgraded insurers would lose their raison d’être and thus face the prospect of selling up or going into “run-off”: closing to new business and gradually winding down.
Worse, from a systemic point of view, when a monoline is downgraded all of the paper it has insured must be downgraded too. Hence, after its move against Ambac, Fitch went on to cut no fewer than 137,500 bonds (including one issued by Arsenal football club).
This is more than academic: holders of downgraded bonds have to mark them down under “fair value” accounting rules. Some, such as pension funds, may hold only the highest-grade securities, raising the prospect of forced sales. And, with fewer top-notch insurers to turn to, bond issuers’ costs would rise. The loss of the AAA badge would cost investors and borrowers up to $200 billion, reckons Bloomberg, a financial-information firm.
Banks that were active in asset-backed markets have multiple reasons to worry. Many not only used monolines to wrap their products but also bought protection from them through credit-default swaps (CDS). One insurer, ACA, has already had problems paying out, prompting Merrill Lynch to write down its exposure to the firm by $1.9 billion. Meredith Whitney of Oppenheimer has calculated that banks may have to write off $10.1 billion of the paper they insured with ACA.