Bond Insurers: The Next Nightmare?

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Alex Grimm / Reuters

Global financial chaos brings about new vocabulary

There's nothing like global financial chaos for enriching the vocabulary. Few realized what sub-prime really meant until a U.S. mortgage market went pop last year. These days it's a byword for bad news everywhere. And who knew those collateralized debt obligations could be such a smack in the chops? But it's time for a new word. One that's no less mean or mysterious. Try the new bad term on the street: monolines.

Here's an example of good, modern usage. A monoline insurer is in the business of insuring bonds, offering investors a way of recouping their cash should their bonds turn sour. For most of the past 30 years, that's meant backing relatively safe bets: rock-solid bonds, for example, issued by municipal governments in the U.S. to help put up new schools or hospitals. But recently, the monolines have upped the ante. Lured by the prospect of greater rewards (though surely not the greater risk), they've taken to guaranteeing debt backed up by fancy new financial products engineered on Wall Street, not Main Street. Caught up in the collapse of the subprime market, the value of many of those products has dived. So for the investors left exposed, monolines are the backstop.

Right now, that's an expensive place to be. New York-based Ambac and MBIA, the two largest monoline insurers, each cover roughly $60 billion worth of investments backed by assets caught up in the subprime snafu. That's only about a tenth of their individual portfolios, but enough to give credit rating agencies a clear case of the jitters. Concern that Ambac didn't have enough capital to protect it against losses prompted Fitch, one such agency, to last week downgrade Ambac's rating from AAA to AA. (On Thursday, it also snipped that of Security Capital Assurance, another bond insurer.) Rival agencies Moody's and Standard & Poor's have put both Ambac and MBIA on watch.

For financial markets already in a tailspin, that's a worry. A bond's rating is linked to that of the guarantor, so a downgrade at Ambac gets passed along to all the debt it's underwriting. That could force many investors — the kind, such as pension funds, restricted to only bonds with the top-notch AAA rating — to dump them on the market, pushing down their price and subsequently cranking up those investors' losses. That will add insult to injury: the subprime collapse has already triggered bumper write-downs of some $130 billion.

Keen to avoid even more market mayhem, regulators are urging Wall Street to bail out the bond insurers. (Ambac was last week forced to pull plans to raise $1 billion in fresh equity after its shares went into free fall.) The meeting Wednesday between the New York State Insurance Department and a handful of big banks was enough to rally markets worldwide. But squeezing cash out of institutions with their own money worries won't be easy. "If you're a bank in good shape, with limited exposure to monolines, why do you want to be forced to make a contribution that will help to prop up a competitor that's overdosed on monoline protection?" wonders David Havens, an analyst with UBS in Connecticut. "It's like trying to herd cats together." Shares in Ambac skidded 17% Thursday — and MBIA's fell only slightly less sharply — after New York State Insurance Superintendent Eric Dinallo said any bailout would "take some time to finalize."

One incentive: that failing to intervene carries a much bigger penalty down the line. The $15 billion that banks are reportedly being asked to pony up would amount to nothing like the losses on Wall Street should a major monoline go belly-up. Moreover, that ought to be enough to mobilize more than a few investment banks, says Havens. "I wonder why it's not the states, the cities, pension funds and hedge funds that might also be asked. Everybody's got skin in the game."

In the meantime, fresh capital for the monolines could emerge from elsewhere. Even after launching his own bond insurance business late last year, Warren Buffett has expressed interest in investing in its rivals. And Wilbur Ross, through his eponymous private equity firm, is currently buried in due diligence on unnamed monolines, hoping "to come to conclusions within a period of weeks," Ross says in an e-mail. His motive? "Longer-term, the survivors will have a viable long-term business model," he says. "We have come through a credit environment in which no one was afraid of anything, and are in a period where everyone is afraid of everything. Ultimately this will mean that a real premium attaches to a real AAA versus riskier securities." By then, you'll know exactly what he's talking about.