Why monoline insurers are so important
Feb 3rd 2008
From Economist.com
ACRES of newsprint and countless hours of research have been devoted to wondering where the Federal Reserve will next move interest rates. But over the last week or two, the Fed has not been the most important factor in moving the markets.
On January 30th, the Fed cut interest rates by half a percentage point, as many (but far from all) economists had predicted. The American equity market duly rallied, but by day's end, the Dow Jones Industrial Average was down, as investors reacted with concern to a downgrade of FGIC, a bond insurer.
The really big gain occurred on January 31st, when MBIA, another bond insurer, said it was confident of retaining its AAA rating. The Dow rose more than 200 points, having been 250 points down earlier in the day. Sentiment was boosted again on February 1st when CNBC, a TV channel, reported that eight banks were putting together a consortium to rescue the insurers.
Why are bond insurers so important? Because their failure would represent another lurch down in the credit crunch. The original business of the insurers, usually referred to as “monolines”, was to lend their names to bonds issued by municipal authorities (American state and local governments). The municipals were not strong enough by themselves to qualify for an AAA rating; the backing of the monolines reduced their borrowing costs. And since municipal bonds very rarely defaulted, everyone was happy.
Had they stuck to insuring municipals, there would be no problem. But a predictable and safe business always brings pressure to diversify, especially for quoted companies. The monolines moved into insuring collateralised-debt obligations (portfolios of bonds that are sliced and diced into tranches bearing different risk), and that got them caught in the subprime crisis.
Insurers have had to take writedowns on their subprime portfolios, which has threatened their AAA rating, and consequently their entire business. They depend on being able to lend their star rating to others. The danger to the markets is that other bonds are depending on the insurers. If the insurers get derated (or worse still, go bust), the value of those bonds will fall. Indeed, there could be a vicious spiral, since some investors are only allowed to own AAA-rated bonds; they will be forced sellers.
The effect could be huge. Gary Vaughan-Smith, a fund-of-hedge-funds manager at Silver Street Capital, says this is the "big negative event" overhanging the credit markets; he reckons that $3.5 trillion in bonds have been insured. One insurer, ACA Capital, is already in deep trouble and Merrill Lynch has taken a $1.9 billion hit as a result; the full effect on banks could be as much as $10 billion.
But we just don’t know, which is why the markets are so sensitive to this news. In the worst case, it is easy to imagine the banks taking a lot more write-offs. That would lead them to restrict lending to companies and consumers, making the economic situation look even more perilous. And, as the latest non-farm payroll data shows, the American economy is already flirting with (if not already in) recession.
This explains the enthusiasm for a rescue plan. Mr Vaughan-Smith expects banks that run the numbers to find an equity injection will work out cheaper than taking a hit to their broader bond positions. Nevertheless, there will be a degree of irony if banks, which have just been begging for capital from sovereign-wealth funds, have to instantly turn from damsels in distress to knights in shining armour.
