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Bond Insurance Crisis Looms On Wall Street

SINCLAIR STEWART, Globe and Mail Update
January 22, 2008 at 9:38 PM EST

NEW YORK — Ben Bernanke may have temporarily halted a crippling nosedive in global stock markets, but bankers aren't convinced the U.S. Federal Reserve's surprise rate cut Tuesday will address what is emerging as a growing threat to the economy: monoline bond insurers.

Monolines, the latest entry in Wall Street's expanding lexicon of doom, have always operated on the fringes of the financial system. Originally, they made money by guaranteeing bonds for municipalities: They would promise to pay the interest on these bonds if a town or city defaulted on the payments.

Beginning around 2000, however, many of these firms migrated into more complex products, and began insuring securities such as collateralized debt obligations (CDOs), which pool various forms of debt, including subprime mortgages.

Of the $2.4-trillion (U.S.) worth of insurance coverage these companies provide, approximately $125-billion is tied to the faltering home market, according to industry estimates.

This latter piece of business, in particular, has created widespread fear among investors, some of whom believe the monolines could represent the next major land mine for credit markets.

The reasoning is this: Major banks, including Citigroup, UBS, Merrill Lynch and Canadian Imperial Bank of Commerce, among others, have used these firms to hedge against their subprime exposure.

Already these banks have collectively absorbed more than $100-billion in writedowns related to CDOs, and the deteriorating health of monolines could compound that figure substantially. If that happens, the banks may further tighten their grip on capital and slow down lending to consumers.

The concern is that these monolines will be less likely to backstop their guarantees on potential subprime losses if their credit ratings are reduced.

“We don't think it will get us out of the mortgage mess,” Nigel Myer, a financial credit analyst at Dresdner Kleinwort in London, said of the Fed's 0.75-percentage-point cut Tuesday. “It won't solve the monoline problem.”

The largest monolines, Ambac Financial Group Inc. and MBIA Inc., did bounce back sharply in U.S. trading, gaining 29 and 47 per cent respectively. But some market watchers believe that was also due to other factors, including Ambac's acknowledgment that it was looking at “strategic alternatives.”

Ambac reported a $3.3-billion quarterly loss Tuesday, just a few days after Fitch Ratings downgraded its triple-A status. Standard & Poor's and Moody's Investors Services have placed both Ambac and MBIA on credit watch with negative implications, while a smaller insurer, ACA Capital, has lost its A rating, and is now struggling to stay afloat after losing almost all of its market value. CIBC has already taken a $2-billion writeoff to cover its exposure to ACA, and Merrill Lynch took a $1.9-billion charge.

“This rate move should not be bad for credit, given that it will eventually ease any funding burden and hopefully support the growth outlook,” Société Générale credit strategist Suki Mann said in a note to clients. But he added that the markets “also need a plan for the monoline insurers, if only to restore some much needed confidence to the credit markets.”

The New York Department of Insurance took a step in that direction Tuesday, announcing it was drafting new rules that would “redefine the future activities” of monoline insurers. “It is clearly time to develop new rules for the road,” Insurance Superintendent Eric Dinallo said an e-mailed statement Wednesday. “The department is engaged with insurers, banks, financial advisers, credit-rating agencies, other regulators and government officials, and other stakeholders in examining and developing measures to help stabilize the market.”

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