Real Estate Lender Implosion

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Crisis in Bond Insurance

The nonlinear phase of the adverse feedback loop from financial markets to the real economy was made more tangible on January 18, when the Fitch Rating Agency cut the rating on the insurance unit of Ambac Financial Group from AAA to double AA. The seemingly modest downgrade--laughable since markets are pricing Ambac's paper as junk bonds--has potentially devastating effects for financial markets. Ambac is--along with MBIA and several other firms--a bond insurer that in effect sells credit rating boosts to municipalities and other weaker borrowers by guaranteeing to pay principal and interest on their loans. If the mortgage insurer loses its AAA rating, so too do its insurees, whose liabilities, held as assets by banks, investment banks, and pension funds, must then be written down in value. The bond insurers have "insured" about $2.3 trillion, approximately $1.3 trillion of which is tied to municipal debt issues and $1 billion of which is tied to structured finance exposure in the form of complex derivative securities.

Markets have been deeply concerned about the mortgage insurers since last summer when, for example, Ambac's shares were valued at about $90 each. The first wave of market turmoil that emerged in August took the shares down by about 30 percent to just over $60 per share. During the last half of October, Ambac shares fell more sharply, by about 60 percent to about $25--a move that coincided with the start of a weaker stock market. Between late December and January 18, Ambac shares collapsed yet again, falling another 75 percent in value. Much of the last drop--from $21 per share to $6.20 per share--occurred between January 16 and 18, signaling a crisis for Ambac and other bond insurers whose shares moved down in tandem with Ambac's. The price declines were tied to the actual reduction in Ambac's rating and the expected reduction in MBIA's rating.

Tamara Kravec, an analyst at Banc of America Securities, wrote on January 18: "The destruction of the bond insurers would likely bring write-downs at major banks and financial institutions that would put current write-downs to shame."[4]

The new crisis initiated by the near-collapse of bond insurers adds to the threat of an accelerating, adverse feedback loop from the financial sector to the real economy. Global equity markets fell by more than 5 percent on January 21 after news spread of the possible collapse of U.S. mortgage insurers. Such an exacerbation of downward momentum in financial markets and the real economy threatens to produce a recession far more severe and protracted than is currently expected or priced into asset markets. Investor risk appetite would be sharply curtailed and liquidity preference would be sharply elevated by the emergence of a nonlinear, adverse feedback loop.

The process whereby an endogenous cycle of risk appetite of investors, households, and businesses exacerbates the cyclical movements in financial markets and the real economy has been explored in academic literature. At a recent Philadelphia Federal Reserve Policy Forum, John Geanakoplos of Yale University made a presentation entitled "The Leverage Cycle," which explored how endogenous flights to liquidity during periods of enhanced market volatility can intensify cyclical behavior. While this brief characterization does not do full justice to the innovative work by Geanakoplos or other authors working in the field, the fact that signs of risk aversion are emerging rapidly in the financial sector, despite substantial efforts by the Fed to ease liquidity conditions, suggests that the economy and financial markets in the United States, and perhaps globally, are exposed to the risk of enhanced volatility.

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Bond insurer charts (ACAH ABK MBI SCA) ... #msg-26226667