Today’s financial problems have one benefit: They are helping people learn about financial markets. Just as the breakup of Yugoslavia taught people the difference between Bosnia, Serbia and Croatia, the current market woes are teaching people the differences between “collateralized mortgage obligations,” “structured investment vehicles” and other securities. Recently, the term “monoline insurers” is appearing with increasing frequency.
A monoline insurer is one writing only a single type of insurance contract. In the context of the securities market, it is an insurance company that guarantees the payment of principal and interest on bonds and has no other business.
Such insurers perform a function somewhat like the Federal Deposit Insurance Corp. If you have money in a bank that goes broke, the FDIC will return your money, as long as it is below a ceiling amount.
Deposit insurance was instituted in the 1930s for two reasons. First, it protected depositors from losing their life savings. More importantly, it restored confidence in the banking system. Money flowed back into banks that could then lend to businesses and households, fostering economic growth.
Bond insurance emerged to fill an analogous need. Investors considering a particular bond want to know how safe or risky it is. Rating companies like Moody’s, Standard & Poor’s and Fitch pore over financial statements and monitor business conditions for a fee. Historically, their ratings provided much useful information about different bonds’ risks.
Major corporations borrow large sums by issuing bonds. Their many bondholders thus have a financial interest in monitoring the corporation.
The dollar value of municipal bonds issued by state and local governments is comparatively small.
The cost of monitoring each municipality, thus, is large compared to the amount of money borrowed. Overall, the risks of buying municipal bonds are very low. But no one wants to own the bond that proves an exception to the rule.
Insurance helps solve the problem. There is historical data on which to estimate the probability of loss. Thus, insuring bonds is feasible.
If a municipality pays a small premium to a bond insurer, its bonds are more attractive to potential investors. Even if the highly unexpected happens, those investors know they won’t lose their money. As a result, the issuing municipality can sell the bonds at a lower rate of interest than if they were not insured.
As with deposit insurance, spreading risk allows resources to be used more efficiently. Society as a whole benefits.
Municipal bonds historically were the core business for bond insurers, but they would cover other types of bonds for a price, including various types of the mortgage-backed securities developed in the past two decades.
The analogy seemed sound. Like municipal bonds, no one knew for sure if a particular set of mortgage-backed bonds would ever go into default. But analysts thought they had enough information on the risks that bond insurers willingly wrote policies guaranteeing mortgage-backed securities.
And now, surprise, surprise, it seems they seriously underestimated the risks involved. They insured such large quantities of these bonds, relative to their own capital, that if many go into default, the insurers will be wiped out.
Some insurance companies insure bonds as part of a broad range of services – life, property and casualty and so forth. Because these firms are diversified, losses in one area can be offset by gains in other lines.
The monoline insurers have no other business over which to spread their losses. Ambac and MBIA are two such insurers that will be broke if they have to cover losses on mortgage-backed bonds they insured.
So what? “Into every life a little rain must fall,” you may say. (Ambac’s chief risk officer has resigned, Bloomberg News reported Wednesday.) But there are broader ramifications. Tens of thousands of other bond issues, apparently still safe, enjoy the bond ratings they do precisely because they are insured. If the insurer goes broke, their ratings must drop.
When a bond’s rating drops, financial institutions holding the bond must mark down its value to reflect higher risk. Certain investors like trusts and pension funds are banned from owning bonds below specified rating levels. These funds would be forced to sell their portfolios, further forcing down bond values, triggering new write-downs by other bondholders, and on and on and on.
Warren Buffett’s offer to take over Ambac’s municipal bond business seems generous on the surface, but the municipal line is the only positive component of the firm. Take it away, and there’s not much left.
Regulators are scurrying for ways to keep the monolines afloat, with no clear fix yet. This story is far from over.
© 2008 Edward Lotterman
Chanarambie Consulting, Inc.