by Jerome a Paris
Mon Jan 21st, 2008 at 09:32:48 AM EST
European markets are down sharply this morning, after a similarly dismal day in Asia, reflecting worries about the now-acknowledged-as-inevitable US recession, and more specific fears about the banking sector.
In particular, the dire situation of the monoline insurers is a particular worry. Monoline insurers are specialised insurers which focus on narrow sectors of the financial world: initially created to carry the residual risk on US municipal bonds (debt raised by local public authorities), they have extended that same function to a few other markets, including asset-backed securities.
Yes, the infamous asset-backed securities.
The very ones at the center of the storm in the financial markets. The category includes in particular the now infamous mortgage-backed securities, which are now understood to be backed to a surprisingly large extent by impossible-to-repay "toxic sludge" - subprime and other mortgages provided to borrowers who could never afford them, used to buy houses at inflated prices that are now collapsing.
Unsurprisingly, the monolines are now in trouble.
Theor core business is, at heart, quite simple: they take the risk on the underlying debt (the payment risk on the relevant municipality, or on the asset-backed securities) via a guarantee to pay that debt to the bondholders who purchase it. The guaranteed bonds are of course paying out less interest than if they were not guaranteed, and the monoline takes a fee on the difference - but not the whole difference, which makes the product attractive to municipalities and other borrowers. The "wrapped" (or guaranteed) bonds are usually rated "AAA", ie the safest possible, thanks to the rating of the monoline insurer itself, which is structured to be an ultra-safe institution. The underlying bonds would themselves be investment grade (ie in the better half of rated paper), but less well rated and thus less attractive to whole swathes of investors. The fact that the monolines do not need to fund their risk taking, and the specific risk profiles they seek in the underlying transactions, is what makes it possible for their guarantee to be cheaper.
Investors get ultra-safe paper. Municipalities (and others) borrow cheaper than they otherwise could. Monolines earn money. A wonderful win-win-win. Until...
Municipal bonds are still seen as safe, so the problem is not there; it's, of course, the exposure to ABSs that is threatening the monolines today, as the underlying risks they are guaranteeing appear to be a lot worse than initially assessed. Whether this was caused by faulty ratings of the underlying paper by rating agencies, or by insufficient risk analysis by monolines, remains to be seen. Faced with that now visible exposure to bad risks, monoline insurers are being asked to build up their capital and reserves if they want to keep their coveted "AAA" rating which allows them to provide the coveted guarantees.
AMBAC, the largest of the monolines, was downgraded this week-end by Fitch, the smallest of the 3 rating agencies (Moody's and S&P are widely expect to follow suite soon), after it emerged that its proposed capital-raising plan would not be seen as sufficient and was cancelled. This means that:
- AMBAC can no longer do any business; clients that were looking to enhance their bonds through them can no longer do so, and will see their borrowing costs increase;
- even worse, all bonds which are already guaranteed by AMBAC will now lose their own AAA rating, which means that all the investors that need to hold a given proportion of such highly rated paper (and there are a lot of them) are going to need to sell that paper, which no longer fits in their portfolio. This could cause a massive drop in their price if they all sell at the same time, losses for many institutions, and more chaos in the financial system.
And there's close to a trillion dollars of such paper around. We're looking at the mother of all financial stampedes here, if and when the monoline insurers are downgraded by the two big rating agencies...
The market panic in this context is quite rational.