Monoline insurers are entities that (used to) have a single activity (hence the "monoline" moniker): providing guarantees to municipal bonds. Thanks to a difference in regulatory requirements between banks and insurers, they could take the same risk (essentially, credit risk on US municipalities) at a lower price, and that (stable and somewhat unexciting) business developed steadily over the past couple decades. With a relatively small capital base, they could get a AAA rating (the best there is), and turn, via their AAA-guarantee low-risk municipal bonds into ultra-low risk bonds much appreciated by various classes of investors (many of which are obliged by their rules or regulatiosn to invest only in AAA-rated securities). That provide cheap financing for municipalities - and thus to local investment, a stable investment product for long temr investors, and a decent return for the insurers.

But, as i noted, this was somewhat unexciting, and monolines started diversifying into other businesses where they thought the same model could apply. One was asset-backed securities, which were deemed to be low risk (at least for the tranches that got an investment grade rating, but as we know now, these we handed out a bit too exuberantly), and could be turned into AAA-rated paper thansk to the monoline's guarantee. The other was credit default swaps (CDS), another new instrument designed to ensure against default by corporate buyers - in effect another form of financial guarantee, except that it was possible to buy or sell these without even touching the underlying security.

As we know, the asset-backed securities have turned out to be "toxic sludge", ie worth a lot less than they were sold for and, alongside most of the banking world, the monolines have been caught with massive exposure to these and have lost huge amounts of money. In addition, there are now increasing worries about CDSs:

Markets assess the costs of a monoline meltdown

Until recently, the monolines insisted that this structured finance "sideline" was as safe as their main business of guaranteeing municipal bonds. However, in the past year default rates have risen sharply on subprime mortgages, with economists now estimating that as many as one in four of the mortgages written since 2005 will not be repaid - an unprecedented level of non-payment and foreclosure.

These defaults have already triggered more than $120bn (£62bn, €82bn) of writedowns at western banks. However, analysts now calculate that the monolines, too, could eventually face $34bn of losses as insurance contracts are activated. While this estimated hit - if it materialises - should be spread out over many years, it has caused huge alarm given that, in last year's accounts, the monolines only had $48bn of funds on hand with which to pay claims. Indeed, credit rating agencies have already removed the all-important AAA tag from some small monoline groups and are threatening to downgrade the largest companies, most notably Ambac and MBIA.

Red Lights Flash in Credit Nooks
Crunch Now Impinges On Highly Rated Firms As Taint Spreads Out

The global financial squeeze is spreading to investments linked to the corporate-debt market, slamming the value of contracts that provide insurance against defaults and marking one of the first times that the debt of major companies has been affected by the turmoil. (...) In recent days, investors in credit-default swaps, which act as insurance policies against defaults, have grown increasingly gloomy because of worries about the global economy and the possibility of problems in the market.

The losses are tracked by several indexes, which track the cost of buying insurance on bonds issued by 125 big companies. Two of the indexes are at records and have doubled since the start of the year, meaning investors who sold this insurance suffered losses.

(...) Credit-default swap contracts have been written on the equivalent of some $43 trillion in all types of bonds, according to the Bank for International Settlements.

The issue is that the "side businesses" that were meant to provide a bit more pizzazz to the staid municipal bond underwiting activity of the monolines is now about to wipe them out altogether, and is right now endangering their municipal bond activity - and the ability of municipalities to borrow. Last week, panic spread through municipalities as they were completely unable to sell the commercial paper they use to finance their short term needs, on worries that they would no longer be able to find long term finance.

So they have been talks, engineered by Eric Dinallo, the insurance superintendant of the State of New York (and a protégé of Eliot Spitzer), to try to save the monoline insurers. Two ideas are being followed: one would be a bailout of the monolines (effectively, a massive capital injection) by banks to protect their ability to pay on those bonds that are defaulting and maintain their AAA-rating. Banks might be "encouraged" to participate to such a bailout because they hold a lot of securities and CDSs backed by monolines, and they stand to lose yet more billions if those are downgraded. The other idea would be to separate the municipal bond activity from the rest, to protect the ability of the municipalities to finance themselves. That part of the business is still seem as fundamentally sound, so it could keep on functioning as it did in the past But that would leave the rest of the activities of the monolines (pretty much all toxic) - and banks would probably be left holding that bag in any case...

So ther's been a lot of pressure on banks to cough up more funds to save the monolines - both for financial reasons, and via regulatory means (Dinallo has suggested that he could impose the breakup of the monolines), and thus, today's announcement that an agreement might be close was seen as real good news by the markets, as it would help solve one of the biggest problems in the market right now - the uncertainty over the value of all bonds and CDS guaranteed by monolines.

But as bad news continue to trickle out of the financial markets (including totally unrelated, but terribly unnerving losses from rogue traders (Société Générale) or trading valuation mistakes (Credit Suisse)) and out of the real economy (yet more bad news from the real estate market, declining orders and morale, and increasing inflation), it's still much too early to call an end to that phase of "revulsion" in the markets.

Everything still points to a massive economic crisis (for an account of how that could play out, read this), and underlines the need for a robust political reaction. So far, the traditional mix of interest rate cuts and tax cuts (the vary cause of the problem in the first place) has been provided - but you don't give more candy to someone suffering from massive indigestion. At the heart of things is the stagnant living standards that were supplemented by debt. That debt bubble is now imploding, and a real solution that does not involve a massive demand crash can only come from income support - real jobs, real wage increases coming from necessary and useful activity (say, building renewable energy infrastructure rather than blowing up stuff and people in Iraq). Instead, we are going for the inflation route - an effective way to reduce the debt burden, but one that also crushes the wage earners along the way. Oil at $100 and gold coming to $1000 suggest that this is only going to cause more pain along the way.