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Tuesday, February 05, 2008

Monolines

If you've heard the term "monoline" in reference to the current troubles in the financial sector and wondered what the term refers to and why you should care, James Surowiecki has the details:

Bonds Unbound, by James Surowiecki, New Yorker: If the ongoing turmoil in the world’s financial markets has made anything clear, it’s that the list of things that can go wrong ... is a very long one. ... The latest looming crisis is the possible implosion of ... monoline insurers. If you haven’t heard of monoline insurers, don’t worry: until recently, few people, even on Wall Street, were all that interested in them. Yet their problems have become a serious threat to global markets. Rumors that monoline insurers, like M.B.I.A. and Ambac, were in serious trouble helped spark the vast market sell-off that prompted the Federal Reserve’s interest-rate cut two weeks ago, and, only a few days later, rumors of a government-orchestrated bailout of these companies set off a six-hundred-point rally in the Dow.

Monoline insurers do a straightforward job: they insure securities—guaranteeing, for instance, that if a bond defaults they’ll cover the interest and the principal. ... Like everyone else in recent years, they wanted to cash in on the housing and lending boom. In order to expand, they started insuring the complex securities that Wall Street created by packaging mortgages, including subprime ones, for investors. This was a lucrative business ... but it rested on a false assumption: that the insurers knew how risky these securities really were. They didn’t. Instead, they gravely underestimated how likely the loans were to go bad... They’re now on the hook for tens of billions of dollars in potential losses, and some estimates suggest that they’ll need more than a hundred billion to restore themselves to health.

Obviously, this is bad news for the insurers ... but it’s also very dangerous for credit markets as a whole. This is because of a peculiar feature of bond insurance: insurers’ credit ratings get automatically applied to any bond they insure. M.B.I.A. and Ambac have enjoyed the highest rating possible, AAA. As a result, any bond they insured, no matter how junky, became an AAA security... The problem is that this process works in reverse, too. If the insurers lose their AAA ratings ... then the bonds they’ve insured will lose their ratings ... which will leave investors holding billions upon billions in assets worth a lot less than they thought. That’s why so many people on Wall Street are pushing for a bailout for the insurers. It may be an abandonment of free-market principles, but no one has ever accused the Street of putting principle above profit. ... [...full article...]

Naked Capitalism has been following this topic closely.

    Posted by on Tuesday, February 5, 2008 at 12:40 AM in Economics, Financial System | Permalink  TrackBack (0)  Comments (13)

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