Bonds Unbound.(The Talk of the Town)(monoline insurers)

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 in those markets is a very long one. Month after month, it seems, another potentially disastrous problem rises to the surface. The latest looming crisis is the possible implosion of a group of companies called 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. Historically, this was a fairly sleepy business; these companies got their start by insuring municipal bonds, which rarely default, and initially they confined themselves to bonds with relatively predictable risks, which were easy to put a price on. Unfortunately, a sleepy, straightforward business wasn't good enough for the insurers. 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--M.B.I.A.'s revenues rose nearly a hundred and forty per cent between 2001 and 2006--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, which meant that they didn't charge enough for the insurance they were offering, and didn't put away enough to cover the claims. 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--at one point, M.B.I.A.'s and Ambac's stock prices were down more than ninety per cent from their all-time highs--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, which meant access to more investors and a generally lower interest rate. The problem is that this process works in reverse, too. If the insurers lose their AAA ratings--credit agencies have made clear that both companies are at risk of ...