Monoline shock waves

If sub-prime was the rock tossed into the financial 'pond', monolines are the most recent ripple -- with potential to create even greater shock waves through the system. 

These monolines are large companies who insure against the risk of a bond or other security defaulting.  MBIA and Ambac, who have a near-50% share of the $2.5 trillion business and carry AAA credit ratings, dominate the sector.  MBIA on January 31 posted its biggest-ever quarterly loss -- $2.3 billion -- raising concern that the company will lose its AAA rating.  Fitch ratings on January 18 already downgraded Ambac to AA status.

The monolines work by 'wrapping' bonds, guaranteeing that if the underlying collateral does not pay timely interest and ultimate principal, they will step in and do so.  This allows bonds that might be rated, for example, at BBB to be issued and trade at AAA.  A good analogy might be parents taking out car insurance on a car driven by their teenage son.  If the policy was in his name it would require higher insurance premiums, but the parents effectively 'cover' him with their better (more established) driving record.

The problem is what happens if these credit ratings are downgraded -- if, in the analogy, it becomes clear that the car's driver is actually a teenager prone to riskier road manoeuvres.  In the case of the monolines, what happened was that they began to insure riskier credit profiles, wrapping a significant amount of sub-prime collateral in their structured finance transactions.  Estimates range from 100 billion dollars (Fitch) to 71 billion dollars (S&P) of collateralised debt obligations (CDOs), and 1.2 trillion dollars of municipal debt.

Downgrading these credit ratings reduces the creditworthiness of the bonds they have insured, including those of local authorities and municipalities. This has potential to lead to serious losses, further bank writedowns, and an asset sell-off -- which could drive asset price falls and create potential for insolvency. 

The monolines are therefore under pressure to recapitalise, as the rating agencies consider them to hold too little excess capital.  The threat of downgrades is damaging already-battered investor confidence, and could have massive knock-on effects.  While a bailout has been proposed -- spearheaded by New York Insurance Regulator Eric Dinallo -- regulators have few levers to encourage bank participation.  Even if recapitalisation succeeds, monolines have seen a huge drop in investor confidence, which will take time to restore and could imply serious problems for the future monoline business model.