Calculating the Damage of a Monoline Meltdown

A good article “Markets assess the costs of a monoline meltdown,” by Aline Van Duyn and Gillian Tett of the Financial Times, endeavors to put the bond insurance crisis in context. While some of this will be familiar grounds to readers, the piece does a nice job of putting together some key data.

The article mentions a notion that was the centerpiece of Richard Bookstaber’s A Demon of Our Own Design, that modern finance suffers from what he calls “tight coupling.” Like a nuclear reactor, the systems are highly integrated, and a failure in a small but important section can have systemic consequences. Another idea he stressed that the complexity and interlinkage make it well nigh impossible to know how tinkering with one part will affect the whole. As a result, measures to reduce risk often wind up increasing it by introducing further complexity and another point of potential failure. The monoline example certainly bears that out.

From the Financial Times:

When losses on securities linked to risky subprime mortgages started to appear a year ago, many bankers hoped that the problem would be easily “contained” – meaning that it would not spread beyond the most esoteric niches of finance on Wall Street or in the City of London.

Now, however, the rhetoric of containment is being replaced by a new buzzword: contagion….

The fundamental problem is that this decade’s wave of banking innovation has created a financial system that is not just highly complex but also tightly interlinked in ways that policymakers and investors sometimes struggle to understand…epitomised by ….the increasingly precarious position of a group of companies known as the monoline insurers.

These companies essentially offer insurance to investors against the possibility that their bonds might default. They initially sprang up three decades ago to guarantee the municipal bond market – a line of business that has hitherto produced a steady, albeit unexciting income stream. Over the past decade, however, the monolines shifted their business into the realm of structured finance too, offering guarantees against the chance that complex bundles of mortgage-linked assets would default by writing derivatives contracts known as credit default swaps (CDS).

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.

This has caused losses for investors holding monoline equity, as the share price of companies such as Ambac and MBIA has plunged. It is also threatening to trigger painful new writedowns at banks, since a ratings downgrade of the monolines means institutions that bought insurance from them will no longer be able to assume that this protection is water-tight. What were considered to be risk-free securities, in other words, will suddenly become risky – at least on the banks’ books. Indeed, Moody’s Investors Service estimated this week that associated bank writedowns could range from $7bn to $30bn, with about 20 banks exposed….

“All of a sudden, the world has been gripped by monoline fever,” observed a recent report from Citigroup, the investment bank. It says that investors are now scrambling to see if the monoline problems are the next example of the “glue which holds together the world financial system” coming apart.

However, the chain reactions extend well beyond Wall Street. As the monolines come under stress, the public-sector bond world also faces upheaval. In the UK, for example, a host of private finance initiative projects, such as hospitals, are being forced to rethink their funding plans. These public-private partnerships have relied on monoline companies such as Ambac to insure their bonds in recent years but can no longer rely on this protection.

Meanwhile, in the US, the monoline woes have caused parts of the municipal bond market almost to break down in recent weeks. The most dramatic sign of pressure has occurred in the $330bn auction-rate securities market, a sub-sector of the municipal bond world (see chart). This market has arisen in recent years to match long-term funding needs with investors seeking short-term investments. For although municipal debt is typically issued with a long-term maturity – say, 10, 20 or even 30 years – in the ARM securities sector, investors can opt to sell the debt every week or month, when the interest rates are reset. This has proven very popular among mainstream investors, since ARM securities are typically insured by a monoline – meaning that they are ultra-flexible but also carry the all-important AAA tag.

However, in recent days the ARM market has essentially ground to a halt….as Congressman Spencer Bachus, the Republican representative for Alabama, puts it: “Unlike other events that have destabilised markets since the credit crunch began last summer – where the pain has been felt largely on Wall Street – the fallout from the troubles in the bond insurance industry is already hitting Main Street.”

Unsurprisingly, the finger-pointing has already begun. In the US the bond insurers are regulated at state level, and it seems that the regulators have been slow to recognise the scale of problems that have been developing in the monoline world. Creditsights, a debt analysis company, said the regulatory capital bases of the monolines grew by 29 per cent between 2003 and 2006 to $22bn. However, guarantees of structured finance – much riskier than the traditional municipal bond business – grew 175 per cent in that period to $1,600bn. “The industry got greedy,” says Rob Haines, an analyst at Creditsights.

Indeed, Eric Dinallo, the New York insurance superintendent, admits that regulators have failed fully to comprehend the link between ratings and the guarantees from bond insurers. As a result, regulation will be reformed to focus on ratings rather than on solvency, he says. “This [bond insurance] might be the only area of insurance where the ratings are as important as the solvency,” he says.

In the short term, however, the more immediate problem for policymakers is how to prevent the chain reaction inside the financial sector from extending even further. Frantic efforts are under way to shield the politically sensitive municipal borrowers from further pain…. This could result in the businesses of companies such as Ambac, MBIA and FGIC being split into two, to ensure that bond insurers can ringfence the riskier assets (such as mortgages) from the municipal guarantee business.

But although such a split currently seems attractive in political terms – most notably because it would enable policymakers to protect the municipal bond market in an election year – it will not necessarilly prevent further turmoil on Wall Street. On the contrary, as Jeffrey Rosenberg, analyst at Bank of America, says: “A split may limit losses in the municipal market, but it would likely exacerbate losses to structured finance . . . To the extent that those losses further constrain financial institutions’ balance sheets, broader credit constaint may follow.”

That could create more potential chain reactions. For example, another issue that is raising levels of concern is the health of the wider credit default swap market. This sector has exploded in size this decade, as a swath of investors – such as mainstream asset managers – have used CDS to protect themselves from the risk of corporate default. Until the monoline companies started to face problems, few of these investors worried about whether CDS counterparties would be able to honour their contracts if defaults occurred.

But the monoline issue has raised anxiety about whether other counterparties in the CDS world, such as hedge funds, will be able to honour their contracts if corporate defaults rise. While the International Swaps and Derivatives Association, the main trade body, vehemently insists this risk should be offset by the fact that most trades are backed by collateral, levels of investor unease are nevertheless rising.

That, in turn, is contributing to a wider rise in anxiety about all manner of complex debt vehicles, many of which are also tied – directly or indirectly – into the CDS and monoline world. There is an alphabet soup of structured products that could unravel, such as tender option bonds (TOBs), which are linked to municipal debt.

Indeed, Tim Bond, analyst at Barclays Capital, likens current events to nothing less than the “demise of the shadow banking system” that has sprung up in recent years around the structured world.

Policymakers pray that this chain reaction of financial implosions can still be contained without sending the economy into a tailspin. After all, they point out, the processes that created the credit bubble have been marked by a circularity. Institutions such as banks, hedge funds or monolines have essentially been cutting contracts with each other, raising overall levels of debt; thus, the hope goes, if this complex network of financial flows is imploding, it may be the financial sector – not the real economy – that ends up bearing the greatest pain.

Nevertheless, the more that financial problems hit sectors outside Wall Street, the more danger there is of a loss of confidence among consumers and companies. Or, as Malcolm Knight, head of the Bank for International Settlements, recently observed: “The longer this [uncertainty] goes on, the greater the risk that this will create a negative feedback loop [with the real economy].” Economists and investors, in other words, now have every reason to watch closely to see what happens next….with all the other corners of the US economy whose fate is now entwined with that of the monolines.