The Next Financial Crisis?

Feb. 20, 2008— -- As bond insurers struggle, it is another sign that banks will have mounting losses, which will make it harder for average Americans to get necessary financing for things like mortgages and credit for purchases.

Starting last summer, as more and more homeowners began to default on their mortgages, banks wrote off billions of dollars in investments, based on those loans. In turn, banks turned off the lending spigot, making it harder to get a mortgage, or for businesses to make billion-dollar deals. All of that has fed into the recent economic slowdown, and what has been called a "credit crunch," a "liquidity crisis," or a "seizing up of the credit markets."

Now, worries by investors and analysts, about the state of bond insurers, indicate more trouble ahead for the nation's financial markets, and perhaps, another period of extreme difficulty in getting a loan or credit.

Recent news stories have focused on an obscure part of the financial sector, called "bond insurance," also referred to as "monoline insurance." Investors worry that the big insurers like Ambac and MBIA will see their credit ratings downgraded.

Traditionally, bond insurers have guaranteed the interest and principle payments of the nation's municipal bonds. Municipal bonds are issued by cities, counties, or states, usually to pay for general infrastructure projects.

By one estimate, it is a $2.6 trillion market, involving 2.5 million bonds, about half of which have bond insurance. About one-third of bonds are held by mutual funds, another third by financial institutions, and another third by individual investors, like you and me.

For example, if the city of Oakland wanted to build a new school, it could issue a bond, and would then have to pay back the balance over time, along with interest, just like a mortgage.

Interest rates for municipal bonds (or "muni bonds") usually range between 3 percent to 5 percent. The rates are low because municipal bonds are considered safe investments, as the issuers — in this example, the city of Oakland — rarely, if ever, default on a bond. That's because cities have the power to tax in order to raise money to pay off the bond.

So, a city like Oakland could purchase bond insurance (for a fee) which, by guaranteeing the regular payments on the bond, would further lower the interest rate that the city would have to pay. The insurance has an excellent credit rating (for example, "AAA" the best) and, basically, gives its good credit name to the bond, making it a very safe investment.