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.

What Is Bond Insurance?

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.

Bored? Well, so were the bond insurers. It's a pretty low-risk, low-profit business, and with increasing competition, the fees or premiums charged for insurance, fell lower and lower. Bond insurers started to branch out from municipal bonds and provided insurance to other types of products.

As banks bundled together thousands of mortgages, and then sold them to investors, bond insurers came in and started providing insurance for those investments or securities. They gave their good credit rating to the mortgages being sold, and essentially guaranteed that investors would get paid, should the payments on the mortgages stop coming, because homeowners defaulted on their loans.

It was a riskier business — if that bundle of loans went bad, because homeowners stopped paying, the insurers could be on the hook — but profits would be greater. And they were.

But guess what? Homeowners started defaulting on their loans, banks began writing off billions in mortgage loans, and now, bond insurers are losing money, as well. As they have less money and are at risk of having to pay even more insurance claims, their good credit rating, their best-in-breed, AAA status, has been called into question.

Investors worry that going forward, bond insurers will have problems making payments on those bundles of home loans, as homeowners lose their homes to foreclosure.

Where Ratings Come From

Bond insurers get their good credit ratings from the ratings agencies, the biggest of which are Moody's, Standard & Poor's, and Fitch.

For example, the other day, Moody's cut the ratings on a smaller bond insurer, Financial Guaranty Insurance, from "AAA" to "A3," a drop of several notches. A bad credit rating means the insurer can have a hard time getting new business. If it can't give its good credit rating to a new bond being issued, investors won't want to buy the bond, and the insurer gets no money. That cuts into future revenues and leads investors to worry that insurers won't be able to pay off all of those failing mortgage-backed investments in the future.

Bad news for the bond insurer, but going back to the municipal bonds they insure, they're fine. Nothing has changed. Municipalities still make regular payments on their bonds. Investors, however, are spooked about all bonds.

Of that $2.6 trillion municipal bond market, anywhere from $600 to $800 billion have interest rates that adjust periodically. Of that, around $200 billion have their interest rate set at occasional auctions — hence, the name, "auction rate securities." This is where the Metropolitan Art Museum and the Port Authority of New York come in.

These auction rate securities are bonds sold by an entity like the Port Authority, most often to corporations that have excess cash and want to find a place where they can invest the money for a few months, get a decent interest rate (payments from the PA), and then get the money back when they need it, by selling the bond at auction. The vast majority of these bonds are insured.

Whoops. Those bond insurers are now in trouble, and now, no one is very interested in buying insured bonds at auction.

In the past, if there weren't enough bidders at the bond auctions, the bank holding the auction, say, Goldman Sachs, would go ahead and buy the bond with its own money, and hold it for a while, and then sell it later. They aren't doing that anymore.

So, when the PA bond went up for auction, and no one wanted to buy, the auction was declared a "failure," and the interest shot up to a previously determined, much higher interest rate. In the PA's case, it went from paying about 4.2 percent interest to 20 percent. Its weekly interest payments went from $83,600 to $389,000.

Good for the business holding the bond, but bad if it needs that money to pay for something. Imagine your bank telling you that your savings rate is now 20 percent. Great, except that you aren't allowed to withdraw any funds. That's bad, because you might need to buy groceries.

Now what? The PA is stuck with a bond that has an extremely high interest rate. Since the auction failed, it's not likely it will get anyone to buy the bond in the future, so it has to find a way to lower that interest rate.

The PA could try to renegotiate the rate with the bond holders. Or it could try to issue a new bond with a lower interest rate, to pay off the old one with the 20 percent rate. But it might be hard to get a new bond sold, especially if you need bond insurance, and that might be a little hard to come by nowadays.

What does this all mean now? In the PA case, in the extreme, if it can't get rid of that higher interest rate, it might have to consider raising tolls. No one is talking about it right now, because it's expected it will work something out.

Also, as the "auction rate securities" market is not expected to get any better anytime soon, and as other entities, like student loans issuers, have some of their rates set at auction, they could see a spike in interest rates in the future.

As the bond insurance market dries up, cities or states wanting to issue bonds to build, for example, a new bridge, will probably have to pay higher interest rates. But we are talking about hundredths of a percentage point. Instead of 5 percent, maybe 5.03 percent. In the most extreme scenario, we might hear stories about a city that decides not to build a school, or a new road because of higher interest rates.

For bond insurers, there is talk about providing funds to prevent future losses, but no one really knows the extent of their future losses, so any given amount might not be enough.

There are also discussions about breaking up the bond insurers into specific entities, like one that insures only municipal bonds, and another part that insures only mortgage-backed bonds.

Essentially, that's what Warren Buffett did when he offered to re-insure $800 billion of municipal bonds. But as we know now — that municipal bonds are very safe and rarely fail — Buffett basically asked for the best, and would leave the worst for the companies to handle. Not surprisingly, the insurers said, "no thanks, we don't want to be left holding onto only the rotten stuff."

There will be continued calls for more investigations and regulations. There is no federal regulator for insurance companies. They are regulated by the state in which they are located, which is why the Insurance Commissioners of NY and Wisconsin are involved in the bond insurance talks, as MBIA and Ambac are located, respectively, in their states.

There will also be more fingers pointed at the rating agencies. They said these insurers had the best credit, but they didn't. Investors will say the rating agencies should have done a better job, giving more accurate readings about the bond insurers' finances, because if they had, we wouldn't be in the current mess.

As independent analyst Sean Egan with Egan-Jones described the big ratings companies, "They are not in the business of providing timely and accurate ratings. They are in the business to facilitate the issuance of securities," meaning, they were less concerned with giving accurate evaluations of the bond insurers, and more concerned with getting the mortgage-backed securities out the door.