Why you should worry about bond insurers

Municipal bond insurance is usually a dull old world. But dabbling in exotic structured finance products may mean credit-rating downgrades. And that may start a chain reaction which could hurt us all.

Don't shout it too loudly, but it looks like the US monolines are about to be downgraded.

Your initial reaction may well be - so what? At first glance, the arcane world of bond insurance doesn't seem fertile ground for an interesting story. But just read on for a moment. Because although it all seems rather remote, we've already seen from the infamous US sub-prime fiasco how ripples from the other side of the pond can turn into tidal waves round the world.

And here's another nasty not-so-little spin off that could yet have a serious knock-on effect on us here in Britain

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Monolines are bond insurers, which means that they 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 pretty safe line of business, guaranteeing loans by public bodies in the US - which has always churned out a steady but unexciting stream of income.

That was a bit too boring, it appears, for the monolines, who decided a decade ago that they wanted a slice of something a bit more exciting. So they 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).

Much sexier, but as you've probably guessed by now, also a lot riskier - although until recently, the monolines insisted that this structured finance sideline' was just as safe as their long-standing municipal bond business. Of course, now we know it's not. Sub-prime mortgage defaults have rocketed over the past year, with many of the loans parcelled up in sliced and diced' bonds guaranteed by the monolines.

That's where the jitters started. The bond insurers have always held top-notch, so-called triple-A, credit ratings. But the damage being done by the US mortgage meltdown started to spook the markets about possible cuts in those AAA ratings. And not only were monoline stockholders being hurt as their shares fell, but also more write-downs were being triggered at the banks.

Why was this all such a worry? Because here's the kicker. A ratings downgrade of the monolines would mean that the institutions who had bought insurance from them "could no longer assume that this protection was watertight", says the FT. What were considered to be risk-free securities, in other words, would suddenly become risky, at least on the banks' books.

Indeed, the shockwaves could well reverberate into huge losses for investors holding some of the more than $1,000bn-worth of bonds insured. What's more, in a chain reaction effect, banks were themselves liable to being downgraded.

Back in February, this prompted former New York governor Eliot Spitzer to warn of a financial tsunami' unless the authorities did something about it.

Then the monolines managed to raise some capital and the problem seemed to go away for a while, or maybe it was just that people started to worry about other things.

But now the bugbear's back. The two big US bond insurers Ambac and MBIA are again on the brink of having their top ratings cut by Moody's Investors Service, who are worried about "diminished new business prospects and financial flexibility, as well as the potential for higher mortgage exposure losses".

Moody's said the ratings were likely to fall to double A, although it did not rule out a cut to single A for MBIA.

This time, the whole thing seems even more serious. Todd Petzel of Offit Capital reckons that default could hit most of the 5.85m US subprime mortgages, about 80% of which are parcelled up in sliced and diced' bonds, many guaranteed by the monolines.

And yesterday we heard that both home loan payment delinquencies and repossession actions in the States have hit a 29-year high. New foreclosures have climbed to almost 1% of all US home loans, taking the total number of homes in foreclosure to 2.47%, while the delinquency rate, i.e. loans where at least one payment is overdue, grew to 6.35%. That's well over one in 20 mortgagees falling behind with their payments.

MBIA's share price has just plunged to a 20-year nadir while Ambac has dropped to record lows, while the cost of buying credit protection against the bond insurers has risen further from already extended levels.

The banks may have already reduced their exposures or made extra loss provisions for what they've seen so far. But with the US housing market apparently crumbling further by the day, this is becoming seriously nasty. And it's bound to spread round the world, like last time.

Banks have already become very cagey about lending us money. If they are once more forced to write off even greater amounts than they thought they would have to, they're bound to become even less willing to lend. That would make a deep recession an absolute certainty.

Turning to the wider markets

UK shares had a better day, with the FTSE 100 index picking up 25 points to 5995. Sector that have recently taken a bashing enjoyed a recovery, like banks where RBS gained almost 4% on talk the rights issue is going well. Housebuilders also rallied on relief that the lateat results from Bellway weren't a total disaster. Taylor Wimpey climbed 6% while Barratt Developments advanced 4%. Argos and Homebase owner Home Retail flipped up 5.7% on broker support.

In contrast, European markets were generally lower, with the German Xetra Dax sliding 0.3% to 6942 and the French CAC 40 easing 0.2% to 4907.

US stocks ended a three-day losing run with a strong rebound as jobless claims dropped unexpectedly and oil stocks surged late in the day. The Dow Jones Industrial Average soared 214 points to close 1.7% higher at 12604, the wider S&P 500 did even better with a 2% jump to 1404 and the tech-heavy Nasdaq Composite advanced 1.9% to 2550.

Overnight the Japanese market joined in with the Nikkei 225 climbing 1% to end 148 points better at 14489, while in Hong Kong, the Hang Seng added 0.9% to 24476.

Brent spot was trading this morning at $126.7, while spot gold was at $880. Silver was trading at $17.19 and Platinum was at $2042.

In the forex markets, sterling was weaker against both the US dollar at 1.9554 and the euro at 1.2541. The dollar was trading at 0.6414 against the euro but 106.09 against the Japanese yen.

No rate changes yesterday from the Bank of England or the European Central Bank, though the latter was hinting that the next move in rates could beup!