Ambac and MBIA: Bonds, Jane's Bonds

How the Monos May Give the Economy Mono

Most Americans don’t know the difference between "monoline" and "mononucleosis."

Suddenly we’re told the fate of capitalism rests on saving teetering monoline bond insurers from losing their AAA credit ratings. Today I report on how this all relates to you.

How They Make Money

The bond insurers protect payments to bondholders for things like a city’s municipal bond to build a school, or a corporate bond backed by mortgages. They give these bonds the insurers’ own AAA rating, even if the actual bond itself is worth, say, a single A. The difference between AAA and A is worth something, so the bond insurer charges issuers a portion of what that "spread" is worth. That’s how it makes money.

Most of the bonds that insurers back are municipal bonds, which almost never ever default, so it’s free money.

But the insurers wanted to make better money. So they began insuring corporate bonds backed by subprime mortgages--often charging higher premiums--assuming these, too, would almost never default. Now some of those bonds are looking shaky, since some of the mortgages aren’t being paid, so the bond insurer has to cover those losses.

Now, the truth is, the insurers haven’t actually had to pay that much in claims. The problem is, they’re having to set aside billions of dollars JUST IN CASE a lot of claims come in. That means they don’t have as much cash, and when you’re an insurer, you only get a AAA rating if you have plenty of cash.

So now these monoline insurers are being threatened with the WORST THING THAT COULD HAPPEN: they lose their fantastic credit rating.

The Danger
Why is the rating loss so bad? Because, the logic goes, why buy insurance from someone who doesn’t have the best credit? For the bond issuers, who will buy your bonds if your insurance is iffy? And if you’re some local government with AAA credit already, why buy any insurance at all now? Lower ratings could mean the end of some insurers--and good times for Berkshire Hathaway and Warren Buffett, as he steps in to fill the void with his own insurance business.

But here’s a bigger part of the problem. It’s what Charlie Gasparino has been talking about: the institutional investors who bought mortgage-backed bonds stopped buying them last year when the housing market started to turn. But the investment houses selling them still own billions of dollars worth of them. They were hoping to find someone to buy them.

Now, no one will touch them.

Maybe they’ll sell if discounted severely, as in, "What would you pay for a house in Stockton?" Something, but not much. That leaves these big investment houses like Merrill Lynch, Citigroup, and UBS with tens of billions of dollars (some say more) in damaged goods they may have to write down.

That could--supposedly--bring down the ENTIRE STOCK MARKET...which would hurt your portfolio.

For local and state governments, it could become harder and more expensive to sell bonds to fund new highways and build new schools, because some investors may shy away from them (plenty won’t because they know this is about as safe an investment as one can make). Still, if the insurance is less credit-worthy, or if some of these insurers go belly up, it’ll cost these governments more to refinance their debt. That means potentially a cut in services, or HIGHER TAXES. Yippee.

I guess that’s why everyone’s in a wedgie now to save these insurers with a fund to insure their insurance.

You have to figure, if you’re an investment bank with, say, $10 billion in these bonds you might have to write down because no one will touch them, wouldn’t it be cheaper to put $1 billion into a pool to insure the insurers to maintain their ratings? Heck, yeah! And since the bond insurers will have to pay premiums for this reinsurance, the investment house could even make money! Assuming the Ambacs and MBIAs of the world don’t end up having to cash in on the policy…

I just hope the whole monoline thing doesn’t actually turn into economic mononucleosis. Mono is so exhausting, and it takes forever to go away.

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  • Based in Los Angeles, Jane Wells is a CNBC business news reporter and also writes the Funny Business blog for CNBC.com.