Saturday, March 22, 2008

Credit Crunch Characters (7) - Monoline Insurance

The monoline insurance companies like Ambac and MBIA got started insuring municipal bonds against default. This was a profitable activity. They took in regular insurance premiums and only paid out if the municipality or bond issuing institution were to default. This rarely happened, because these organisations do not default, they just raise taxes. Monoline insurance was a great line to be in. Premiums rolled in and very little money rolled out. It rolled into the owners' pockets.

The municipalities benefited too, because their bonds took on the AAA rating of their insurers, so they got very low interest rates on the money they borrowed. These companies are called monoline, because federal laws prevent them from going into general insurance.)

However, the Monoline insurers were ambitious to expand their profitable business into other fields. They saw all the securities being offered by investment banks as a good opportunity. Soon they were offering insurance against default on the variance MBSs and CDOs. The banks enjoyed this too, because any action to reduce risk would allow them to squeeze more out of the 3% to 5% margin that limits the profits that can be made from mortgage finance.

While property prices were going up, the monoline insurers had a great business. They took in even more premiums and they hardly ever had to pay out, so profits the profits kept rolling in. But then house prices fell, and defaults followed right behind. Now the monolines had to make payouts to the owners of securities subject to default. The payouts were soon larger than their reserves and their capital. Ambac will only survive, if it can sell $1.5 billion in stock to expand its capital.

The various municipalities have also suffered. They took on the AAA rating of the monolines. However now the monolines have had their credit ratings down graded severely. This also down grade the rating on the bonds of the municipalities they insure. These organisations are now paying higher interest rates, because they are theoretically more risky.

The monoline insurers tried to insure risk that was bigger than they were.


This full series is here.

1 comment:

Charlene said...

Well written article.