FAQ: Why Bond Insurers Matter

If one of these little-known companies should fail, the consequences for the economy would be huge.

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The day on Wall Street was supposed to be about the Fed's decision to cut its key interest rate by another half point. But after news of the cut sent blue chips surging 200 points, the markets turned abruptly south amid growing concerns about a little-known corner of the financial sector: bond insurers. And if Wednesday's market action is any guide, maybe it's time to get to know bond insurers better.

What is a bond insurer?

Like insurers in any other industry, bond insurers promise to repay bond holders in the event of a default. These companies use their AAA credit ratings to guarantee lower-rated debt issued by private companies or public municipalities. All told, bond insurers currently guarantee about $2.4 trillion of investment-grade debt around the world. What's the problem today?

For years, bond insurers focused primarily on municipal debt, but with profit margins narrowing in the 1990s, state regulators allowed them to begin guaranteeing mortgage-related bonds as well. The growing number of souring mortgages, however, has triggered concern that mortgage-related bond defaults may soon rise. That would force bond insurers to pony up more cash to cover the defaulting securities. Such concerns have put shares of the two biggest bond insurers—MBIA and Ambac—into free fall in recent months. But isn't guaranteeing bonds what bond insurers do?

It should be. However, observers have grown increasingly concerned that bond insurers may not have enough capital to cover the potential increase in defaults. "The premiums that were paid were not high enough to fully cover [bond insurers'] exposure to riskier bonds," says David Resler, chief economist of Nomura Securities. "Like everyone else, the bond insurers did not fully understand the nature of the risks they were exposed to." As a result, credit rating agencies have begun downgrading bond insurers. Fitch Ratings recently downgraded Ambac—the industry's second-largest player—and other bond insurers have been cut as well. Investors remain worried that more ratings cuts could be on the way.

What's the big deal about a downgrade?

First, bond insurers themselves would take a serious hit. Since bond insurers are essentially renting their AAA credit ratings to lower-rated debt, it would be extremely difficult for them to get new business without such ratings. Second, lowering the credit rating of a large bond insurer would reduce the value of bonds guaranteed by that insurer. As such, those holding these bonds—such as hedge funds, financial institutions, and even individuals—would see their portfolios decline in value. Oppenheimer analyst Meredith Whitney says banks may be forced to write down $70 billion more should bond insurers' credit ratings slide further—the last thing they need after already taking billions in write-offs to cover subprime-related losses.

What would happen if a large bond insurer went under?

The failure of a large bond insurer could send shock waves through the corporate world by putting companies on the hook for debt they thought had been guaranteed by a third party. That could lead to large-scale write-downs, tighten credit markets, and make life even more difficult for politicians and central bankers scrambling to keep the United States out of a recession. How likely is that to happen?

It's still way too soon to push the panic button. Mark Lane, an analyst covering bond insurers for William Blair & Co., says the industry's key players have sufficient capital to continue doing business. "I don't see solvency risk," he says. While some insurers may face possible ratings downgrades, "in terms of actual default—not being able to pay—the probability of that is very small," Lane says. Is a bailout coming?

Given the key role that bond insurers play in debt markets and the deteriorating position of the industry—MBIA just reported a $2.3 billion quarterly loss—interest in a bailout plan has been building. Wall Street banks and brokerages reportedly met recently with New York state insurance regulators in an effort to put together a plan. But in light of the number of institutions involved, finding a quick and effective solution will be difficult. A government-brokered plan to rescue foundering structured investment vehicles failed to come to fruition after it was announced last fall.