Under-Reported Collapse Of Bond Boys

World's Largest Bond Insurers Collapsing!
by Martin D. Weiss Ph.D. 01-21-08
Martin here with an urgent update on the rapidly unfolding credit crack-up:
Ambac and MBIA, the two largest bond insurers in the world, are careening toward collapse.
Barring a miraculous rescue, their demise could promptly deliver a massive blow to the U.S. bond market ... severely damage America's already shaken big banks ... and largely trash the net worth of millions of investors.
Yet, strangely, except for investors who owned Ambac and MBIA shares themselves — and who have now driven those shares into the gutter — few are paying attention.
And fewer still are taking appropriate defensive action.
Look. If this crisis were just a theoretical possibility, like it was when I first wrote about the fatal fallacy of bond insurance years ago, I might understand the stubborn complacency of most investors.
But now it's here, staring them in the face: Just this past Friday, soon after the closing bell in New York, the watershed event happened: Ambac lost its triple-A rating!
Fitch slashed Ambac's rating by two notches to AA, downgraded the long-term rating of Ambac's parent company by three notches, and said more cuts could be on the way.
Since the ratings of insured bonds are tied directly to the ratings of the insurer, Fitch was also forced to take action on the 137,000 bonds that are covered by Ambac, setting off a veritable ratings massacre in the market for municipal and mortgage-backed bonds.
Similarly ...
If I were still one of the only ones talking about the collapse of bond insurance, I could also understand the complacency of most investors.
But now, based on the current market price of credit swaps (bets on future defaults), Wall Street itself believes that the chance Ambac and MBIA will avoid bankruptcy is less than one in three.
And still most investors aren't paying attention!
Next, Brace Yourself for the Other Shoes That Could Soon Be Falling
First, the other two leading rating agencies — Moody's and S&P — are likely to follow Fitch's lead and also downgrade Ambac. In fact, on Thursday, Moody's already warned it could do so very soon.
Second, the other major bond insurers, such as MBIA and FGIC, will get smacked with downgrades.
Third, the ratings massacre now taking place in Ambac-insured bonds will spread to $2.3 trillion worth of municipal bonds, mortgage-backed bonds, plus asset-backed bonds packed with credit card and auto loans.
Fourth, $45 trillion in the world's fastest-growing type of derivative — credit default swaps — will be in jeopardy. Indeed, according to Friday's Wall Street Journal ("Default Fears Unnerve Markets") ...
"The turmoil on Wall Street is beginning to rock a foundation of the financial system: the ability of institutions to make good on their many trades with one another.
"Today, a struggling bond insurer, ACA Financial Guaranty Corp., will ask its trading partners for more time as it scrambles to unwind more than $60 billion of insurance contracts it sold to financial firms but can't fully pay off, according to people familiar with the matter. The contracts were intended to protect Wall Street firms from losses on mortgage securities and other debt they own.
"The problem is that the insurer itself is teetering — with repercussions across the financial world. Some of its trading partners, called counterparties, already are writing off billions of dollars because of its inability to pay ...
"This has investors and regulators worried that, through such swaps, some market players could spread their own problems to the wider financial system ...
"The issue is raising broader concern among regulators and investors over what Wall Street calls 'counterparty risk,' the danger that one party in a trade can't pay its losses. ...
"Few envisioned a little-known bond insurer like ACA causing so much instability."
But despite this rude awakening described in the Journal, Wall Street is not asking the obvious next question: If little-known ACA could cause so much trouble, what kind of damage would be caused by the collapse of Ambac and MBIA, which are far larger?
Fifth, virtually all credit ratings, whether tied to bond insurers or not, will come under intense scrutiny. The reasons are twofold:
Deteriorating finances: If you're running a bank, a hedge fund or a major brokerage firm, and most of your trading partners get swiftly downgraded, your credit rating will also have to be slashed.
Declining investor confidence in the accuracy of the ratings themselves: If you're an investor and you see thousands of ratings falling like flies, you're going to seriously doubt the accuracy of every rating under the sun.Investors will say: "Either Fitch, Moody's and S&P must announce across-the-board downgrades by redefining their rating scales ... or we'll do it for them by assuming each and every rating they issue is greatly inflated."
Sixth, the crisis could spread to hundreds of trillions in other derivatives beyond credit swaps.