Monoline Insurance, the next shoe……

By Reuters Staff
January 18, 2008

…..to drop, that is. The large bond insurance companies, Ambac and MBIA, may soon see their debt downgraded to junk like their smaller cousin ACA. This will make the insurance the two have written against bond defaults virtually worthless. The fear many have is the havoc this could cause in municipals. I’m not as concerned with that piece of the market; Warren Buffett’s Berkshire Hathaway is gearing up to insure high quality municipal issues. And with $40 billion of cash on its balance sheet, Berkshire Hathaway is in a good position to write insurance. Besides, default rates on municipals have always been close to zero. There will clearly be disruption in the municipals market, but not the widespread bloodletting that we’re seeing with securities tied to subprime. At least I hope not.

My concern is about counter-party risk. As the WSJ reports today, the monolines tried to goose net income by insuring abstruse derivative contracts from the structured finance world. These guys facilitated bets that were being placed by hedge funds and others who bought credit default swaps and other securities that pay off in the event an issuer defaults on its debt.

Here’s an instructive image from the WSJ article:

Ambac and MBIA are two of the largest players on the left side of the chart. If they go under, the contracts held by those on the right side that dealt with them are effectively worthless. It’s hard to know what the impact will be if hundreds of billions of derivative contracts suddenly have zero value.

One thing’s for certain, it would lead to billions more in write-downs at the major Wall Street banks, which will further reduce their capacity to lend.

[At the risk of going off on a tangent here, this is a big reason many argue inflation really isn't a big threat right now. Inflation literally refers to currency losing its value. Currency loses its value when there is more of it relative to the amount of goods and services available in the economy for purchase. How is money created? Primarily through fractional-reserve banking, which is a technical term that refers to the process by which banks create money when they make loans. But as banks write-off billions, their capacity to lend is reduced. To the extent that banks aren't able to make new loans, they are taking money out of the economy. That's why Japan faced the threat of deflation for so long even though their interest rates were effectively zero. Banks didn't have any money to lend.]

Back on topic, a good quote from the article regarding potential new writedowns:

Bill Gross, chief investment officer at PIMCO, recently told investors that if defaults in investment-grade and junk corporate bonds this year approach historical norms of 1.25% (versus a mere 0.5% in 2007), sellers of default insurance on such bonds could face losses of $250 billion on the contracts. That, he said, would equal the losses some expect in the subprime-mortgage arena.

The trouble is, Ambac, MBIA and the other insurers behind these contracts don’t have sufficient capital to pay out in the case of defaults. A way to think about it is to imagine an insurance company not carrying enough capital to pay off insurance policies written to homeowners hit by a catastrophic storm. $250 billion is a rather catastrophic storm alright. One the bond insurers clearly wouldn’t survive.

With no central trade processing of credit-default swaps, defining trading-partner risks can be a Herculean task. Mr. Buffett learned the difficulty of unraveling such complex instruments in 2002 when he directed General Re Corp., a reinsurer that had been acquired by his Berkshire Hathaway Inc., to pull back from the business of these swaps and other derivatives. It took General Re four years to whittle the business from 23,218 contracts to 197 by the end of 2006.

Doing so involved tracking down hundreds of counterparties to General Re’s trades, many of which Mr. Buffett and his colleagues had never heard of, he says, including a bank in Finland and a small loan company in Japan, to name just two. One contract, Mr. Buffett says, was designed to run for 100 years. “We lost over $400 million on contracts that were supposedly” safe and properly priced, “and we did it in a leisurely way in a benign market,” Mr. Buffett says. “If we had to unwind it in one month, who knows what would have happened?”

Buffett has also referred to derivatives as financial weapons of mass destruction. A tongue-in-cheek comment when he uttered it. We’re likely to see them wreak more havoc with the banking system over the next year……

I hope the system survives.

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