The Fed slashed rates by 0.75% last week, but investors treated the move as a “footnote”, as Saskia Scholtes puts it in the FT. It led to a short-lived rally, but what really improved the mood on Wednesday and Thursday was not the cut but the news of a potential bail-out for America’s ailing bond insurers. The FTSE 100, having suffered its biggest one-day slump on Monday since September 11 2001, had its biggest single-session rally in almost five years on Thursday.
“There may be no better example of how a dull province of finance, when snared by complex risks it barely understands, can become terrifyingly unboring,” says The Economist. And so it is with the bond insurers, or monolines. Recent losses from mortgage-related securities – losses that they have insured – have left them short of capital and facing downgrades from ratings agencies; Ambac, one of America’s biggest monolines, has had its debt cut to AA by ratings agency Fitch. Another agency, Standard & Poor’s, said last month that the industry could face losses of around $19bn on bad collateralised debt obligations – the packaged securities of mortgage debt they have also insured.
Downgrades at ailing monolines automatically apply to all the bonds they have insured, raising the prospect of a fire sale by investors only allowed to hold top-rated debt. That’s bad news for institutions with exposure to some of the $2trn and upwards of debt guaranteed by bond insurers.
According to an (admittedly aggressive) Barclays Capital estimate, banks may need as much as $143bn of fresh capital if insurers are downgraded to an A rating. But it could get worse, says Investorsinsight.com’s John Mauldin. What if major monolines are downgraded to junk, just as small insurer ACA has been, as downgrades on mortgage assets and CDOs mount?
Now New York State Insurance Superintendent Eric Dinallo is holding talks with banks to ensure $15bn of capital to secure monolines’ ratings. But banks have different exposures to each of the insurers, so a bank participating in a sector-wide rescue might end up helping rivals more than itself, says Breakingviews. And in any case, the banks are hardly flush with spare capital themselves.
Still, it seems to make sense in principle, given their undisclosed exposure to the monolines is surely far higher than $15bn, says The Economist. A “painful contribution” now has got to be preferable to more “agonising writedowns” later. But Dinallo will need to move fast. As discussions began, another insurer, SCA, lost its triple A rating. This, says a regulator, “is a race against time”.