The Monoline Express

The benefit of the current market mess is that we are learning so much about the most exotic parts of the financial services industry. Think about it---over a year ago, very few outside of the lending community knew about sub-prime mortgages or the securities associated with them. We are now getting a lesson in another segment of the industry: monoline insurers and how they may affect the fragile markets.

Monoline insurers guarantee securities against default. That means if they have insured a bond and the issuer defaults, the monoline insurer will cover the interest and principal due to the investor. Most of these companies originally guaranteed municipal bonds, which rarely defaulted. They then moved into bonds with a bit more risk and as they spotted the mega-profit potential in riskier bonds, the temptation was too great to avoid.

Enter the housing boom in 2001, when defaults were low on even the riskiest loans (subprime) and the monoline insurers started to guarantee risky loans, in addition to their more staid (and less profitable) business lines. Initially, the strategy reaped enormous benefits: revenues rose for the largest firms, including M.B.I.A., Ambac and FGIC but in hindsight, they did not have a clear understanding of the risk they were assuming. As a result of not properly assessing the risk, the insurers did not charge enough for the insurance offered, and even worse, did not earmark enough money to cover loans that might go bad.

The latest worry among investors is that monoline insurers are in serious trouble and may in fact be headed towards failure unless the government can orchestrate a bailout. Estimates go as high as a hundred billion dollars necessary to turn around a quickly deteriorating problem. Even Warren Buffett entered the fray by offering a stop-gap plan to bail them out, which none of the companies have agreed to.

Maybe you’re thinking: just let them fail—who cares if a business that screwed up goes down the tubes? I know, we all have that feeling, but the failure of these massive companies would be terrible for an already-shaky credit market. For that reason, even I have to admit that while it feels rotten to help out a bunch of folks who made a bad business decision, it is important to focus on the bigger picture and mitigate further potential damage to the financial system. Otherwise, the Monoline Express may take global markets down even further, an outcome we all would like to avoid.