Grant Ringshaw

A NEW and serious crack in the world's financial system appeared last week when problems surfaced at a small set of obscure, but vitally important institutions – monoline insurers.

They make money by insuring against loans going wrong. If the issuer of a bond goes bust, they guarantee to step in and make interest payments and repay the principal. This security makes borrowing cheaper for companies.

Though the monolines started out in the 1970s to insure bonds issued by American local authorities, they have jumped on the boom in debt markets to grow explosively in recent years. They are estimated to stand behind bonds worth $2.5-$3.3 trillion.

In America, they have helped fund everything from building power stations to schools and hospitals. In Britain, they played a key role in financing the Channel Tunnel, upgrades to the London Underground, Arsenal’s new stadium and in £5.7 billion of private finance initiative projects.

Hundreds of thousands of other bonds have relied on the monolines’ top-notch triple-A credit rating – bonds that are now held on the balance sheets of financially stretched banks that can ill-afford more multi-billion dollar write-offs.

When monolines stumble, the rest of the financial world is in for a nasty fall.

The crisis started nine days ago. America’s Ambac, the biggest monoline, suffered the indignity of having its credit-rating slashed by Fitch, the ratings agency. It was a hammer blow, undermining Ambac’s ability to write new business and forced the group to abandon a desperately needed $1 billion issue of new shares.

The knock-on effects were equally dramatic. Fitch then downgraded 137,000 individual bonds protected by Ambac.

Though the move will not increase the cost of borrowing for companies that have already issued bonds, it threatens to make it harder and more costly to raise debt in the future.

Other monolines have been battered. MBIA, the second-biggest group, is clinging to its AAA rating after raising $1 billion from the private-equity group Warburg Pincus. Fitch downgraded smaller player Security Capital Assurance (SCA) last week.

In these febrile markets, the fear is the monolines’ woes could spark a fire sale of the bonds they have insured, racking up more huge losses for investment banks and investors.

“The big risk right now to credit markets is if a monoline insurer unravels. The downside could be very extreme,” said one leading analyst.

For years monoline insurers had been hugely profitable – MBIA’s profit margin over the past five years averaged 39%, Ambac’s 48% – more than four times the average for companies in the S&P 500 index.

Now the good times have come to a juddering halt. For many, the crisis has been building for six years after the monolines aggressively expanded into insuring collateralised debt obligations (CDOs) – exotic parcels of debt created by investment banks. It looked like a lucrative business as the debt markets boomed. But it has morphed into a monster that now threatens to consume them.

Last month, Standard & Poor’s warned that the monolines could face potential losses on CDOs of $19 billion.

The problems are so severe that some observers believe they were a significant factor in the Federal Reserve’s shock decision to slash interest rates last Tuesday.

The American government, through New York insurance superintendent Eric Dinallo, has urged banks to look at providing $5 billion immediately to bail out the insurers. That figure could rise to $15 billion.

But one man’s disaster is another man’s opportunity. Legendary investor Warren Buffett is set to swoop after his Berkshire Hathaway group hastily obtained a monoline licence. The billionaire Wilbur Ross, is understood to be in talks about a possible takeover of Ambac.

No, this didn't start 9 days ago. This has been moving the markets for the last several weeks. That's like saying the Enron crisis started the day they filed for bankruptcy...The municipal market is immediately impacted by any trouble here. Capital has been pouring in to support these institutions just like capital poured into all of the major banks. I believe Warburg Pincus poured in a $1 billion into Ambac during the fall, but obviously more was needed.

Monoline insurance typically insures the timely payment of interest and sometimes principal. The obligation of payment is still due from the underlying. It's like a co-signed loan. Just because the person that co-signed bails, doesn't mean the loan has defaulted, but it does mean you have a riskier loan that you probably would not have issued at a given rate without the co-sign from a more credit worthy person.