Rivers of Red Ink Become Tsunamis

Many ordinary Americans might be wondering why there is so much fuss over the fate of bond insurers, despite the widespread recognition that many seem to be careening towards insolvency.

If people only hold what they believe are safe money market funds and municipal bonds or they have their money in a bank CD, how can the troubles in this little corner of the financial universe possibly hurt them?

Well, the answer is that these firms were allowed -- encouraged -- to play a growing and pervasive role in all sorts of financing deals because investors always seemed to place a much higher value on their stamp of approval than it cost the issuers to obtain it.

No one really thought too long and hard about what it really meant to have their securities guaranteed by a third party with only a sliver of capital underlying a fast-growing mountain of financial obligations, and everyone assumed -- incorrectly, it now appears -- that a triple-A designation meant what it always did.

Over time, this allegedly cheap insurance enabled many deals to be done on terms that likely made little sense and for issuers that probably should have paid a lot more for the privilege -- if they were allowed to come to market at all -- to borrow on the cheap.

Still, for a long while, it didn't matter. Yield-hungry small investors and institutional money managers simply filled their boots with the stuff that had been blessed by the insurers, assuming that if everyone else was doing it there was no problem and giving short shrift to the financial wherewithal of the actual issuers.

Now, though, with the growing prospect that those bonds may soon have to be evaluated solely on the basis of the creditworthiness of the actual borrowers -- because the bond insurer's guarantee ain't worth jack -- a lot of banks, institutions, and mutual funds that are only permitted to own highly-rated paper will become forced sellers into what could be a rapidly collapsing market.

At the same time, those holders of municipal bonds, for example, who thought they had safe sources of tax-free income will discover they also have a sudden and unexpected loss of principal -- as market prices are adjusted downward to take account of the new credit realities -- that can only be recovered if the securities are held to maturity (assuming that the municipality actually pays off those debts in the end).

This is the kind of fallout that can turn the rivers of red ink we've seen so far into a full-scale tsunami. In "Money Market Funds Wait to See Where the Buck Will Stop," the Financial Times' Saskia Scholtes Gillian Tett report on the latest growing fears about where this all may be headed.

Uncertainty over the fate of the embattled bond insurance industry has in recent months caused some sleepless nights for US money market fund managers.

For decades, money market funds have bought municipal bonds and, more recently, structured finance securities that have been insured by companies such as MBIA, Ambac, FGIC and SCA.

But these investors are increasingly concerned that the insurance may not provide the comfort it once did as the bond insurers face losing their crucial triple-A ratings after losses on mortgage bonds they have insured. Ambac and SCA have both been downgraded below triple-A by Fitch Ratings in the past week and further downgrades are thought likely.

"The potential problem of the money market funds is what is really scaring people now," said one senior investment banker yesterday.

Money market funds are the sacred cow of the US fund management industry, designed to be the safest possible place for investors to park their money. They pledge never to "break the buck", meaning that they promise to maintain the value of every dollar invested.

To keep that promise and to ensure that they can redeem investors' cash whenever needed, money market funds often demand that underwriters agree to buy securities back if needed. The critical issue now is that investment banks typically only agree to repurchase these assets on the condition that a certain level of ratings is maintained.

However, if the insurers lose their triple-A ratings, the $2,400bn of securities they have insured will also be downgraded. This could force some money market fund managers to sell to comply with strict investment guidelines, which could in turn force prices on insured securities to distressed levels.

For money market fund managers, if there is any risk that the price of a security might fall, they must sell. Similarly, if they see the value of their existing investments decline, they may need to seek a bail-out from their bank sponsors, which could create further pressure on their balance sheets, or face a widespread loss of investor confidence.

The potential scale of the problem has added a sense of urgency to the regulators' concerns about the bond insurance industry, and has helped to drive efforts to co-ordinate a rescue plan. On Wednesday, the New York State insurance regulator held talks with banks and pressed them to provide up to $15bn of capital to support the ailing industry.

One senior regulator said yesterday: "In the old days, what we had to worry about was the idea of runs on banks in terms of retail deposits. But there is a prospect that we could see a run centred around the money market funds of the type we have not seen before - this is generating a lot of concern."

If there were widespread losses in money market funds, policymakers fear the political heat will ratchet up as retail investors start screaming and, worse, it could precipitate a widespread withdrawal of cash from money market funds, which could cripple the entire short-term funding market.

For their part, portfolio managers at money market funds are taking precautions. "The bond insurers are absolutely a pressing concern," said Steven Shachat, a money market fund manager at Alpine Woods Capital Investors. "We have sold out of all our positions in bonds wrapped by MBIA, FGIC, Ambac and SCA - we just don't want to take that risk."

The wave of selling from Mr Shachat and other such investors has already pushed prices for insured securities much lower than those for comparable uninsured securities. Mr Shachat says this has created a "two-tiered market" in which yields for insured securities are up to 350 basis points higher than those for uninsured securities - in a dramatic reversal of conventional pricing.

Thus the fear for investors and policymakers is that downgrades of the bond insurers could set off a further panicky wave of selling by money market funds.

George Soros said in Davos this week: "There is growing concern about monolines . . . there is also a potential problem with money market funds which could be holding doubtful assets."

Investors have not lost money on a US money market fund since 1994 and it is unlikely any fund operator now would allow such an event to occur.

Last year, several money market fund sponsors were forced to bail out funds that had suffered losses on investments related to subprime mortgages. The tally of US money market and cash fund bail-outs hit more than $4bn last year as parent companies stepped in to prevent their funds from "breaking the buck", or falling below the $1 a share value.

Comments

[Independent Accountant]

At least one person thought about the economics of the monolines, Ackman. He prepared a 66-page report in July 2002 about MBIA. Would anyone listen to him? I did. I read a summary of his report and concluded the market was crazy. In 2005 Bethany McLean of Fortune wrote about the monolines. Would anyone listen? No.

[Rocky]

There has been plenty in the press about the monolines MBIA and AMBAC, but almost nothing about FGIC. Has anyone written about FGIC recently and posted it to the Internet? Are links available to such articles?