America’s bond-insurance industry in deep trouble.

To start, a small introduction: American cities and counties finance themselves by issuing municipal bonds.  If a person chooses to invest in such a bond, he can insure it by a so called monoline-insurance.
These monoline-insurances are considered safe, because they rarely defaulted.

Now, what is the problem?One of the largest insurers, Ambac, skipped an interest payment this November and filed for bankruptcy within the month. Other insurers find themselves in an equally bad situation.
The problem was simple: Ambac had a debt of 1.6 billion and only 76 million in cash.
Such an inequality cannot hold for a very long time.

Where did everything start to go wrong? At the beginning of monocline-insurance, think 1970’s, they only insured safe, municipal bonds.
But along the way they started to expand their insurance to, among other bonds, risky, mortgage-backed securities. When things started to go wrong, a domino-effect initiated.  As you all very well know, the subprime mortgages were bound to backfire. So when they did, Ambac and the others had to pay up. This made their credit ratings drop, so people were less willing to have them for insurers. And that’s how we got to the big, gaping hole the monoclines have to deal with today.

The conclusion I draw from this story is that insurers can be useful, but only if the problems aren’t too big and structural.

Sarah Duurloo
The Economist
November 6^th 2010.