The $2.5 trillion bond insurance problem: James Saft

By James Saft

LONDON (Reuters) - Bond insurance, a key safety net of the financial system, is looking vulnerable, raising the possibility of another round of forced sales, writedowns and contagion.

Fitch Ratings said on Tuesday that it may cut the AAA ratings of bond insurers after an upcoming review of their exposure to complex collateralized debt obligations.

This matters a lot, because the bond insurance companies, such as Ambac and Financial Guaranty Insurance Company, have insured a collective $2.5 trillion of bonds and structured financings.

If the ratings of one or more of the bond insurers are cut, the rating on the bonds they insure, many of which are municipal bonds, will fall too. This may force some investors who can only hold very secure debt to sell, depressing prices which would already be under pressure due to the lower value of an insurance policy from a lower rated company.

It could also touch off another round of writedowns by banks, insurance companies and others who hold instruments insured by these companies.

It could hit the staid municipal bond market especially hard, as about $1.6 trillion of the bond insurance in force is municipal. The rest is asset-backed debt of various types, including subprime.

None of this, including the review, will make it easier for the insurers to raise capital to shore themselves up.

In the unlikely event of a default, things could get really dire.

"What if the bond insurers default? You could think it does not matter because they are small companies," Credit Suisse analyst Guillaume Tiberghien wrote in a note to clients.

"The problem is that overnight the $2.5 trillion of insured bonds would reverse back to the ratings of the issuer... Imagine the impact on the economy of a downgrade of $2.5 trillion of assets.

"The current LBO and CDO write-downs experienced by the banks during the third quarter would appear very small in comparison."

While Tiberghien cautions that what he lays out is a very gloomy scenario, fear of it is probably a large factor behind the recent market sell-offs.

SAFE AS HOUSES?

So, how did the insurers get themselves into this situation and how worried should we be?

Fitch said it was carrying out a review after a series of downgrades of CDOs tied to subprime mortgages by itself, Standard & Poor's and Moody's, saying they had been "broader and deeper" than previously anticipated.