.....The companies stumbled as they expanded beyond municipal
securities into structured finance such as collateralized debt
obligations, which package pools of bonds and loans and slice them
into separate pieces. The insurers guarantee about $1.2 trillion of
structured finance debt.....
bank buy insurance to cover the risks of buying
bonds
However,the insurance company also get into the troubles
and banks cant get any compensations when bonds default!!
1.
By Jon Markman
Nearly seven decades ago, the eight months between Germany's
invasion of Poland in 1939 and its invasion of France in 1940 was
known as the "phony war" -- a period of escalating anxiety, denial,
appeasement, danger and death, but nothing like the murderous
global train wreck soon to follow.
Likewise, we may come to look at the period between July 2007 and
January 2008 as a sort of phony war in the worldwide credit crisis,
because although the market has fallen 15% since summer, there have
been no defaults of key bonds or asset-backed securities. The
curious lack of real blowups has led even seasoned observers to
believe that fears were exaggerated and that chaos will be
averted.
In reality, however, the skirmishes we've seen so far might be
little more than a prelude to a deeper, harsher, longer decline
than most yet perceive possible. And in a very postmodern twist, it
is beginning to look like unexpected consequences of an investment
instrument designed to mitigate risk could turn out to be the
nuclear option that bombs the globe into the financial equivalent
of World War III.
Banks left exposed
That instrument is the credit default swap, or CDS. It was
developed as a way for bondholders to buy insurance against the
possibility that companies might fail to pay their debts, and later
it morphed into a way for big traders to actively bet on the
likelihood of the default of bonds and other credit instruments.
But what is only now becoming clear is that major U.S. and European
banks and hedge funds bought up to $20 trillion worth of that
insurance to offset their exposure to mortgage-related securities
they owned. And those banks and hedge funds are discovering the
sellers of the swaps may not pay up.
This leaves already deeply troubled banks virtually naked at just
the moment they most need protection, as the pace of credit
defaults is likely to accelerate this year so long as the Federal
Reserve remains behind the curve in cutting interest rates. It's as
if the banks already have pneumonia, and they're now being marched
into a snowstorm wearing little more than bathrobes.
The problem surfaced to an important degree in a footnote to the
news last week that Merrill Lynch (MER, news, msgs) would take an
$11.5 billion write-down of bad debts for the fourth quarter. Of
that amount, $3.1 billion was a write-down of credit default swaps
that Merrill had purchased from bond insurer ACA Capital to hedge
the risk of owning a lot of collateralized debt obligations, or
CDOs, which are leveraged bundles of asset-backed securities. (In a
typical CDS transaction, a debt holder or speculator agrees to pays
1.5% or more per year for $10 million worth of insurance on a
specific slice of a debt security.)
This means that not only is Merrill unprotected against a default
in the CDOs, but it has lost all the money it has paid for that
insurance. It's as if you had paid $200,000 in premiums over the
years in a $1 million life insurance policy for your spouse, and
when a death occurs not only does the insurer tell you it's broke
and can't pay -- but your premiums are down the drain, too.
Don't count on insurers
Several other major banks and brokers, such as the Canadian
Imperial Bank of Commerce (CM, news, msgs) and Lehman Bros. (LEH,
news, msgs), have been stiffed by ACA to the tune of billions, and
all have let the insurer seek more capital before forcing it into
bankruptcy. So the case gives us just a taste of what may come.
Consider that ACA was no fly-by-night outfit. It was AAA-rated and
met all standard benchmarks for safety. Yet those benchmarks now
look ridiculous, as the company was allowed to provide $60 billion
worth of guarantees on a capital base of just $500 million.
Can you imagine, as a citizen, if you were allowed to collect fees
on $60 million worth of loan guarantees because you owned a house
worth $500,000? It's nuts.
Specialty bond insurers such as ACA and troubled Ambac Financial
Group (ABK, news, msgs) at least are well-known companies subject
to modest scrutiny. But because we are coming out of a long period
in which debt defaults have been unusually low, hundreds of
little-known hedge funds, pension funds and insurers worldwide were
lulled by a false sense of complacency into the practice of selling
CDSs -- and their ability to pay up in the event of widespread
defaults amid a long, hard recession is not just in doubt but
completely unlikely.
pl tell your sources