The Madness of Insurer Downgrades

Found an interesting article on the net the other day. Thought might be a good idea to publish this on my blog as well. What the article says is:

The US madness is poised to hit us very soon. Note that I say poised to hit us - it has not quite hit us, and it has not quite hit America either.

This thing is bigger and badder than one can imagine. Very soon, two of the worlds biggest bond insurers, Ambac and MBIA may be downgraded to AA, because they also insured Subprime CDOs, which as you all probably know, are scraping the bottom of the neighbourhood gutter.

When CDO prices are in the pits, and defaults are increasing, the insurers are liable to pay out - and this is not a small sum of money, not the pocket change type really. This is $200 billion or so, which in Indian terms is about 800,000 crore, more money than Chidambaram balances in his budget (I think). If you feel this is a lot of money, wait till you hear the real story.

So if Ambac and MBIA are downgraded, they insurance they provide suddenly isn't AAA anymore. That's bad. Why? Because some of the people who bought these fantastic subprime CDOs bought it partly because of the AAA rating of the insurer. After all, who cares if the underlying issue is BBB- (subprime), if the funda is that should we make losses, we get paid by our insurance, who is rated AAA. Effectively I hold a AAA security, and I pay a little premium for the AAA insurance.

Now if the insurers aren't AAA, the buyers of insurance - note that they are banks, pension funds, even school funds and counties - are psyched out, because they may not be allowed to hold anything rated less than AAA, or they may be spooked by the lowered rating. so er, they have to sell, but who will buy? There's very little in terms of transactions happening in that market now - so the prices are likely to slide seriously before they buy.

Uhm. That's still not the end of the story. So Ambac and MBIA are primarily bond insurers right? They insure municipal bonds. Earlier, municipalities needed money to build roads, ensure water supply etc. and would issue bonds, for which they would pay interest after collecting taxes. After the savings and loan crisis in the early 90s, and some real estate crashes, some of them defaulted on the bonds, making bond investors really unhappy. So Ambac and MBIA would insure bonds against default for a premium, making the municipal bonds "safe".

Now, there is a HUGE market for such bonds, leading into the trillions. A trillion is about 40,000 cr, which is about the GDP of India. And the muni-bond market is much bigger than that. A lot of bond buyers have paid Ambac and MBIA premium to ensure the AAA safety of their investments, and that was because the bond insurers were rated AAA. When they are downgraded, that safety goes away and the bond market has a pretty serious problem. Because there are transactions happening there and a selling crisis might end up destroying all sanity.

So when all of this happens, chances are that the insurers will go into bankruptcy. Because they have no chance of actually paying out multiples of hundreds of billions of dollars, and since they dont quite have the capital, they will file for a chapter 11, meaning the creditors won't need to get paid. If they do file, then all the buggers who've bought all this insurance must take the losses on to their books. Note that carefully. If the insurers go bankrupt, the net effect will be that banks and pension funds will take the losses, which will be of the order of multiple hundreds of billions of dollars. In comparison Citi has taken on just $15 billion or so, pennies in comparison with their real losses.

Chances are that the US government won't let that happen. I don't know what can be done but I'm sure there are thoughts going into a rescue attempt. This time it won't just involve the US, but the whole world which invested in this stuff. Quite a doomsday theory but it's basically saying that if the situation goes the way it looks like it will, the next ten years will be the bleakest in the closely remembered history.

And if anyone thinks India is unaffected by all of this they are just blind. It's absolutely going to cripple us as well, maybe not for 10 years but at least the next three. We have to build our local economy, and that will take us the next couple decades. The next three years are going to be spent fighting for sanity.

I sure hope that doesn't happen.

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