Bond Insurers at the Brink
Financial guarantors faced especially sharp problems. These institutions sell insurance on bonds, guaranteeing to make investors whole if the bonds ever default. Providing insurance on municipal bonds has long been their principal business; because state and local governments almost never default, it has been very profitable, if a bit dull.
The government agencies that issue municipal bonds, from the Port Authority of New York to the state of California, are willing to insure their bonds only if such insurance costs less than the added interest they would pay with no insurance. The formula normally works because the guarantors have their own top-grade seal of approval, which the pension funds and endowments that invest in risk-free assets such as insured municipal bonds demand.
Now, however, it appeared that the guarantors had undermined their own financial viability by expanding beyond their core municipal insurance sphere of business. In search of bigger profits, the guarantors wrote hundreds of billions of dollars in insurance contracts in the credit default swap market, a market in which investors buy and sell insurance on a wide array of bonds and CDOs. They promised to compensate buyers if their mortgage-related bonds ever defaulted. As the calamity in the housing and mortgage markets unfolded, these payouts began to look as if they would cut deeply into the insurers’ capital base.
The rating agencies that rate the bond insurers’ debt warned the guarantors to shore up their capital or see their ratings downgraded. Downgrades would almost certainly put the insurers out of business, rendering their insurance worthless. Investors with a mandate to purchase only risk-free assets would have no choice but to sell their insured municipal holdings, at whatever price they could get.
The formerly staid muni market launched into turmoil as the odds of this scenario rose. Rock-solid municipalities found themselves in the unlikely position of having to pay interest rates reserved for only high-risk borrowers. Waves from the subprime financial shock had now engulfed state and local governments.