http://www.newyorker.com/talk/financial/2008/02/11/080211ta_talk_surowiecki
February 11, 2008 The New Yorker
Bonds Unbound by James Surowiecki
If the ongoing turmoil in the world's financial markets has made
anything clear, it's that the list of things that can go wrong in those
markets is a very long one. Month after month, it seems, another
potentially disastrous problem rises to the surface. The latest looming
crisis is the possible implosion of a group of companies called
monoline insurers. If you haven't heard of monoline insurers, don't
worry: until recently, few people, even on Wall Street, were all that
interested in them. Yet their problems have become a serious threat to
global markets. Rumors that monoline insurers, like M.B.I.A. and Ambac,
were in serious trouble helped spark the vast market sell-off that
prompted the Federal Reserve's interest-rate cut two weeks ago, and,
only a few days later, rumors of a government-orchestrated bailout of
these companies set off a six-hundred-point rally in the Dow.
Monoline insurers do a straightforward job: they insure
securities--guaranteeing, for instance, that if a bond defaults they'll
cover the interest and the principal. Historically, this was a fairly
sleepy business; these companies got their start by insuring municipal
bonds, which rarely default, and initially they confined themselves to
bonds with relatively predictable risks, which were easy to put a price
on. Unfortunately, a sleepy, straightforward business wasn't good
enough for the insurers. Like everyone else in recent years, they
wanted to cash in on the housing and lending boom. In order to expand,
they started insuring the complex securities that Wall Street created
by packaging mortgages, including subprime ones, for investors. This
was a lucrative business--M.B.I.A.'s revenues rose nearly a hundred and
forty per cent between 2001 and 2006--but it rested on a false
assumption: that the insurers knew how risky these securities really
were. They didn't. Instead, they gravely underestimated how likely the
loans were to go bad, which meant that they didn't charge enough for
the insurance they were offering, and didn't put away enough to cover
the claims. They're now on the hook for tens of billions of dollars in
potential losses, and some estimates suggest that they'll need more
than a hundred billion to restore themselves to health.
Obviously, this is bad news for the insurers--at one point, M.B.I.A.'s
and Ambac's stock prices were down more than ninety per cent from their
all-time highs--but it's also very dangerous for credit markets as a
whole. This is because of a peculiar feature of bond insurance:
insurers' credit ratings get automatically applied to any bond they
insure. M.B.I.A. and Ambac have enjoyed the highest rating possible,
AAA. As a result, any bond they insured, no matter how junky, became an
AAA security, which meant access to more investors and a generally
lower interest rate. The problem is that this process works in reverse,
too. If the insurers lose their AAA ratings--credit agencies have made
clear that both companies are at risk of this, and one agency has
already downgraded Ambac to AA--then the bonds they've insured will
lose their ratings as well, which will leave investors holding billions
upon billions in assets worth a lot less than they thought. That's why
so many people on Wall Street are pushing for a bailout for the
insurers. It may be an abandonment of free-market principles, but no
one has ever accused the Street of putting principle above profit.
Normally when companies make bad decisions and fail to deliver value,
it's just their workers and investors who suffer. But monoline
insurers' desire to grab as much new business as they could, risks be
damned, quickly radiated across global markets and will have huge
consequences for millions of people who have never heard of M.B.I.A. or
Ambac. The situation illustrates a fundamental paradox of today's
financial system: it's bigger than ever, but terrible decisions by just
a few companies--not even very big companies, at that--can make the
entire edifice totter.
In that sense, the potential collapse of monoline insurers looks like a
classic example of what the sociologist Charles Perrow called a "normal
accident." In examining disasters like the Challenger explosion and the
near-meltdown at Three Mile Island, Perrow argued that while the events
were unforeseeable they were also, in some sense, inevitable, because
of the complexity and the interconnectedness of the systems involved.
When you have systems with lots of moving parts, he said, some of them
are bound to fail. And if they are tightly linked to one another--as in
our current financial system--then the failure of just a few parts
cascades through the system. In essence, the more complicated and
intertwined the system is, the smaller the margin of safety.
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