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Will Bond Insurer Bailout Hold Water?

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Huge losses from insurance contracts backing subprime mortgage securities have endangered bond insurers' credit ratings.

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As the market staged an afternoon rally in the face of fierce selling in tech stocks, New York regulators announced they had gathered the major investment banks to discuss a bailout of beleaguered bond insurers Ambac (ABK) and MBIA (MBI).

Huge losses from insurance contracts backing subprime mortgage securities have endangered the credit ratings of these firms, who together insure $2.4 trillion in bonds, according to the WSJ. Fitch, one of the top three rating agencies, has already lowered Ambac's rating to AA from AAA as the firm struggles to raise capital as its shares shed value and losses mount.

Although municipal governments back most of the bonds Ambac and MBIA insure, markets are concerned payments on obligations tied subprime debt will render the firms insolvent. This counterparty risk has shaken the $45 trillion market for credit default swaps, or CDS, which we explain in more detail for those fortunate enough to be unfamiliar with this esoteric form of legalized gambling. Professor Zucchi believes these instruments will be at the forefront of credit market concerns in 2008.

Hoofy can point to history for reasons to cheer news of a possible solution to the bond insurer problem. In 1998 when Long Term Capital Management's blow up nearly took down the entire financial system, the Federal Reserve forced Wall Street executives to gather for a high-stakes weekend meeting to sort out the mess. While many herald the bailout as regulators forcing the market the clean up its own problems, others complain the government simply bailed out reckless speculators and paved the way for more excessive risk-taking.

Boo, on the other hand, is likely not convinced the latest rescue attempt will do much good. Washington's batting average for bailouts since the credit markets lurched last summer wouldn't exactly put it in the clean-up spot. After its initial shock value, the Fed's lowering of the discount rate aroused little response from the capital markets; the Super-SIV designed to bailout banks from their off-balance sheet exposure to asset-backed commercial paper failed to get off the ground; and the Hope Now Alliance to help subprime borrowers has run into significant road blocks, even after White House got the phone number right.

The most effective measure regulators have taken to stabilize the credit markets has been a massive liquidity injection via its Term Auction Facility program that allows banks to borrow under the veil of secrecy from the Federal Reserve.

Efforts at fiscal stimulus by Congress and the White House have received a mixed response, but Professor Shedlock believes the stimulus will not materially help the economy.

And in just in the last few days, Senate Banking Committee Chairman Chish Dodd announced a plan to raise capital to establish a government body to buy distressed mortgages from investors. Washington, however, may be better served to put the capital to use reducing the massive inventory of over-priced houses and dumping them back onto the market at levels the average homebuyer could actually afford. As we have continually stated, the problem is not that home values keep falling, it's that they haven't fallen far enough.
No positions in stocks mentioned.

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