Posted on 01/22/2008 4:18:54 PM PST by TigerLikesRooster
January 23, 2008
Fed rate cut triggered by fear of bond insurance collapse
Suzy Jagger, Christine Seib and Tom Bawden
Fears that America’s bond insurance market could implode triggered the US Federal Reserve’s biggest interest rate cut for more than a quarter of a century, Wall Street economists claimed yesterday.
Market analysts said that Wall Street had spent last week gradually realising the grave consequences of a major bond insurer defaulting on its commitments and attributed the surprise rate cut to averting such a crisis.
As well as guaranteeing company debt issues, the bond insurers underwrite paper from local government in the United States. The failure of a bond insurer would reduce funding for state governments or increase its cost, threatening infrastructure projects such as building of schools and roads, slowing the US economy further.
The Federal Reserve yesterday cut the cost of borrowing by three quarters of a percentage point to 3.5 per cent, a week before its scheduled meeting.
Kevin Logan, senior economist for Dresdner Kleinwort, the investment bank, said: “The red light that triggered this cut is the issue of the bond insurers. The Fed realised what the consequences were in the event that a bond insurer fails. They hit the emergency switch and cut rates.”
Having watched the sharp losses in equity markets in the Far East, London and Europe on Monday, Ben Bernanke, Chairman of the Federal Reserve, hastily assembled members of the rate-setting Federal Open Market Committee for a video conference at 6pm US Eastern time on Monday to discuss whether to cut rates.
Wall Street had been paralysed on Monday because US markets were closed for a bank holiday. On a phone conference call yesterday morning, eight of the nine present members voted for the 75 basis point cut.
The move triggered initial panic on Wall Street, as traders worried that the cut represented an admission that the US economy was deteriorating far faster than had been believed and that turmoil in the credit markets had spilt over to hit growth. The Dow Jones industrial average lost 4 per cent, or 455 points, within minutes, before recovering to close down 128.10 points at 11,971.20. The move also helped to bolster the FTSE 100, which closed up 161.9 points at 5,740.1.
Mr Logan said that investors, bankers and analysts last week began discussing the consequences of a bond insurer failing to pay out in the event that a large bond defaulted on its interest payments. He said: “They spent last week talking about it, calling their contacts. They gradually came to a conclusion about what would happen if a bond insurer failed, about the consequences for the financial markets and for the economy in general.
“The picture started to look very messy and people realised it could get a lot worse. Then the White House came out with their fiscal stimulus programme which didn’t address anything. The problem is the credit markets.”
Last week, Ambac became the first bond insurer to lose its AAA credit rating after it cancelled plans to raise $1 billion of new capital which it was thought to have earmarked to cover its expected liabilities. Bond insurers such as Ambac guarantee to pay the interest and principal on bonds that they underwrite in the event of a default. State governments cannot raise money through debt markets without bond insurance. Many bond investors require that debt be insured by an AAA-rated underwriter. Wall Street is scared that the consequences of a bond insurer failing would feed through the financial system, and cut credit lines for US municipalities that need capital for projects such as road building.
Chris Whalen, of Institutional Risk Analytics, a Wall Street consultancy, said: “Once an insurer fails, then we are in a serious situation and people will see how fragile the market is.”
Mr Whalen predicted that if a bond insurer failed on its obligations, another insurance company, or a bank or an individual such as Warren Buf-fett would acquire the group cheaply.
Mr Logan said that his “worst-case scenario” would involve investment banks having to write down even more asset-backed securities on their books after insurers failed to pay out on defunct bonds. “The banks themselves are already bleeding and wounded,” he added.
Ambac’s downgrade had a knock-on effect on UK companies, as Fitch downgraded bonds insured by the monoline. Companies including Northern Electric Finance and Yorkshire Electricity had sold hundreds of millions of pounds of bonds wrapped in insurance from Ambac. The ratings agency downgraded the bonds from AAA to AA.
Yesterday in London, bank shares were among the biggest fallers amid fears that they would also be hit by fall-out from bond insurers. Analysts at Credit Suisse said that Barclays and Royal Bank of Scotland could declare further writedowns of a “few hundred million pounds” when they report 2007 results next month, on the back of exposure to the insurers.
Ping!
I may be wrong but I thought I could detect the Plunge Protection Team at work on the markets today.
I do not really see how cutting rates will help bond insurers.
In any case, if one insurer loses its AAA rating, municipalities can just use another one, such as Warren Buffet’s startup.
Those that lose their AAA ratings may still be able to pay claims, but can’t write new business. If a bond issuer failed, they would only be liable for the interest until the maturity date of the bond.
It will NOT help.
Thanks for the ping.
“Ambac crisis” seems to be the party line today, there was a clown on CNBC even before the market opened, earnestly peddling that theory.
I wrote earlier that that’s BS — they didn’t know it was a crisis until the very day that Fitch downgraded them from the completely imaginary “AAA” rating?
PPT was definitely on the job today. Every time stuff needed a little boost to get through a trendline or a magic number (e.g. DJII 12000), a big volume and price spike appeared out of nowhere.
Until somebody leaked Apple’s earnings report just before the closing bell, that is! That’s the only thing that can explain that 100+ point DJII drop in like 15 minutes that close to the close. Apple is now down 25 points in after-hours trading and Nasdaq-100 futures are down 2+%.
So tomorrow could start out on a sour note again.
That's my take. It was a problem but not a huge problem.
The reason the Fed cut rates is the world markets voted on W's stimulus plan and said it stunk.
Bond insurance, which some may have never heard of before, sounds like something that would trigger the Fed to change the rate.
About a month. Then, some other game will be played to stretch this out as long as possible. Not only are these bond insurers not AAA - they are bankrupt.
There was a good WSJ on this last week.
If I recall, the bond insurance market is not very regulated at all, and was likened to a bunch of people making side bets on fights.
The current worry is that some of the folks writing policies on bonds issued by the companies don’t have the assets to cover the bets. If a large number of companies go under, the value of the assets used to underwrite the bond insurance goes down as well, calling into question whether they can pay.
On top of that, as companies ratings go down, the policies themselves go up in value, and are TRADED. The tighter a company’s circling the drain, the higher the value of the bond insurance policy on a company. The holder of the bond can sell it to somebody else.
Insider trading? Why not? You can hold a bond, or an option on a bond, and no stock, and profit on either the health or death of a company.
Anyway, its complex, and not a lot is known about it, and there are trillions of dollars involved.
I’m wondering about the relationship between the instability with bond insurers and the bond market in general. Bond funds, like Vanguard’s VBMXF (an intermediate term bond fund) have risen noticeably in the past month. It’s made up of about 10% government bonds and the rest are “high quality” commercial bonds. I’m wondering why this fund hasn’t dropped in value. Any thoughts?
Perhaps it’s due to money pulled out of the stock market going into safer investments......
I would guess that the corporate bonds are bonds issued directly by the various companies in a bond issue, e.g. a Ford Motor Company 30-year bond of let’s say 4%.
The stuff that is killing Ambac et al are “derivative” bonds, a/k/a CDO’s or CMO’s: a big bunch of dodgy mortgages that magically become AAA-rated when you have a hundred of them averaged out.
Conventional bonds like what your fund is talking about are going up in price as interest rates go down. I do not offer an opinion as to whether this will continue!
this was sarcasm by the way
“I may be wrong but I thought I could detect the Plunge Protection Team at work on the markets today.”
Yeah, a panic open despite the cut announcement pre-open. Great playing of market psychology.
I don’t take myself seriously on short-term overall market direction but I think this is at the very least a short-term market bottom, there was enough panic to possibly make it one. Of course that is just this week....
“this was sarcasm by the way”
Well, it may accurately describe what the visible process of bundling some of the tranches resulted in.
It's like the emperor's new clothes, combined with the knowledge that the emperor will have a fatal heart attack if he finds out he's been naked.
We have to break the news to him NOW...but gently.
Cheers!
When bailing my 401k out of the S&P500 last summer, I looked at the one offering my 401k plan has in the “high grade corporate bond” category. It was 60% invested in “mortgage related securities”. No thanks. My nest egg is safe in what is essentially a cash fund (US Government debt only). But it really scares me that a large percentage of people in this country wouldn’t even know how to find out what a mutual fund actually holds before putting a big chunk of their retirement savings in it. “High Grade Corporate Bond” sounds so conservative and safe, but it’s often a bald-faced lie.
That may be what’s killing Ambac now, but those same piles of pseudo-AAA bonds were formerly the driving force behind Ambac’s high-flying stock price and pseudo-AAA rating. As I said on another thread last week, I’d give more credence to Britney Spears’ opinion on the credit-worthiness of a bond issue, than to one of these scammy ratings from the rating agencies’. Since Britney doesn’t have a clue what a bond is or what creditworthiness is, if you showed her a list of ratings and offered her some drugs for picking one, she’d just take a wild guess and at least have a chance of getting it right. The rating agencies know exactly what they’re doing and give the wrong answers on purpose.
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