Fed rate cut triggered by fear of bond insurance collapse

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.

Okay, stupid question from a financially challenged former scientist who is now a photographer (vanity of vanities, all is vanity).....where did all the money go? You guys seem to be up on the shell game here. Was there really no money - we were all just playing with pretend money....or did someone all of a sudden just put a bunch of cash in their vault and are waiting to buy a few NFL franchises.....why doesn’t the money just recycle and trickle down again....(I AM fully clothed in asbestos, so go ahead and make my day) My question is where is all the cash? In foreign countries? Why are they in financial trouble also.....thanks & Best regards,

So, when’s the right time to buy some US Bank Stocks?

Probably not next week, but how about in a few weeks??

These guys have reserved for the “kitchen sink” based on all of their “potential” loan losses materializing, all based on what they have to do based on GAAP/FASB/SEC principles, but not real losses, not real cash.

Who knows how many sub-prime home owners will default, but certainly it will not be to the extent that the market has shed their stock value.

Seems to me to be a huge investment potential, just need to pick the timing!

??Thoughts anyone??

the bond insurance market is not very regulated at all, and was likened to a bunch of people making side bets on fights

You're thinking of credit default swaps (CDS), which is not the same as bond insurance. MBIA-type bond insurance is used by municipalities that may not have stellar credit to obtain AAA grade financing. They buy AAA rated insurance for the bonds they issue (that's what's meant by "wrapping" the bond) and then the overall bond gets the AAA rating, lowering the interest rate.

OTOH, CDS is unregulated and can be entered into by just about anyone - hedge funds, banks, insurance companies, corporations... To enter a CDS one party "insures" a company's bond against default by paying an upfront fee and then an annual charge for the promise to be paid the face value of the bond in the event of default. But if the entity that made that promise is insolvent, the "insurance" is worthless. That's known as counterparty risk - the risk that the other side of your financial contract can't live up to the contract's terms.

In the first of many of these writeoffs to come, Merrill Lynch just wrote off about $3.2 billion of CDS that were entered into with ACA Capital Holdings. Last I had read, there were about $45 of CDS covering only $15 billion or so of corporate debt (that's the side bet aspect) and hundreds of billions of CDS covering CDOs issued by companies such as ACA. Many of these CDS will prove to be worthless.

Now to confuse matters a bit more, the bond insurers such as MBIA didn't get involved in CDS. And the municipal bonds they insure is still a good business (which is why Buffet is getting into it.) But they did get into insuring CDOs and many of those are going bad, which is impacting their capital structure. The 75bp rate cut likely won't help much here. Not when MBIA had to pay 14% interest to be able to sell a $1 billion issuance last week. BTW, that was rated AA by the bond rating agencies. 14% interest and an AA rating...

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