In: Root » » Loans and mortgages
Not all investors had been reckless. Some limited their purchases of mortgage securities to the top-rated Aaa tranches, and to be even more conservative, they had also purchased insurance. The insurance came from financial guarantors, also known as monoline insurers. These firms had traditionally insured municipal bonds against default; now they were also insuring the highly rated tranches of mortgage securities. The guarantors themselves were rated by the credit-rating agencies guarantors had promised to make investors whole if anything went wrong with their bonds, so it was important that they be rock-solid Aaa firms. Yet after the subprime shock, the guarantors began to appear markedly less solid than their ratings had indicated. Monolines weren't failing to make payments on defaulting bonds, but with the pace of defaults soaring, it looked increasingly likely that some might not be able to meet their commitments in the future. As the mortgage securities they had insured were downgraded, odds were increasing that the guarantors would eventually have to make big payouts bigger than their executives, investors, or clients had ever imagined would be necessary. The rating agencies warned the guarantors to raise more capital or risk losing their Aaa-rating. It was a potent threat: Without that supersafe rating, the guarantors would be out of business and their insurance meaningless. No investor would trust them to be able to make payouts if needed. Most guarantors took the warning to heart and raised more capital. This wasn't easy or cheap because potential investors knew there was a reasonable chance the insurance firms might not survive. Nevertheless, the two biggest monolines, MBIA and Ambac, held on tenuously to their Aaa ratings. The guarantors' problems exacerbated the nervousness in financial markets. A chain of events that had once seemed unimaginable suddenly began to loom as a possibility. It would work like this: Many large institutional investors, such as pension funds and insurance companies, are barred by law or their own rules from buying any securities rated less than Aaa. Without bond insurance, many securities would lose their Aaa ratings; thus pension funds and insurance companies would be forced to sell them. If a guarantor went out of business or even lost its own Aaa rating the securities it had insured could suddenly face such a downgrade. As the monolines' problems grew, so did the odds they would lose their Aaa ratings. The prospect of institutional investors suddenly flooding the markets with massive amounts of bonds began to haunt financial players. Such worries reinforced the free-fall in mortgage securities and also pushed the formerly staid municipal bond market into turmoil. Perfectly solvent state and local governments and authorities found themselves having to pay interest rates reserved for high-risk borrowers. This was most clearly demonstrated by the disruption of the auction- rate securities market. In this out-of-the-way market, certain long-term municipal bonds were treated as if they were short-term investments, with interest rates set once a week in an auction run by large Wall Street investment banks. The rates were typically lower than for comparable fixed-rate bonds, making them attractive to municipalities issuing debt. The weekly auctions effectively turned longterm municipal bonds into more liquid short-term bonds, which appealed to investors such as money-market funds. Both features, however, depended on the success of the weekly auctions. So important were these auctions that, to ensure their smooth functioning, the investment banks would step in and buy the debt themselves if they failed to attract enough outside bidders. In early 2008, spooked by the potential failure of the monolines and other worries, investors stopped participating in the auctions, causing scores of them to fail. Even the investment-bank sponsors, worried about their own financial exposure, refused to play their usual backstop role. As a result, the interest rates on auction-rate securities surged. Municipalities were suddenly forced to pay rates far higher than even junk corporate borrowers. Trust had broken down so thoroughly that municipalities couldn't even count on their own investment bankers. The subprime financial shock had engulfed even state and local governments.
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