The problems in the financial sector as a result of the U.S. subprime mortgage meltdown have revealed a number of other complicated operations that most of us were never aware of in the first place. This includes the category of insurance firms called “monolines”. It turns out that there are companies (the monolines) that offer insurance protection with respect to such debt instruments as: (1) bonds issued by municipalities; and (2) commercial paper offered by financial institutions. It is category (2) that has gotten these monolines into such trouble.

Monolines have traditionally been solid financially. As a result, they have played an important role. An issuer (for example, a municipality) pays a monoline to insure its debt instrument (e.g., a municipal bond) for a very good reason. In the past, this has virtually guaranteed that purchasers will get their money back no matter what. As a result, the issuer receives the highest of credit ratings (e.g., AAA) and this pays for the cost of the insurance by lowering the interest rate.

Where this has gone wrong lately is that the monolines have moved beyond insuring municipal bonds to covering commercial paper as well. The security behind these has often included a subprime mortgage component. Failures in this area have thrown the commercial paper into default and taken the financial security of the monolines with them. The credit ratings of the monolines have been in jeopardy and this has threatened the credit ratings of the insured instruments as well.

Municipal bonds are an important source of funds for infrastructure construction. The problems of the monolines spread over to the municipalities in several ways. They raise insurance costs; they raise interest rates; and they limit the potential “float”. For example, the incorporation papers of some pension funds require that their holdings be “only of the highest grade”.

The two largest monolines, MBIA and Ambac, as well as several others have been scrambling around trying to shore up their financial backing. Some regulators are proposing that the business of the monolines be separated into two categories, “lower risk” and “higher risk”. This may be okay going forward, but it cannot be applied to instruments already under coverage without a blizzard of lawsuits.

Alex Carrick

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