Indirect Economic Effects of The Subprime Mortgage Crisis - Effect On Municipal Bonds and Bond Insurers

Effect On Municipal Bonds and Bond Insurers

A secondary cause and effect of the crisis relates to the role of municipal bond "monoline" insurance corporations such as Ambac and MBIA. By insuring municipal bond issues, those bonds achieve higher debt ratings. However, some of these companies also insured CDOs backed by low-rated tranches of subprime mortgage-backed securities, and as default rates on those MBS have risen, the insurers have suffered significant losses. As a result, rating agencies have downgraded several bond insurers—as well as the bonds they insure--some to low speculative grade rating categories.

The downgrades further threaten the bond insurers because they become unable to underwrite new business going forward. The downgrades may also require financial institutions holding the bonds to lower their value or to sell them, as some entities (such as pension funds) are only allowed to hold the highest-grade bonds. The effect of such a devaluation on institutional investors and corporations holding the bonds (including major banks) has been estimated as high as $200 billion. Regulators are taking action to encourage banks to lend the required capital to certain monoline insurers, to avoid such an impact. However, rather than recapitalizing insurance units plagued by exposure to subprime related products, some insurers are focused on moving excess capital to previously dormant units that could continue to underwrite new business.