America’s sneezed a couple of times, and Germany’s catching a cold (G). But according to a couple of recent articles, America may be in for a severe flu, which will put Germany in intensive care.
The most interesting part of the story is the subprime crisis, which we all find a transatlantic high-finance morality play (don’t we?). Latest signs indicate it is spreading far beyond mortgage loans. According to this MarketWatch article, bond insurance agencies are now being downgraded, which could trigger further financial meltdowns. This article in the Wall Street Journal gives some background to the current problems:
At the center of these concerns is a vast, barely regulated market in which banks, hedge funds and others trade insurance against debt defaults. This isn’t like life insurance or homeowners’ insurance, which states regulate closely. It consists of financial contracts called credit-default swaps, in which one party, for a price, assumes the risk that a bond or loan will go bad. This market is vast: about $45 trillion, a number comparable to all of the deposits in banks around the world.
Essentially, it goes like this. You are a housing construction firm (or a city), and you want to build a new subdivision. You issue corporate bonds to finance the cost of the new construction. Normally, the risk of you defaulting on your bond would be built into the interest rate: the more risk to the person who buys the bond, the higher the nominal rate (although bond valuation is a lot more complex than this in reality).
However, firms like ACA, the subject of the Wall Street Journal article, began to also offer bond insurance: for a fee, you could buy an insurance policy that would require ACA to continue paying the interest and principal on the bond if the actual bond issuer couldn’t make the payments. Finally, very recently (only since about 2000), they began offering credit default swaps. This is a private contract in which a bond insurer (swap seller) promises to pay some party (the swap buyer) a set amount of money if a bond issuer defaults. These transactions allowed banks to improve their earnings reports by off-loading the risk of market-price fluctuations onto third-party insurers.
A credit-default swap is a private contract between two parties, and thus is not subject to the intensive regulation of ordinary banking or insurance transactions. For instance, credit-default swap sellers were often not required to post anything more than nominal collateral — that is, there was no law setting an amount of liquidity they had to possess in order to make good on claims arising from the swaps. Back in the salad days, of course, this counted as an advantage.
These mechanisms seem to have been used to further disperse the risk of default, and to "launder" riskier bonds. That is, if a reputable, A-or-above rated bond insurer sold the insurance or swap, the swap itself would often receive a rating comparable to the rating enjoyed by the insurer who offered it — and, conceivably, higher than the risk of the underlying securities would justify. The real problem is that this entire scheme rests on the market believing that the bond insurers’ judgment is as good as it should be; that the bond insurers genuinely deserve their ratings. Like the high-rise apartments built by El Mistico’s powers of suggestion in the Monty Python sketch, the entire edifice starts to crumble if the bond insurers’ judgment is no longer taken at face value: when "a bond insurer is downgraded, all the securities it has guaranteed are, in theory, downgraded as well," to quote the Marketwatch piece. This could also affect municipal bonds, which are used by American public authorities to finance new schools, sewer systems, and the like.
Now, I’m no expert here, so maybe I’ve gotten some of this wrong. Corrections welcome in comments.