The financial news has been reporting on the hard times of the monolines, or bond-insurance companies lately. Ambac and MBIA are the two biggest ones. But it is not like bond insurance has become the latest sexy business sector.
Bond insurance is like your home's foundation. If you have to think about it, it probably isn't good news.
It is not good news. The core of the monolines' business has been insuring municipal bonds. Originally this was all they did and thus the odd name (which I had never heard of, like everyone else, until recently). Like many sensible businesses that worked perfectly well, they got bored of the municipal bond insurance trade. Maybe it didn't generate 20% return on capital or some other obscene profit target? In any case they wanted a little more action, and they got it — by expanding into mortgage-security insurance. They were probably crowing about innovation..
Now they are in trouble. The problem with any insurance company is that they would be fine if a few of their policies filed claims. But suppose a whole lot of mortgage-backed securities (which are a form of bond) defaulted at the same time? There is no way they can pay all those hundreds of billions of defaulting mortgages. Of course we all know that the sub-prime mortgages are toast, and that the alt-A and prime mortgages will soon follow. But the real problem is how insolvent monolines will affect municipal bonds.
Cities and towns assume that they will be able to get cash when they need it to build schools and transportation and other infrastructure. And typically they would issue a bond, which has to be insured for it to trade in public markets. On the one hand, paying premiums to a likely insolvent insurance company seems rather stupid. On the the other hand buying a bond insured by an insolvent company seems also stupid. So, right now, simply on the suspicion that the bond-insurers are insolvent, they are probably experiencing a devastating cash flow shortfall. Business on both ends of their model will fall off very sharply if they can't inspire confidence.
The upshot is that it will be much harder for municipalities to raise cash this year, or at least until credibility can be brought back into the insurance business. This is the sort of thing that makes a recession painful and last a long time. It is a much bigger problem for most Americans than the stock market. We might see construction projects halted suddenly, bus drivers not getting paid.