Monoline bail-out

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Can something be done to restore confidence in the bond insurers – and who would do it? The grim news on Friday of Ambac’s downgrade helped to push equity markets over the brink, so it is likely that someone, somewhere, is trying to figure out how to structure a bail-out that can keep up with the ratings agencies’ ever more bearish assessment of the insurers’ subprime exposure.

Wall Street might seem like a contender to be involved. After all, if various banks and brokers have hedged out some of their subprime-related exposure via contracts with monolines, and fear that some of these hedges may potentially be less valuable, that raises the prospect of yet more writedowns.

Finding a clever way to avoid that would certainly be nice. But it is unlikely to be easy. The problem is figuring out who has what exposure to whom.

Merrill Lynch provided an extraordinary level of detail last week, outlining the value of its monoline hedges for collateralised debt obligations. Citigroup has also noted its hedged exposures, but we do not know what proportion of that is with the monolines.

To add another layer of complexity, investors do not know how effective Wall Street has been in protecting its hedges against a monoline meltdown – in effect hedging the hedges.

Outside of Wall Street, there are many other constituencies fearing the ripple effects of a monoline crisis. The insurers’ role in the municipal bond market is huge, though in the longer term it is not as scary as the current market turmoil because of the good record of municipal bonds, with historically very low defaults.

Of course, if there is enough of a panic, systemic risk will affect everyone. But getting Wall Street to act now, with everything else it has on its plate, will be a tall order.

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