Bond Insurer MBIA (MBI) Drops a Bombshell - Down 30%

I realize reading about bond insurers is like going to the dentist but as I implored yesterday [What a Day on the Street] I think it is imperative to understand what is really going on behind the scenes here and the magnitude of potential risks, even if all you care about is fertilizer or solar stocks. We have such a leveraged financial system, and the delevering of this system is 100x more scary than anything simple such as a simple recession. Again let me point to Financial Day of Reckoning Approaches. I keep writing that we have so many layers of this credit web, and much of it won't be discovered until things implode in the dark of the night. How it stops or how it ends, I am frankly, totally unclear about. This is what worries me; I don't see what a solution could even be if we truly begin to unravel decades worth of leverage of credit. Maybe there is some stop gap I cannot think of; I assume there must be something being cooked up but the worry here is finally the problem is larger than the system. I think the general game plan by central banks is to try to keep pushing this off for 2-3 more years and hopefully the main asset much of this junk is based on (home prices) rebound by then; or drive mortgage rates to 5-5.5% levels so people can refinance. But many of these people have little to no equity in their homes, or worse are upside down - hence cannot refinance. All at a time the credit market is drying up as we become more risk averse by the day. Ugh.

Today, bond insurer MBIA made some troubling 'surprise' disclosures.

• The financial guarantor's shares dove more than 30% in early trading after the firm dropped a bombshell revelation that it has significant exposure to some of the most risky elements of the structured product market.
• MBIA announced that it guarantees $8.1 billion of structured products called CDOs-squared, among some $30.6 billion in total exposure to CDOs, or collateralized debt obligations. That means MBIA guarantees payment on CDOs that package up other CDOs. Many are filled with subprime or other mortgage-backed debt, which has been subject to downgrades, deterioration in value and default of late.
• "We are shocked that management withheld this information for as long as it did," writes Ken Zerbe, analyst at Morgan Stanley in a note Wednesday.
• The news comes as investors are increasingly concerned that the credit market woes that have roiled financial markets in the second half of this year will intensify with the potential default or credit rating slide for a financial guarantor.
• The credit ratings agencies have been scrutinizing the finances of companies like MBIA and competitors Ambac (ABK), Financial Guaranty Insurance Co., XL Capital Assurance, CIFG Guaranty and Financial Security Assurance. The guarantors rely on having pristine credit ratings and more than enough capital to guarantee that investors receive their payments on securities they own.
• A ratings downgrade could force some fixed-income investors into a selling spree, because parameters of their investment funds require that their holdings be insured by a guarantor with a triple-A rating.
• But the fallout of a guarantor downgrade reaches beyond forced bond sales. The guarantors also underwrite credit-default swap protection on securities like bonds, CDOs and other asset-backed debt. These firms have already taken writedowns based on widening risk premiums, or credit spreads, on their credit default swap portfolios, and analysts expect they'll take more.
• Zerbe had thought Ambac had more risky CDO exposure until MBIA's announcement Thursday. He notes that the news validates S&P's prediction that MBIA's stress-case scenario would engender losses 61% higher than Ambac's $1.5 billion.
• And many banks and brokerage firms are buyers of guarantors' insurance and credit default swaps as well, begging the question -- why wouldn't someone pony up cash to rescue the firms from capital shortfalls?
• According to a New York Times report Wednesday, Merrill Lynch (MER ) and Bear Stearns (BSC) were negotiating a bailout of smaller insurer ACA Financial Guaranty Corp., but they were too late. The firm's rating was slashed Wednesday deep into junk territory by Standard & Poor's, to triple-C from single-A.

I know... it's dry reading... blah, even for me. But these companies essentially hold the key for the entire credit system. Without their insurance, it all implodes. As the flashlight searches around the dark room, we see more and more cockroaches emerge - one by one.

More of a detailed look here in a Fortune article - whats interesting is the companies (banks) that bought this insurance are so desperate not to have the insurance agent go under they are willing to infuse capital into the insurance agents to keep them afloat. In layman's terms what is happening on Wall Street is if you had a medical emergency, and your Blue Cross was about to go under, but you knew if it did you'd be on the hook for the 70K hospital bill so instead you start sending money to Blue Cross to keep it afloat - just so it can cover your insurance. That's essentially the stage we are now entering.

While a cash infusion to struggling bond insurers may keep downgrades and write downs from happening right now, at the end of the day the bonds, insured or not, are full of worthless paper. Someone will have to pay, whether it be a bank a bond insurer or some other party. "What we're seeing now is a valuation crisis," says Sylvain Raynes, a former Moody's analyst and principal at the structured finance consultancy R&R Consulting. "Wall Street is a big wheel that is moving the same losses in a circle and only postpones the ultimate reckoning and makes it much worse."