A painful fix for the credit crisis

By Jim Jubak

It's the end of the beginning for the credit crisis: There are now plans to split up the companies that insure bonds and derivatives based on mortgages and buyout loans.

What that means for you and me is that the credit crunch -- which has hobbled the stock and bond markets and is causing the U.S. economy to grind to a halt -- would be over in 2008 rather than producing a Japanese-style lost decade.

The breakup plans also would lead to tens of billions more in write-downs from banks and other investment companies that have already written down tens of billions. And I'd expect the likely losers from these plans would fight them tooth and nail in the courts. It could be years before all the litigation was settled.

But confirmation that a big insurer like Ambac Financial Group (ABK, news, msgs) is well along in talks to pursue this kind of breakup will provoke a rush to the exits by investors and institutions. They know prices for risky debt aren't going to get any better and could indeed get a whole lot worse. That giant whoosh you'll hear is the sound of somewhere between $50 billion and $125 billion in losses getting flushed down the toilet by the end of 2008.

And that's a good thing. This drastic medicine is the only remedy that would put the financial markets on a relatively quick path to health. Anything else promises to stretch this crisis out for years and years and keep the U.S. economy grinding along in low gear.

Like a 1930s bank run

The crisis of confidence that has gripped the debt markets is like an old-fashioned, Depression-era run on the banks -- but now with trillions of dollars on the line.

In a bank run, depositors, fearing their bank might not have enough capital to cover its obligations, rushed to pull out their money before it all disappeared. The bank would try to call in whatever loans it could to provide cash and, of course, stopped making loans. If the run was fast and heavy enough, the bank would shut its doors, freezing the accounts of depositors who hadn't been quick enough to pull out their money and calling in all outstanding loans to the borrowers who depended on the bank.

If the bank was big enough, the run and subsequent closing of its doors could send ripples out across the banking sector as customers at other banks began to worry about whether their banks were safe. That often led to runs on other banks and a banking crisis like the panics of 1930-33, when 2,489 banks failed.

The rise and fall of trust

In the current credit crisis, as in the bad old days of bank runs, the key questions are: Whom can you trust to pay what they owe? How do you restore confidence to the system? For individual depositors, that question was answered by the 1933 creation of the Federal Deposit Insurance Corp., which guarantees the safety of bank deposits (up to $100,000, anyway).

In the debt markets, it's not so simple. There were three primary ways to figure out whom to trust:

• Ratings. Bonds and credit derivatives, the things with names like collateralized debt obligations and mortgage-backed securities, were built on top of mortgages, car loans, credit card receivables and so on. They came with ratings from companies such as Standard & Poor's, Moody's (MCO, news, msgs) and Fitch that indicated how likely the credit was to go bad.

• Insurance. Investors who weren't certain they wanted to trust a rating (or who wanted extra security) and borrowers who wanted to get a higher rating (and thus pay less for the money they were borrowing), could pay an insurance company like Ambac or MBIA (MBI, news, msgs) to guarantee a bond or derivative against default.

• The derivative market. A derivative called a credit-default swap let companies buy and sell the risk of a default on a debt. In October, for example, a financial company or investor wanting to insure a $10 million basket of already top-rated AAA commercial mortgages against default would have paid another financial company or investor a "premium" of about $39,000 to do so.

Over the past year, however, the crisis in the debt markets has stripped away each layer of guarantee and left investors completely at sea over how to figure out whom to trust:

• First, the subprime-mortgage crisis told buyers of debt they couldn't trust ratings. Moody's, Standard & Poor's and Fitch started to downgrade AAA and other highly rated bundles of mortgages and mortgage derivatives that they had rated only six months or a year ago. The ratings on this debt couldn't have fallen that much so fast unless the original ratings were wrong, the market quickly concluded.

• Second, with highly rated debt suddenly turning risky, the market started to take a harder look at how much it could trust the insurance against default purchased from the bond insurance companies. The amount of debt guaranteed by the insurers dwarfed their capital. In the municipal market, the original core business of these insurers, they had guaranteed about $1 trillion in bonds. In the new business of insuring credit derivatives, the insurers had backed $1.2 trillion in debt. That's a lot of insurance given that the largest insurer in this business, MBIA, has by its own count about $17 billion in total claims-paying ability, after raising $3.1 billion in capital in the past two months.

• And third, credit-default insurance first soared in price and then fell in credibility -- to near zero in some markets. The same AAA-rated bundle of mortgages that cost $39,000 to insure not long ago had climbed to $214,000 by Feb. 15. The increase for buying a credit-default swap to insure a similar $10 million package of riskier BBB-rated commercial mortgages had climbed to $1.5 million from $672,000. But, increasingly, even the availability of credit-default insurance wasn't enough to create buyers in some parts of the debt markets. At the end of 2007, the market for commercial paper backed by mortgages and other assets had dried up almost completely because there were no buyers for this short-term debt, typically used to fund company operations.

Continued: An ultimatum

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