Musings of an Actuary (To Be)

First, I intentionally made the title of this post as stupid as possible - so you can refrain from insults.

Anyways, in regards to the vast majority of finance/business related topics currently consuming headlines, I concede my knowledge is notably inferior to my colleagues. However, there is one notable topic recently in the news that I thought I might help shed some light on. That being the topic of Ambac and MBIA's recent financial struggles, since they are bond insurers and I do know a thing or two about insurance.

Let's start with a brief rundown of the function and initial purpose of bond insurers such as Ambac and MBIA. Briefly, bond insurers take on the default risk of a particular bond. Basically, a bondholder will pay the bond insurer a certain premium so that the insurer will pay the full value of the bond should the bond issuer go into default (be unable to pay back the debt). In essence, this turns any bond into a treasury bond as the default risk is stripped away. Anyways, one of the major reasons these bond insurers came into existence was to insure municipal bonds. All to often, local and state governments would struggle to raise capital for projects as investors were reluctant to take on the additional risk tied to their bonds. However, through the emergence of bond insurers, people were more willing to purchase these bonds since they could now insure away a portion or all of the default risk they previously feared.

Anywho, this was all well and good until many bond insurers decided they wanted to seek greater returns and start insuring other bonds - most notably CDOs (many backed by subprime mortgages). Now why did they decide to insure these bonds that we all know have wreaked havoc on the financial industry? Well because they listened to the rating agencies. Moody's, Fitch, and S&P had given these bonds AAA ratings - the same ratings they gave to CDOs backed by far less risky mortgages. Why did the rating agencies do this? Because there was no historical data present to evaluate the risk of these bonds, so they put together some mathematical formulas, churned the numbers through, and came to the conclusion that the risks weren't that bad. Whoops.

So you can just blame the rating agencies, right? Well certainly they should foster some of the blame, but think about this for a second. You have two kinds of bonds - one backed by financially stable, responsible mortgage holders who put down a sizable down payment, the other backed by financially distressed mortgage holders lacking the ability to put down any kind of a down payment - and your going to believe that they bear equal risk of default? That's like saying you're State Farm, and you're going to charge people in Iowa the same about for flood insurance as people in Florida just 'cause someone tells your they're about as likely to experience a flood - it just doesn't make sense. No doubt, there is more to it than that; yet, in a very simplified sense, that's the gist of it. But nevertheless, the bond insurers decided they'd go ahead and believe the rating agencies and insure billions of dollars worth of CDOs for premiums that didn't even almost cover the risk.

Not surprisingly, the hurricane hit, and these insurers got smoked. These CDOs backed by subprime mortgages were defaulting at a ridiculous rate and the insurers were paying out absurd losses. Then, somewhat ironically, after suffering enormous write downs, they've been scrambling to preserve the ratings (put together by Moody's, S&P, etc.) of their own corporate debt with Ambac being the first to get downgraded.

So here we are, with bond insurers falling apart 'cause of their atrocious risk analysis, looking to be bailed out. Some have been finding success, but it's undoubtedly a mess to all. The largest purchasers of bond insurance are banks - just think of how much more trouble they'll be in if the insurers default... Anywho, I hope that sheds some light on the situation that I'm guessing most of the readers weren't 100% clear on. The following link is where I got a fair amount of the info from and is an incredible read if you don't mind churning through it.

Bond Insurers Financial Struggles