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The next threat

• Robert Peston
• 20 Dec 07, 12:10 PM

Whoops.

Yesterday's decision by to downgrade the credit rating of one specialised bond insurer, place four others on "negative outlook" and one more on a downgrade review, is bleak news.

These insurers underpin the prices of trillions of dollars of bonds, both plain vanilla municipal bonds and the concocted CDO variety.

They insure the bonds so that they are classed as AAA rated and more or less of the same quality as the best sovereign debt.

This allows the most risk-averse investment institutions – certain pension funds, banks and other collective investment funds – to buy them.

So if the bond-insurers’ own respective ratings were downgraded, there would be a knock-on to the rating of the bonds.

That would have two painful consequences.

It would lead to sharp falls in the prices of those bonds – forcing huge losses on their holders.

And it could also lead to forced sales of those bonds by institutions which for regulatory or contractual reasons are simply not allowed to hold lower quality bonds – precipitating a further downward spiral in bond prices.

The consequence would be a further serious erosion of banks’ capital and losses for those of us dependent on pension schemes and insurers for future retirement income.

Or to put it more starkly, the weakness of these specialised insurers – known as monolines – is a potential threat to the soundness of the global financial system, at a time when the confidence of banks and financial institutions is already at a low ebb.

The weaker insurers are trying to raise new capital to prop up their credit ratings.

And it’s in the interest of banks and funds to supply this capital – since the cost to them of not doing so, in the form of a bond-market crash, would be devastating.

Reason dictates that a commercial solution will be found.

Bankers tell me they are confident the worst can be avoided.

But if the monolines can’t be recapitalised by the private sector, batten down the hatches and pray that the US Government will fill the breach.

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