LegiStorm

Summary:

Beginning in 2007, higher than expected defaults and delinquencies in "subprime" mortgages led to a significant slowdown of the housing market. Most of these mortgages were financed by capital markets through asset- or mortgage-backed securities, rather than by traditional banks. Thus, rather than being confined to the institutions that made the now-questionable loans, losses caused by unexpected mortgage defaults have been felt throughout the financial system by any entity who bought mortgage-backed securities. In addition, financial guaranty insurance companies, often known as "monoline" insurers, have also been affected because they insured the prompt payment of interest and return of principal for various securities that may now not be able to pay the promised amounts. With most possible insurance payouts still in the future, these insurers have yet to experience large real losses. Possible massive future losses, however, have caused financial turmoil for insurers, downgrades from rating agencies, and fears about further harm to other institutions, individuals, and municipalities. While the federal government does not currently oversee any insurers, various proposals for broad federal oversight have been introduced, including S. 40/H.R. 3200 in the 110th Congress. The House Financial Services Subcommittee on Capital Markets, Insurance, and Government Sponsored Enterprises held a hearing entitled "The State of the Bond Insurance Industry" on February 14, 2008, and the full Financial Services Committee is scheduled to examine "Municipal Bond Turmoil: Impact on Cities, Towns, and States," on March 12, 2008. The financial guaranty insurance industry began less than four decades ago with insurance policies being offered on municipal bonds. Bond insurers became known as monoline insurers because they were limited by the regulators to offering financial guaranty insurance, and relatively few companies entered the business. While insuring municipal bonds has remained the majority of their business, bond insurers also expanded into offering insurance for international bonds and the aforementioned asset-backed securities. The insurance provided on the asset-backed securities has been offered through relatively new financial derivatives known as credit default swaps, rather than through traditional insurance policies. The coverage provided through such swaps has in most cases been essentially identical to that provided through traditional insurance policies, but the accounting treatment is different for these tradeable contracts. As the risk of default for the underlying securities has risen, the value of the credit default swaps to insurers has fallen, resulting in multi-billion dollar paper losses for bond insurers. With the possibility of wider financial damage spilling over from bond insurer difficulties, various market participants and government regulators have broached the idea of some sort of rescue for the troubled insurers. Uncertainty about the need for, and size of, such a rescue, as well as complexities in the bond insurer situation have stymied any such rescue to this point. In addition to the immediate demands of crisis management, the turmoil surrounding the bond insurers may also bring longer term regulatory issues to the fore, including questions about future federal oversight regulation of insurers and future federal oversight of derivatives, many of which are essentially unregulated. This report will be updated as events warrant.