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Bailout could rally weak bond market

NEW YORK – If the struggling bond market is saved by a potential bailout, turbulence in the stock market could ease, but without a bailout, cities across the country could have difficulty building everything from sewers to schools.

A string of gains in the stock market this week came in part from the Federal Reserve’s cut of a key interest rate, but news of a potential bailout of the bond insurance industry also sparked hope that credit markets could return to a more normal environment.

Hope for a bailout has “kept the Titanic from going straight down, and now we have a listing ship that needs to be righted,” said Joseph Battipaglia, a market strategist for the private client group at Stifel Nicolaus. “The insurance iceberg was probably a sinker.”

Over the past few months, ratings agencies have downgraded or threatened to downgrade bond insurers’ vital financial strength ratings, saying the insurers do not have enough extra cash to cover a potential spike in claims. Bond insurers pay principal and interest on bonds when the issuer is unable to make payments.

A downgrade from a “AAA” rating would likely end the insurer’s ability to book new business. That in turn reduces the options for municipalities looking for insurance.

“A lot of municipalities have good reason to go to market,” said Donald Light, a senior analyst at Celent LLC, but he added it would be more expensive for to issue bonds without insurance. Most municipalities do not have pristine “AAA” ratings, so they go to bond insurers and pay to use their ratings. That in turns makes the interest rates on the bonds lower, saving the group money.

Those added costs are likely to lead some municipalities to delay or cancel certain projects, or at least scale them back, Light said. A collapse of the bond insurance market could lead to a 10 percent to 25 percent decline in new issuance, he added.

A continued plunge in ratings for the bond insurers not only hurts municipalities, but it also puts already struggling banks in a precarious position. Investment banks – which are still trying to sort of the mess from the subprime mortgage market – have already reduced portfolio values by nearly $140 billion during the second half of 2007 because of bad bets on troubled loans. Now they could face a fresh round of losses tied to the bond insurers.

Investments held by banks and insured by companies like Ambac or Security Capital or insurance contracts banks hold on the bond insurers themselves would all likely lose value if bond insurers ratings continue to fall.

That means more uncertainty surrounding banks’ future earnings, which could drag down the stock market further.

But bailing out the bond insurers is very complicated with trillions of dollars in insurance coverage at stake, Battipaglia said, echoing sentiments a deal might take a while to finalize.


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