The Circle of Life

Story Highlights:

• After insuring risky mortgage-backed securities, bond insurers face an uncertain future as their ability to back defaulted loans is called into question
• Credit rating agencies like Fitch and Moody's have increased pressure on bond insurers to raise capital or face a cut in rating
• New competitors are seizing the chance to gain market share and turn the focus away from high risk policies

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The latest Financials companies to make the endangered subprime species list, bond insurers MBIA and Ambac were in the headlines today. Though both firms have been in trouble for some months, ratings agencies this week announced MBIA's AAA rating was under review, while Fitch officially lowered Ambac's rating two levels to AA. Though this will be painful in the short term for bond insurers and those who depend on them, a closer look at the industry reveals an environment ripe for more competition and moderated risk.

The bond insurance business backs up fixed income debt issued by corporations, agreeing to pay investors principal and interest should the issuer default. Similar to a debt rating, the rating on bond insurance reflects the ability of the insurer to pay down its liabilities. Many less credit-worthy companies rely on bond insurers with good ratings to improve the ratings of their riskier debt offerings. So, should their insurers' ratings worsen, the insured debt will become more risky and less valuable.

Over the last several years, insurers increasingly backed the boom in mortgage-related financial products. And as problems in the subprime market have grown more pronounced, the ability of the big insurers to pay off bad debt has been called into question. As speculation swirls over the fate of their ratings, the market value of industry leaders Ambac and MBIA has swooned.

Ambac Insurance Loses AAA Ranking at Fitch Ratings
By Christine Richard, Bloomberg.com

So, how could this possibly be a good thing? Think the "Circle of Life" from your kids' favorite standby DVD, the Lion King. Or if you're in more of a National Geographic Explorer mood, imagine the allocation of resources in the Serengeti (tasty gazelle in weakened state feeds agile, strong, and hungry lion). That which seems painful and ruthless makes the population of both gazelles and lions healthier and more robust.

Now apply this concept to the business world. Good companies make bad business decisions. The market calls them on those decisions and pain abounds as the injured companies can't meet investor expectations and lag behind the pack. Enter financially healthy competitors, hungry for market share and ready to transform ailing businesses into the sinewy killing machines lurking just beneath the surface.

Something similar is taking place in the bond insurance business. Berkshire Hathaway recently established a bond insurance unit: Berkshire Hathaway Assurance Corporation. The new Berkshire venture will guarantee bonds for municipalities, the core business of most other bond insurers before they became entangled in mortgage-backed securities. And other opportunistic insurers will undoubtedly enter the market as well.

Berkshire Hathaway Opening Bond Insurer
Staff, Associate Press

Ailing companies like MBIA and Ambac, whose shares are selling for a fraction of what they once were, could make prime targets for acquisition. Their years of industry experience will not go to waste; rather, it will be absorbed by newer, healthier, and less stigmatized firms. And don't forget the risky subprime stuff isn't all these companies have to offer. Other healthier business units and infrastructure will make the prospect of acquisition even sweeter for incoming competitors.

Nothing goes to waste on the fertile plains of the Serengeti, nor in the jungles of the business world.

Have a great holiday weekend.