One of the reasons, some market experts believe, for the monster selloff yesterday (and future selloffs down the road) was a concern that the large 're-insurers” of mortgages were having their credit rating downgraded.
One of those is Ambac Financial Group Inc. of New York. Here's how it Ambac fits into the ecosystem:
When a bank lends you money for a house, it buys insurance in case you default and it can’t get back all of its money even if it seizes your house. So, in this way, the bank gets its money back either from you or the insurance company or a combination of both.
The bank's insurance company wants to hedge its bets, too, and so it buys insurance from another, bigger insurance company in case all of its bank customers have trouble at once.
This other, bigger insurance company is Ambac and others like it. It insures insurers.
If Ambac's credit rating falls, it cannot backstop the insurance companies who are backstopping the banks who are dealing with defaulting mortgagees.
With banks losing money to defaulting mortgagees and unable to get decent insurance to spread their risk around, banks have a serious capital problem. Their solution: stop lending money to anyone. And with that, the whole bloody system comes to a grinding halt.
This is a big problem – a way bigger problem than a mere recession.
This morning, Ambac announced its financial results for the fourth quarter 2007. Ambac lost $3.2-billion.
Wow.