More banks feel subprime heat

Some analysts fear that mainstream banks will be burned by a time bomb in the bond insurance business.

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(Fortune) -- Wall Street banks aren't the only ones taking a drubbing these days. Bond insurers, which guarantee municipal bonds and operate in a sleepy corner of the fixed income world, also insured subprime mortgage-backed securities. As a result, shares of bond insurers like Ambac Financial Group, MBIA and ACA Capital have tanked.

Now ratings agencies are thinking about downgrading their debt. If that happens, the repercussions could be serious, not just for the bond insurers but also for the municipalities that issue bonds and the banks that underwrite them. Indeed, analysts speculate that problems in the municipal bond business could be the next shoe to drop on Wall Street.

If so, more ugly surprises may be in store for wary investors. As more mortgage-backed securities threaten to default, billions of dollars in additional losses could loom. Moreover, banks like Canadian banking giant CIBC (Charts) and Britain's Barclay's, which many assume have dodged the worst of the bad-mortgage bullet, could be on the hook for insurance payments guaranteed by bond insurers (more on that later).

"It's like the perfect storm," said Kyle Bass, the managing partner with Hayman Capital, a hedge fund that scored big by shorting subprime securities. "The insurance industry is dealing with 10 hurricane Katrinas."

To understand what's going on, it's important to look at the problems dogging bond insurers, commonly known as monolines.

Traditionally, insurers like Ambac (Charts) and MBIA (Charts) have insured municipal bonds. Their back-up guarantee made it cheaper for local governments to borrow money. In turn, the insurance companies had sterling reputations -- and credit ratings -- because municipalities rarely default on their bonds. High credit ratings have meant that bond insurers don't have to keep much capital on hand.

In recent years, however, monolines have diversified into, among other things, structured finance products -- the same investments that have walloped Citigroup (Charts, Fortune 500), Merrill Lynch (Charts, Fortune 500) and other Wall Street giants. Because the value of structured finance investments has plunged in recent months, Moody's and other ratings agencies are now questioning whether bond insurers have enough capital on hand to cover the now-shaky paper they've insured.

Ambac, for instance, has guaranteed an estimated $620 billion in structured products, but has only about $9 billion in cash. Similarly, ACA (Charts) is on the hook for $61 billion in insured assets, but has only about $326 million in cash.

Downgrades from the ratings agencies would be devastating for the bond insurers.

"If these insurance companies are downgraded it will impact the prices of the bonds they insured -- municipal bonds and structured finance products," says Joe Patire, managing director of Yield Quest. That amounts to about $2.2 trillion in bonds, according to estimates from UBS. Those bonds will not only plunge in value, but they too could be downgraded.

Bond insurers didn't used to put up collateral when doing business with Wall Street, but that all changed as they started insuring riskier products. As a result, Ambac and other monolines were required to find counterparties with strong balance sheets to back them up when they insured the exotic bonds that Wall Street cranked out in recent years.

Enter CIBC and Barclay's, relative newcomers to the bond insurance business. With sound balance sheets and lots of cash, they were eager to help guarantee these insurance contracts for a fee. Bond insurers even packaged and sold their own debt in the form of credit derivatives -- risks that CIBC and Barclay's took on as well.

As one person close to the situation explained, it's like when someone with little savings wants to buy a house. The banks want their parents to co-sign the documents. CIBC and Barclays effectively co-signed for the bond insurers.

It seemed like a good idea when financial exotica looked like easy money. Now, with mortgages in an asset-backed securities defaulting and ratings downgrades galore, those banks may pay dearly for these deals. That's because, if the insurers are downgraded, their cost of doing business will become a lot more expensive, which means they'll have less money to meet their guarantees on troubled bonds. The responsibility for these guarantees will fall to the likes of CIBC and Barclay's.

Christopher Whalen, a risk analyst with Institutional Risk Analytics, predicts that ACA is most at risk for a downgrade. "If [ACA] can't make good on its promise to insure these exploding mortgage-backed securities, a bank like CIBC that worked as the intermediary will be on the hook," said Whalen.

ACA did not return calls seeking comments. CIBC declined to comment for this story.

As for Barclays, they're not worried. "Barclays remains comfortable that monolines are able to perform in line with their contractual obligations. We closely monitor our total monoline exposures and their exposure to the sub-prime market in total," the company said in a statement to Fortune.

Worst case, the monolines might be forced to seek a capital infusion from a big bank to stay afloat. But Kyle Bass, of Hayman Capital, doesn't see that happening anytime soon. "How many investment banks have a spare $4 billion right now [to bail out a bond insurer]?"