Risk assessment

To be sure, there remain a number of destabilizing forces that could reinvigorate the financial shock, which in turn could deliver the economy another body blow. Default and delinquencies among credit worthy borrowers (non-sub prime) are rising. The rot is also spreading outside of the mortgage sector, to home-equity loans, credit cards, and auto loans. Deteriorating labor market conditions could lead to additional debt stress and credit restriction in a vicious cycle.

There are also powerful potential knock ons that could emanate from the downgrades of the bond insurers. Nearly $2.5 trillion worth of bonds have guarantees or insurance wrappers. The credit rating of Ambac, one of the larger insurers, was cut two notches by Fitch Ratings on Friday, Jan. 18. Some observers link the global equity market collapse the following Monday to this downgrade. Major Asian equity markets plummeted hours before a large French bank began unwinding the fraudulent trades that captured the headlines a few days later.

Reports suggest that banks hold more than $800 billion of structured securities. Moody’s Investor Services and Standard and Poor’s are reviewing Ambac and MBIA (another large insurer) for possible downgrades. The deterioration in quality, and therefore the value, of the insurance may require banks to add to their loan-loss reserves and write-downs.

Municipal bond markets may also feel the pressure from bond-insurance depreciation. The monolines insure tens of billions of dollars of municipal, local, and state governments. Slower growth will squeeze local government finances as it lowers tax revenue just as counter-cyclical spending increases and the housing market slide takes its toll.

For example, California — the largest U.S. municipal bonds seller with almost $50 billion outstanding — was placed on credit watch for a possible downgrade in mid- January by Fitch Ratings. In November 2007, S&P educed California’s outlook to stable from positive (an A+ rating).Moody’s rates California A1, which is similar to S&P’s A+, and only Louisiana has a lower rating among the 50 states.