Wednesday, November 7, 2007

The Next Shoe?

Everyone is waiting for the next "shoe to drop" in the financial markets. No one knows when or what it will be but the market spends an inordinate amount of time thinking and speculating about it. Here is one scenario.

Ambac Financial Group, Inc. (ABK) is at a 10 year low. ABK insures billions of dollars worth of Municipal Bonds. Small investors basically treat this guarantee from ABK and other insurers as gold. It lets them sleep warm and comfy at night knowing that their nest egg is secured.

The Stock Market panics further and drives down the price of ABK even more after further disclosures on its exposure to risky securities, and ABK loses its ability to provide a AAA credit rating to the bonds it insures. Municipal Bond funds, some of which must hold only AAA or insured bonds according to its prospectus, start selling ABK backed bonds. There are few buyers for these bonds. The market for these bonds shows sharp declines in price since the Municipal Bond market is a fairly illiquid market. Auditors, not wanting to end up like Arthur Andersen, insist that the muni funds mark the bonds down based on the few forced sales out there.

The bond funds holler and scream but they price the bonds at the end of the month based on the few comparable sales out there and on the underlying credit assuming no insurance.

The retail investor opens the statement and sees its fund or individual bond marked down 5 to 10%. A wave of panic selling ensues as they call their stockbroker and tell them to sell. Prices decline even further. Since there is too much supply and not enough demand, public finance slowly grinds to a halt as States and Municipalities can't roll over existing debt or start new projects.

While this scenario sounds like a little bit of a stretch, who knows? If someone had told you six months ago that the largest bank and the largest brokerage firm in the United States would sack its CEOs, that would have sounded a little crazy also.

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