The Saga of AMBAC

The bond insurer AMBAC announced yesterday that it was going to restructure in an attempt to ward off a possible bankruptcy. AMBAC provides another example of the way our convoluted financial system got itself into trouble by overextending itself.

The first question to answer is: What does a bond insurer do? Municipalities issue bonds to raise money, as you all know; the top-rated bonds are rated AAA, and the ratings go down from there. A city with a AAA rating has to pay less interest on its bonds than a AA city, and so on down the line. What AMBAC and other bond insurers did was insure the bond issuances for the AA and A cities, allowing them to pay only the AAA interest rates.

Eventually, these companies saw the opportunity to make more money than they could by insuring simple municipal bonds, so they branched out into insuring mortgage-backed securities, credit default swaps, and things like that. You can probably see where this is going: AMBAC insured some things that weren't worth insuring, and eventually the ratings agencies downgraded AMBAC's own creditworthiness below AAA. A company without an AAA rating itself can't raise a AA municipality to AAA, which brings us to where we are today.

At least if AMBAC totally collapses, it shouldn't bring a lot of other entities down with it. But the loss of it and the other bond insurers will make it more expensive for cities to raise money through bond issues.