Bond Insurer Rescue Plan Continues to Pressure Mortgage Rates

As was anticipated, more details were released today regarding the proposed bailout for AMBAC, one of the largest bond insurers.

Bond insurers like AMBAC, FGIC, and MBIA are crucial to the economy and thus mortgage rates.  Big investors have an interest in the financial health of these bond insurers because a downgrade for the bond insurers means that the assets held by investors would be less valuable.

 That is a drastic oversimplification, but this is the basic reason that there is such a sense of urgency to maintain a good standing with ratings agencies such as Moody's, S&P, and Fitch.

 And that oversimplification sets the stage for the events of the past hour.  Though not officially finalized yet, the deal is taking form, with Citigroup and Wachovia supposedly proposing to capitalize the bond insurer to the tune of roughly 3 billion dollars.  The final approval is dependent on the ratings agencies signing off on the deal.  But at least for today, they have maintained the AAA credit rating of the bond insurers.

After this news, the stock market shot up impressively and mortgage bonds fell through the floor.  Why?  Healthy bond insurers provide financial strength.  Citi and Wachovia are two of the largest finance companies in the world.  If they take these steps to increase the quality of their assets, it can soften the write-down problem that the financial stocks have been experiencing on Wall Street.  To oversimplify again, healthy bond insurers solidify asset value on Wall Street, which promotes growth and investment in much downtrodden stocks.  The money to create that growth and investment is often pulled out of the "saftey net" holding area otherwise known as the bond market.

As the economy has weakened, investors exhibit "flight to safety" buying, meaning they buy bonds because of the guaranteed return.  As news and economic data hint at staving off recession, and possibly actual improvement, those safety buyers move money back into stocks.  This increases the competition in the Bond pit.  A lot of sellers and fewer buyers mean that prices must go down to move their product, just like any other good or service.  And when prices go down, yields go up.  Yields are directly tied to mortgage rates.

As was said earlier this morning, we can hope for economic weakness to bring rates back down, but it must coincide with easing pressures on inflation.  In related news the Fed's Mishkin commented on the importance of inflation control over economic stimulation when it comes to recovery.  Inflation is as bad as it has been in a long time and it alone can prevent mortgage rates from dropping again, even in the face of economic turmoil.

Tomorrows PPI report will be our major inflation report for the week.  Bernanke will also speak later in the week. 

The rest of the week will also confirm or mitigate the effect that the AMBAC news had today.  Possibly the market has overeacted.  We will find out when the ratings agencies approve the plan or not.