First, some background. The monoline insurer business works like this. The Widget Co doesn't have the financial strength to get a decent interest rate on its debt, so it approaches a monoline, say AMBAC, and essentially buys insurance wherein the insurer, with its solid credit rating, serves as collateral in the event Widget Co defaults on its debt. The Widget Co then essentially gets the same credit rating as the insurer.
Monolines used to only insure municipal agency debt, but in the last few years took on more mortgage related debt (ah, there's the good ol' real estate market again). With the meltdown in subprime markets, the financial strength of the monolines come into question. What good is insurance if you think the insurance company may go belly up?
As the graphic presented here from the NY Times shows, the CDS (credit default swaps) market is HUGE, bigger than even the stock market.
John Maudlin discusses this scary scenario:
But what if the above-mentioned monolines are downgraded to junk, as was [ACA Capital] when it could not raise capital? As the downgrades on various mortgage assets and the CDOs continue to increase, the ability of the monolines to deal with the problems is going to come under increasing question. The losses at major banks could be much worse than $122 billion if they are downgraded to the same junk level that ACA was.
I have read somewhere else that in addition to the $250 billion written down in 2007 for subprime, banks and financial firms may write down another $250 billion in CDS. Wow! But that's not the start of it. What if you have your port authority paying 20% on its debt? That's not a recipe for keeping things cheap...