THE FREE MARKET FAIRY IS A DRUNK!

One good thing that might come out of the sub-prime debacle is the growing realization that Wall Street is just another example of a Village with its own, non-reality based, rules. (Via Atrios)

Dec. 20 (Bloomberg) -- MBIA Inc. tumbled the most since 1987, and the risk of default soared after the world's biggest bond insurer revealed that it guarantees $8.1 billion of collateralized debt obligations repackaging other CDOs and securities linked to subprime mortgages.Credit-default swaps tied to Armonk, New York-based MBIA's bonds climbed 115 basis points to 595 basis points, the widest on record, according to CMA Datavision in London. MBIA shares plunged $4.73, or 18 percent, to $22.29 as of 9:38 a.m. in New York Stock Exchange composite trading. MBIA posted a document on its Web site late yesterday showing it insured the so-called CDOs-squared, a potentially riskier form of security than what the company typically guarantees. Rising defaults on subprime mortgages packaged into securities have led to bond downgrades and threatened MBIA's AAA guaranty rating.

What to do about your insurer? LEND IT MONEY???? (Via Calculated Risk)

Banks Study Bailing Out Struggling Bond Insurer
By VIKAS BAJAJ and GRETCHEN MORGENSON
Published: December 19, 2007

Officials from Merrill Lynch, Bear Stearns and other major banks are in talks to bail out a struggling bond insurance company that has guaranteed $26 billion in mortgage securities, according to two people briefed on the situation, because the insurer’s woes could force the banks to take on billions in losses they had insured against.

The insurer, ACA Capital Holdings, which lost $1 billion in the most recent quarter, has been warned by Standard & Poor’s that its financial guarantor subsidiary may soon lose its crucial A rating. If it did, the banks that insured securities with the ACA Financial Guaranty Corporation would have to take back billions in losses from the insurer under the terms of the credit protection they bought from the company.

The troubles at ACA could also serve as the first real test for credit default swaps, the tradable insurance contracts used by investors to protect, or hedge, against default on bonds. In June, the value of bonds underlying credit default swaps rose to $42.6 trillion, up from just $6.4 trillion at the end of 2004, according to the Bank for International Settlements.

Now, where to get the capital back that you lent to an almost bankrupt insurer. FROM THE FED (BUT DON'T TELL ANYBODY ABOUT IT) (Also via Atrios)

From the New York Times:

The Federal Reserve said on Wednesday that it had collected bids from 93 financial institutions in its first auction of short-term credit, a turnout that suggested banks might be more inclined to borrow from the Fed under its auction-based system. Banks have typically feared negative reactions from investors when borrowing directly from the Fed, which some interpret as a sign of weakness. The auction, announced last week, tries to combat that stigma by offering banks the opportunity to borrow directly from the central bank in an anonymous forum and at a lower-than-usual interest rate.