Fears that claims and investment losses will mount in sub-prime backlash

The continued woes of US bond insurers will spark losses for London market insurers, analysts have warned.

This week, MBIA, one of the world’s largest bond insurers, unveiled a $1.9bn (£950m) loss for 2007, while another major bond insurer, Ambac, revealed a fourth quarter loss of $3.26bn (£1.63bn) last week. Both companies blamed the sub-prime crisis.

The recent setbacks affecting these and other bond insurers are expected to hit the London insurance market with claims , as well as losses to insurers’ own investment portfolios.

Charles Coyne, analyst at KBC Peel Hunt, said that losses to London market insurers would occur when claims on directors’ and officers’ (D&O) and errors and omissions (E&O) policies began to trickle through. He added that losses to reinsurers would eventually occur as bond insurers’ losses accumulated and hit treaty reinsurance policies.

Chris Hitchings, analyst at Keefe, Bruyette and Woods, said: “I’m sure a London market insurer will have a CDO [collateralised debt obligation] wrapped by one of these bond insurers somewhere in its investment portfolio.”

A CDO is a type of security that pools together a number of debt obligations – and these debt obligations may well include sub-prime debts. If a CDO itself is insured by a bond insurer, it takes on the financial strength rating of the bond insurer. This is also known as ‘credit wrapping’.

If the bond insurer is downgraded or goes bust then the holder of the CDO faces greater exposure to investment losses.

Reports also revealed that investors were predicting a gloomy future for MBIA and Ambac, as they continued to bet on share price falls by taking ‘short’ positions.

But Coyne said: “I wouldn’t be surprised if the shorters get squeezed and the stocks climb higher. Everyone knows about the likelihood of downgrades and banks have a vested interest in preserving the bond insurers.”

Bond insurers are keen to hang on to high financial strength ratings, which allow them to underwrite a greater number of bonds, but ratings agencies are forging ahead with downgrades.

These downgrades were triggered because of fears that bond insurers do not have enough capital to pay for losses on sub-prime-related bonds, such as CDOs..