The latest saga in the credit market relates to the nexus between monolines, borrowing by state and local governments (the muni bonds market) and the related troubles in the tender option bonds (TOB) and auction-rate securities (ARS) markets.

A few issues are clear now: the monolines don’t deserve their AAA and are unable to raise enough capital to maintain such a rating. Moreover, an unavoidable downgrade of these monolines would lead to several side effects: loss of AAA status for the muni bonds insured by the monolines; inability of monolines to generate new business in the muni space as such borrowers expect AAA rating and could not get it from firms that don’t have an AAA rating themselves; a massive writedown – about $150 billion – of the mortgage related securities (RMBS, CDOs, etc.) that had been “insured” by the monolines.

Let us then analyze in more detail the consequences of the above observations for: the future of the monolines; the losses that a downgrade of the monolines would imply for financial firms and investors; and the market for state and local (muni) financing.

The conventional wisdom is that state and local government rarely default; thus, there is a viable business for monolines that insure only state and local government. We will argue in this article that such conventional wisdom – behind the current plans to split the monolines’ business in a “good” muni insurance component and a “bad” structured finance insurance component – may be wrong…