My understanding has been that the net effect of the presence of the counterparty, the presence of the insurance, is that the price of the bond, or of the interest rate from the bond, reflects the supposedly lower risk, since the possibility of default (the bond not making regular payments) is covered by the counterparty.
IF the counterparty is insolvent, or is too highly leveraged, such that they *can't* make good on all the bonds they're insuring, that means the price and/or interest in the bonds no longer reflects the *actual* risk present, since there is no longer anyone acting as a backstop against the loss of payments from the bond.
That means that those who are *selling* bonds have to pay higher interest to the bond holders, since the risk of holding said bonds has gone up. And when there is commercial paper based on short term auctions of longer term bonds, there may be a dearth of buyers; and the auction houses no longer have the confidence to buy up the bonds on their own; thus some vultures may sweep in and bid the interest on the bond up to exhorbitant levels, which the bond issuers weren't planning on having to pay.
Both of these in effect depresse he price of the bond; and those holding bonds (if the bonds are listed as collateral for something else) suddenly aren't sufficient, and so "margin calls" against the bond holders may result.
Since all of the swaps, loans, and other paper are held by a relatively small group of players, in a more or less incestuous tangle, the result is potentially a galactic sized Mongolian Flustered Cluck©TM.
Is that more or less a decent layperson's description of it? Please give feedback...
Cheers!
Ah HA! Now, I’m starting to get it. One thing I remember from economics class: When interest rates go UP, tradable bond values go DOWN.
I’ve always understood why bond rates would increase w/o a re-insurer. But, I never really considered what the lost of such would do to those already owning bonds..
And, of course... I understand Mongolian Fluster Clucks...