The beams are creaking. Plaster is falling from the ceiling. The cracks in the walls are widening. The entire edifice of wholesale financial markets is under the greatest strain in years. No one any more believes the soothing noises from the builders (aka investment bankers), who say the worst will soon be over. The Federal Reserve’s drastic cuts in interest rates amount to little more than a bit of cosmetic repointing.

Yesterday there was a fresh buckling noise coming from the foundations, where the monoline insurers reside. These are the institutions that insure trillions of dollars of bond issues against default. Having strayed from their original safe but dull role of insuring municipal bonds to underwriting racy sub-prime-backed securities, they are paying the price. One of the biggest, MBIA, announced a $2.3 billion loss yesterday, while another, FGIC, was downgraded by Fitch. All have seen their shares thumped and face further downgrades.

No one quite knows how bad the impact would be if one failed. Together they insure bonds with a face value of $2,400 billion. Most are rock solid, but there is still a residual $231 billion of more questionable securities, a large chunk of them backed by US sub-prime mortgages. Defaults by struggling American homeowners are going to work their way back along the food chain, ultimately to the monoline insurers.

Monolines played a key role in the gigantic game of financial pass-the-parcel that has characterised the credit markets in the past few years. The basic rule was to make a quick turn and pass the risk on to the next mug as quickly as possible. Monolines were where the buck was supposed to stop. If one of these insurers were to fail, the liability would be passed back to the banks.

Toby Nangle, a fund manager with Baring Asset Management, reckons a failure would create panic “on the same scale as Long Term Capital Management”. LTCM, the hedge fund that failed in 1998, was of itself tiny, but was at the centre of a cat’s cradle of trillions of dollars of bets with counterparties comprising most of the world’s biggest banks.

It was the number of zeros on the face value of those bets, plus the uncertainty of who the counterparties actually were, that created the jitters ten years ago. This time around, markets are again unnerved by the size, complexity and opacity of both the underlying assets and the insurance policies supposedly underpinning them.

Private sector attempts to shore them up have not been happy thus far. Warburg Pincus appears to be sitting on a nasty loss from its rescue investment in MBIA, although its shares perked up last night after some encouraging words from its chief executive.

An industry-wide lifeboat orchestrated by the New York State Insurance Superintendent could work, but has dispiriting echoes of Treasury Secretary Hank Paulson’s doomed super-SIV plan.

Researchers at Oppenheimer say there is no systemic risk and insurers could fail and not spark a cataclysm. But it would certainly sort the sheep from the goats: the limping trio of Citigroup, Merrill Lynch and UBS would bear the brunt of an additional $40 billion in writedowns this year. It isn’t yet time to doff the hard hats.

patrick.hosking@thetimes.co.uk

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