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LATE  TO EARLY : BILLIONS IN SUBPRIME LOSSES 

rated us that that mark-to-market variation was not important to our rating, from a
financial strength point of view at the insurance company.” 
In early November, the SEC called the growing concern about Merrill’s use of the
monolines for hedging “a concern that we also share.”  The large Wall Street firms
attempted to minimize their exposure to the monolines, particularly ACA. On De-
cember , S&P downgraded ACA to junk status, rating the company CCC, which
was fatal for a company whose CEO said that its “rating is the franchise.”  Firms like
Merrill Lynch would get virtually nothing for the guarantees they had purchased
from ACA.
Despite the stresses in the market, the SEC saw the monoline problems as largely
confined to ACA. A January  internal SEC document said, “While there is a clear
sentiment that capital raising will need to continue, the fact that the guarantors (with
the exception of ACA) are relatively insulated from liquidity driven failures provides
hope that event[s] in this sector will unfold in a manageable manner.” 
Still, the rating agencies told the monolines that if they wanted to retain their stel-
lar ratings, they would have to raise capital. MBIA and Ambac ultimately did raise
. billion and . billion, respectively. Nonetheless, S&P downgraded both to
AA in June . As the crisis unfolded, most of the monolines stopped writing new
coverage.
The subprime contagion spread through the monolines and into a previously
unimpaired market: municipal bonds. The path of these falling dominoes is easy to
follow: in anticipation of the monoline downgrades, investors devalued the protec-
tion the monolines provided for other securities—even those that had nothing to do
with the mortgage-backed markets, including a set of investments known as auction
rate securities, or ARS. An ARS is a long-term bond whose interest rate is reset at
regularly scheduled auctions held every one to seven weeks.  Existing investors can
choose to rebid for the bonds and new investors can come in. The debt is frequently
municipal bonds. As of December , , state and local governments had issued
 billion in ARS, accounting for half of the  billion market. The other half
were primarily bundles of student loans and debt of nonprofits such as museums and
hospitals.
The key point: these entities wanted to borrow long-term but get the benefit of
lower short-term rates, and investors wanted to get the safety of investing in these se-
curities without tying up their money for a long time. Unlike commercial paper, this
market had no explicit liquidity backstop from a bank, but there was an implicit
backstop: often, if there were not enough new buyers to replace the previous in-
vestors, the dealers running these auctions, including firms like UBS, Citigroup, and
Merrill Lynch, would step in and pick up the shortfall. Because of these interven-
tions, there were only  failures between  and early  in more than ,
auctions. Dealers highlighted those minuscule failure rates to convince clients that
ARS were very liquid, short-term instruments, even in times of stress. 
However, if an auction did fail, the previous ARS investors would be obligated to
retain their investments. In compensation, the interest rates on the debt would reset,
often much higher, but investors’ funds would be trapped until new investors or the