Once upon a time there were some companies (monolines) that insured the bonds of American governmental organizations big and small^*. It was a good business: governments virtually never default permanently, and only rarely get behind on payments. It was kind of pointless, but pension funds and the ilk liked having an extra pocketbook to lean on. Returns were a little lower, but the bonds got magically inherited the highest-rated AAA rating from the stolid insurers.

Then the monolines lost their collective minds and started insuring crappy mortaged-backed securities, charging premiums not much higher than government bonds, and the rating companies went along with it and rated the mortgage paper highly.

The thing is, the government bonds and the mortgage bonds were put in the same insurance pool. By all rights the monolines should be rated down to junk status because of their mortgage lunacy. However that would also downrate the insured government bonds, which is Bad. A lot of fixed-income investments like pension funds are only allowed to buy high-rated bonds, so a downgrade would really hurt the ability of governments to sell bonds. Moreover there is also the potential spectacle of fixed-income funds being required to dump downgraded bonds, but also required not to dump them to avoid fire-sale losses.

The ratings agencies have thus far made ominous noises and but done little real downgrading. This avoids a government bond bloodbath, but also gives giant fig leaves to the financial and other companies holding crappy insured mortgage-backed bonds. (Some are calling this fraud and treason. I figure if a village hires you to pour cyanide into the town well, it's OK to pour it in slowly over several months. If somebody wants their medicine full strength, they can always show up with a spoon on pouring-day.)

Enter Warren Buffet, who today openly announced his entry into the government bond insurance business. This is excellent news for both buyers and sellers of American government bonds. Buffet knows insurance, and his people are as immune to financial manias as they come.

In response, the stock market soared across the board, which makes no sense. Most stocks get very little benefit from government bonds. Most public companies are all about risk and rewards, not steady reliable income.

At the same time, the existing monolines' high ratings are no longer needed to protect government bonds. The mortgage bond insurance business is long gone, and no one will bet government bond insurance on them if Buffet is the alternative. Their obituaries are now being written; their downgrades are as good as in the mail. The ratings companies will no doubt downgrade by increments to miminize panic, but they will do it. Those downgrades will trickle through to the insured bonds, then to the companies that hold them, then to people owed money by those companies, and so on. When that happens, the meltdown will finally be in full swing.

Things are going to get much worse before they get better.

^*FYI, American government bonds are called "municipal bonds", whether or not they are issued by cities or towns.