Monoline insurers collapsed dramatically during the subprime crisis. This paper

    presents  a  stylized  model to account for the  market  breakdown. The initial

    neglect of severe downside risk by local thinking agents can trigger subsequent

    rating downgrades of insurers. However, the model identies a more fundamental

    problem.  Even when the agents are rational, bond insurance exerts a negative

    externality on investors by  eliminating a bond’'s  price discount. Surprisingly, as

    this externality is likely to be less severe when the agents engage in local thinking,

    excessive focus on rational risk management can actually harm the market welfare.

    Keywords: Local thinking; credit enhancement; financial guaranty; downside risk;

                 capital coverage