Volatility, anyone?

In just the past three days, bond-insurance giants have been on a seesaw that has spun the heads of even the most iron-stomached investors.

Ambac Financial (NYSE: ABK) has undergone one crazy week of trading, rising 170% throughout the first part of the week, and then falling 26% from the week's high. Instate rival MBIA (NYSE: MBI) saw similar moves, with its shares more than doubling from the week's opening price to Thursday morning's high.

The huge volatility comes after Ambac had its credit rating downgraded last week by rating agency Fitch. Without a pristine reputation, the future of the bond insurer looked dire at best, causing investors to question whether bankruptcy loomed.

I got it, I got it! Oops, I don't got it ...
But much of that fear was sapped away earlier this week as news spread that the New York insurance regulator was in preliminary talks about a bond insurance industry bailout. Fear turned to jubilation on Wednesday, sending Ambac higher by some 72%, and MBIA up more than 33%, on the bailout news. But on Thursday, both Ambac and MBIA went down after many felt the bailout wouldn't amount to much more than other proposed government bailout plans that faltered, like the super SIV plan a couple of months ago.

More to the point, a bailout would likely call on Wall Street banks like Citigroup (NYSE: C) and Merrill Lynch (NYSE: MER) to pony up billions of dollars to loan to bond insurers -- whose futures clearly remain precarious. The issue then becomes whether other banks have the resources to provide the capital and take on the extra risk. Nearly every major financial house in the country has fallen into rough waters amid a roiled subprime market, and many of the largest players have needed to raise billions of dollars from outside investors -- what basically amounts to a bailout for themselves.

Bringing down the house
A collapse of these bond insurers would have serious ripple effects on the rest of the bond market. When a bond insurer suffers a credit downgrade, the bonds that it insures should technically be downgraded as well. With an estimated $2.4 trillion in bonds being covered by bond insurers, such a scenario might make the current debt debacle look like a minor hiccup.

Amid rising defaults on mortgage-backed securities stemming from an overheated housing market, fear has taken hold of debt markets around the globe. Perhaps one of the only glimmers of hope for investors has been the assurance of being backed by players like Ambac and MBIA. If insurers lose their ability to cover bonds they insure, fear of anything debt-related might indeed go through the roof, sending the economy into a tailspin.

Doomsday scenario aside, the fall from grace of bond insurers brings back the question of "Whose fault is this, anyway?"

Some point the finger at greedy management who ventured away from the tried and true model of insuring government-issued municipal debt into the more lucrative CDO market.

Risk in disguise?
One of the main pillars in any insurance business is knowing the risk profile of those you insure. Car insurers like Mercury General (NYSE: MCY) know with great certainty the odds that someone of your age, gender, and driving history will get in an accident, and how much that accident will cost -- and they adjust the amount they charge you accordingly. Vast amounts of data and decades of history are used to come up with these calculations, so insurers generally sleep well at night knowing their claims shouldn't be too far off predictions.

When Ambac and MBIA ventured into the world of insuring mortgage-backed securities, however, they were paving new ground. Nobody really knew the exact risk these bonds held because, well, nobody really knew what was in them. As the sheets get pulled off and the true nature of these bonds appears, we're starting to understand the risk they entailed. The bad news for bond insurers? They contained a lot of risk; probably much more than they accounted for.

In light of this, should other banks, maybe even taxpayers, be responsible for bailing out companies who went out on a limb to squeeze out profits? In most cases, no, but the ramifications of a bond insurance fallout puts us in quite a pickle.

Events like this show us just how incredibly intertwined and complex our financial system has become. When one side sneezes, nearly everyone else runs the risk of catching a cold.

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Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. He appreciates your questions, comments, and complaints. Mercury General is an Income Investor pick. The Fool's disclosure policy doesn't venture into uncharted waters.