naked capitalism

Companies that provide credit enhancements to bond deals, such as monoline insurers MBIA and Ambac, as well as other type os financial guarantors, have come under a great deal of scrutiny of late as the rapid deterioration in certain types of structured finance products had made their guarantees look less solid. However, lowering their credit standing would have the effect of downgrading all the securities that they insured. As a result, ratings agencies are particularly reluctant to lower their ratings, since the knock-on effects are considerable. Hence there is already skepticism about these ratings. Some observers believe the monolines no longer belong in the AAA category, although they have not been downgraded; other guarantors, who generally do not have AAA ratings, are also at risk of having their ratings cut.

Two developments confirm the weakening of the guarantors. A Bloomberg article informs us that JP Morgan has issued a report saying that ACA Capital, 29% owned by the private equity group at Bear Stearns, is likely to be downgraded, which will force banks to take $60 billion of collateralized debt obligations on to their balance sheets. The Financial Time’s Alphaville adds that ACA was particularly active in providing credit support to collateralized debt obligations. The Wall Street Journal reports that CIFG will receive $1.5 billion of capital from its parent to prevent a downgrade.

Note that the Journal attempts to put a positive spin on the story, asserting it “provides a roadmap for other bond insurers.” Huh? CIFG is being shored up by its parent. I am not certain how many bond insurers have sugar daddy owners they can hit up for cash, but the most important players, MBIA and Ambac, do not. Indeed, the only company that the Journal identified as a candidate to follow CIFG’s lead is FGIC, a significant player in municipal bond insurance.

Ironically, however, the FT’s coverage does provide some support for the Journal’s assessment, but I don’t see it as any source for comfort. It says that ACA is likely to be propped up, albeit reluctantly, because banks and investment banks don’t want to suffer a downgrade.

How many measures can financial firms take to validate asset prices without taking on undue risk, or simply tying up so much capital that it restrict their ability to conduct business? We are entering that zone sooner than anyone anticipated.

First, from the Bloomberg piece on ACA:

S&P on Nov. 9 began considering New York-based ACA’s A rating for a downgrade after it posted a $1.04 billion third- quarter loss. ACA said in a filing this week that it won’t meet collateral requirements if its rating falls below A-.

ACA is among nine bond insurers being vetted by ratings companies after the value of the CDOs they insure fell. Moody’s Investors Service and Fitch Ratings are examining AAA rated insurers including MBIA Inc., Ambac Financial Group Inc. and FGIC Corp. to see if they have enough capital. A loss of the top ranking by the insurers would throw into doubt ratings on $2.4 trillion of debt.

“ACA is a likely candidate to get thrown to the wolves first,” Wessel said in an interview today. If ACA defaults, banks would then have to bring their ACA-guaranteed CDOs onto their books, said pJPMorgan Chase & Co. analyst Andrew] Wessel….

The private-equity investment arm of New York-based Bear Stearns Cos., the fifth-largest U.S. securities firm, bought a 29 percent stake in ACA in 2004 for about $100 million. The stake is owned by MBP II, one of the funds raised by the merchant banking unit. Bear Stearns has likely written down the declining market value of ACA in previous quarters, according to Lehman Brothers Holdings Inc. analyst Roger Freeman. Even if Bear Stearns had to write down ACA fully, it would face a $6 million charge, according to Bloomberg calculations….

Merrill Lynch & Co. may need to write down $3 billion of CDOs if ACA defaults on its obligations, Freeman wrote in a note to clients on Nov. 5…

ACA, which has claims paying resources of $1.1 billion, also has insured bonds with a par value of $7.1 billion, according to the company’s Web site. Most of that debt is for tax-exempt organizations, including $51.5 million of bonds sold to finance the construction of a jail in Pinal County, Arizona, and $4.7 million of bonds for the city of Deadwood, South Dakota

Next, the FT’s Alphaville on ACA:

ACA are a big manager of CDOs and also a leading provider of CDO default insurance policies – which strikes us a pretty shortsighted combination.

Considering that ACA’s prime line of business is in structured finance, a $1.6bn writedown is hardly surprising, but it’s still worthy of note for several reasons:

Firstly, relative to ACA’s size, it’s a very big hit.

Secondly, the writedown ACA has taken may yet be a lot worse. The main cause for concern here is the fact that ACA’s Q3 results only cover the period up to September 30. And the very worst month for CDOs was October. Testament to that the fact that Lancer [a CDO squared, meaning a CDO of a CDO]] has now entered an event of default.

And thirdly, as a monoline insurer, ACA’s problems are not just ACA’s problems. The security of their insurance – on billions of dollars of CDO paper – is dependent on the safety of ACA’s own rating. And in the light of such a big writedown and the prospect of more trouble ahead, S&P has put the group on review.

ACA has been used as a “dumping ground” by subprime securitizers says Barrons, and that might now come back to haunt them. Wall Street does indeed seem keen to prop ACA up. According to filings with the SEC, a consortium of banks has provided liquidity facilities to the company. In spite of disastrous performance, banks have also continued to take out ACA insurance, unwilling perhaps, to pull the rug from under ACA’s feet.

Next, the Wall Street Journal on CIFG:

In the first sign of relief for the troubled bond-insurance industry, financial guarantor CIFG Services Inc. will receive a $1.5 billion capital injection from controlling shareholders of its French parent so it can preserve its imperiled triple-A credit rating, according to people familiar with the matter.

The plan, which is scheduled to be announced as early as Thursday, provides a roadmap for other bond insurers whose businesses, reputations and share prices have been hit hard in recent weeks. Rating agencies have warned that they will downgrade guarantors that fall short of capital necessary to absorb potential losses in their portfolios of risky mortgage-loan pools known as collateralized debt obligations, or CDOs…

A rating downgrade could wipe out a bond insurer’s business, since most issuers only pay an insurer to guarantee its bonds because of the rock-solid financial strength implied by the triple-A rating. If any of the major guarantors lose their ratings, it could lead to widespread downgrades on the hundreds of billions of dollars in debt securities that they insure, ranging from water and sewer bonds to CDOs. In turn, bond investors such as retirees, mutual-fund holders and hedge funds would be hurt….

While privately held CIFG is smaller than its publicly traded peers such as Ambac Financial Corp. and MBIA Inc., its capital-infusion plan may serve as a potential model for other bond insurers including Financial Guaranty Insurance Co., or FGIC, and Security Capital Assurance. Less than three weeks ago, Fitch Ratings and Moody’s Investors Services named CIFG and FGIC as among the most likely to fall short of capital guidelines and face downgrades.

Privately held FGIC, which guaranteed about 15% of all new public-finance debt in 2006, has been in discussions about how much to tap its investors for capital, according to people familiar with the matter. Private-equity firms Blackstone Group and Cypress Group each bought 23% stakes in FGIC in 2003, while mortgage insurer PMI Group Inc. owns a 42% stake. General Electric, FGIC’s former owner, retained a 5% stake while CIVC Partners, a Chicago private-equity firm, owned 7%.

Some of these investors are considering injecting about $200 million and are prepared to put in more if necessary. Like CIFG, these investors are considering a mix of pure equity and reinsurance, according to people familiar with the matter. FGIC could not be immediately reached for comment.