To date, the market has paid the most attention to the most dire forecasts, including vague numbers thrown out by Fitch such as ABK and MBI need $1bn and SCA needs $2bn, while not providing any details on how they came up with those numbers. Moody’s analysis was even more vague – though they provided a 19% 2006 subprime cumulative loss assumption, they didn’t disclose loss estimates or how much capital the insurers would need to raise.

S&P’s analysis was by far the most transparent and provided many details on the process, as well as the actual numbers of their loss projections. Until the revised results, the biggest criticism for S&P was that they were still behind the market on their mortgage loss assumptions, namely 15.5% cum losses compared to Moody’s 19%. Having now raised that loss assumption to 19%, S&P’s analysis should be the most valid in the market, since S&P has access to much more detail about the insured portfolios than any analyst in the Street attempting to make projections. Street analysts can model potential losses all day long, but without the detail that only the insurers and the rating agencies have about the underlying collateral, analysts have to apply broad vintage, ratings and collateral assumptions that can cause huge variances in loss estimates.

However, as a caveat, the S&P analyst did tell me that the stress test results were updated only for increased subprime loss assumptions. So if the S&P mortgage team decides to raise loss assumptions on other asset classes such as Alt-A, HELOCs, CES or NIMs then they would update the bond insurance stress test results once more. For reference, S&P’s 2006 loss assumptions for those asset classes were: Alt-A 3.50%, HELOC 15.75%, CES 40%, NIM 15.5%.

Thanks for the link to the Insurance Journal article. Obviously, I missed it, and that was despite looking around for it more that a bit. Wonder why none of the logical suspects picked it up.

S&P Updates Results of Bond Insurance Stress Test for Revised Assumptions

As for Moody’s, a typical review lasts for three months so I wouldn’t necessarily expect a resolution anytime soon. I do agree that given the actions they took on Ambac and MBIA (which were pretty inconsistent with the previous Moody’s analysks), Moody’s seems overdue for some ratings actions on SCA and FGIC.

To the last comment: If the agencies were that mindful of not setting off a spiral in the markets, Moody’s would not have placed Ambac on review for downgrade after Ambac announced its plans to raise equity. If you recall, the Moody’s review sent ABK stock down 50%, therefore rendering it impossible for ABK to raise that equity. Given that Moody’s affirmed Ambac and Aaa/Stable less than a month earlier, a more consistent action would be a negative outlook rather than a review for downgrade. That was a clear case of a rating agency action directly impacting the rated company’s operating ability.

For days there has been speculation on the size of the spillover impact on banks and other institutions if bond insurers continue to lose their AAA ratings.

Now Barclays Capital has come up with a very big and scary number: a $143 billion shortfall in capital at Tier 1 and possibly other banks. Like all estimates, this one has a lot of assumptions behind it, not all of which may be supported by reality.

But if the Barclays Capital estimate is even remotely in the ballpark, it indicates that the cost of a bond insurer bailout is a lot less than the cost of shoring up banks’ mark-to-market losses. And that, oddly enough, is good news because it means that these banks suddenly look more likely to throw some capital at the bond insurers. Then the only rain cloud threatening this parade will be whether the ratings agencies think all the balance sheets have actually become stronger.

I understand that pension funds and the such might be forced to unload bonds if they lose their AAA rating, but I suspect that many of them are starting to unload anyway, since they fully expect the monolines to go under and the bonds to get downgraded in the next few months.

Or is that the whole point? To buy a couple of months time for a gradual transition?

Committee on the Global Financial System

Credit risk transfer Report submitted by a Working Group established by the Committee on the Global Financial System January 2003

In the 1980s monolines entered the ABS market and in the 1990s they expanded their business to the CDO market. Today the amount insured in these areas is larger than in the initial core business. Most monolines have AAA ratings and rating agencies apply a “shadow” rating and a capital charge to virtually every transaction. Since these charges are sensitive to the rating of the obligor, monolines have a strong disincentive to insure sub-investment grade risk or take large exposures, which expose them to “event risk”. In structured finance, they typically sell protection using financial guarantees or portfolio credit derivatives on the most senior (so-called “super-senior”) AAA-rated tranches. Since insurance of these tranches only becomes effective if the junior equity, mezzanine and senior tranches are exhausted, monolines should not be exposed to idiosyncratic credit risk on companies within their portfolio. The risk profile of their exposure can be compared to a written out-of-the-money put option to protect investors against extreme market events.

In some countries insurance firms are prohibited from entering into derivative transactions directly.They have, however, found ways to circumvent this restriction. (The restriction derives from legal and/or regulatory requirements for those purchasing insurance to have an “insurable interest” in the risk and is designed to mitigate the moral hazard underlying insurance contracts). Major insurance firms and (investment) banks have established companies, so-called transformers, often in Bermuda, where the prohibition does not apply. The transformers sell protection to the risk shedder in a derivative transaction and buy insurance from an insurance company via a conventional insurance policy.

Although it seems clear that low interest rates induced insurance companies to move to higher-yielding assets, it is not clear whether their involvement in CRT markets has increased their overallinvestment risk or how it has changed their credit risk profile.

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