naked capitalism

We have been skeptical about the possibility of a private-sector rescue of the troubled bond insurers. Nevertheless, both the Wall Street Journal and the Financial Times reported progress on discussions to shore up Ambac, the number two insurer, and that efforts were underway to assist the smaller fry. From the Financial Times:

US and European banks are joining forces to try to solve the crisis among US bond insurers that could exacerbate the impact of the credit squeeze.

One group, including Citigroup and Barclays, is examining options for supporting Ambac Financial, the bond insurer. Separate teams are working with other bond insurers, according to people close to the process.

Note that the worst outcome for Wall Street isn’t that the insurers are downgraded; it’s that they spend money trying to salvage them up and they nevertheless lose their AAAs later. What we find surprising is that Wall Street is willing to stump up cash, worse, at least some equity funding, at a time when money is tight and more writeoffs are likely. And this is also taking place despite the fact that the majority of Wall Street analysts who have taken a look at the bond insurers are putting out even bigger loss estimates than Bill Ackman, the head of Pershing Square who has been saying that the monoline business model is unworkable since 2002.

What gives? Two things: the investment banks’ assumptions and the rating agencies actions.

A mere patching of the leaks at the bond guarantors is not a sensible move unless you have a very optimistic set of assumptions. If you believe that the economic downturn is only a two-quarter event and that a rising economy will take pressure off the insurers, investing would be attractive.

The problem, of course, is that the bond insurer troubles are driven primarily by the housing market. The last housing recession, which started in 1989, lasted 15 quarters and had less unsold home inventory (as a percentage of outstanding) than we have now. Even if you date the start of this housing slump at end of second quarter 2007, we have a long way to go. Thus the idea that this charade can be kept gong beyond two or three quarters is highly questionable.

Or is it? The mistake is believing, as we perhaps have too much, that the rating agency saber rattling means they have the will to downgrade. They don’t. The very last thing they want to do is be accused of causing The End of the Financial World as We Know It.

Even thought anyone who has looked at these companies in a serious way knows the AAA ratings for MBIA and Ambac are a sham, they are coming to resemble guys on death row that it takes 20 years to execute. The rating agencies, while threatening that downgrades are imminent, keep allowing the timetable for fundraising to be extended. According to the Wall Street Journal:

Moody’s prepared investors for bond-insurer downgrades in a research note Thursday and subsequent investor call Friday.

Some firms “may be unable to restore financial strength to levels consistent with a Aaa rating,” the firm wrote. Moody’s is likely to make decisions on downgrades this month, it said, possibly sooner in the month for insurers having trouble raising capital.

While this sounds like the heat is on, the reality is more nuanced. If the rating agencies believe serious negotiations are underway for specific firms, the decisions on downgrades “this month’ probably means that they have until at least the end of February.

The focus on Ambac makes sense too. Its troubled exposures are primarily CDOs, which will come a cropper sooner than other instruments might, and will also inflict damage on Wall Street firms. MBIA’s guarantees, by contrast, are spread across more types of instruments. The cost of an MBIA downgrade is likely to be shared more broadly, making it harder to round up interested parties to write checks.

Also note that despite the continuing deterioration in the credit markets, the rating agencies have not increased the required fundraising for the bond insurers. That seems highly inconsistent with recent developments, most notably S&P saying that it will either downgrade or put on review $534 billion of debt, and estimated that this move could increase bank and investment bank losses from $130 billion to $265 billion.

Pray tell me how this has no impact on MBIA and Ambac? This confirms that Moody’s and S&P will take advantage of any route open to them to avoid downgrading the insurers. If they raise remotely adequate amounts of money (or can use some reinsurance hocus-pocus), the game will go on until events, or a big disparity between the top two agencies and Fitch, make the charade untenable.

A jaded and informed view comes from reader Scott, an institutional investor who has been on this beat for some time (and is holding his short position):

I have two problems with the concept. One, the size of the help involved, particularly given the rumored rescuers. Certainly Citi and UBS, and to a lesser extent WB, who in any event doesn’t to my understanding have tons of exposure on their own books, just don’t have the wherewithal to do more than pay lip service to a real bailout, so it will be almost totally cosmetic if they’re the real players–just enough to allow Moodys and S&P maintain the charade that ABK’s a triple A credit.

And perhaps more importantly from an investor’s viewpoint, Dinallo’s only interest here is in making sure insured claims get paid, and mostly muni ones at that, I suspect, so that from an investor’s viewpoint the money will remain at the insurance subsidiary, and will not get upstreamed to the public holding company. Maybe that will allow these guys to stay open, but in terms of competing for future business, they’ll clearly be left with the worst stuff available–anybody in their right minds, assuming anybody in their right minds will be buying this insurance going forward in the first place, will place their business with Buffett, so they’ll be competing for business he doesn’t want–adverse selection of the worst sort.

I’m sure that somebody like 3rd Avenue believes that they’ll be able to negotiate some sort of anti-dilution deal alongside of Warburg, and it strikes me as possible that they’re sitting at table with the rescue party, and will be able to. But anybody later to the game, or less savvy than Marty Whitman in this kind of investing, will get killed by the dilution involved even in a cosmetic rescue, I’d think. And even a reinsurance deal will make them less profitable going forward, although I’m not sure what would get reinsured–reinsurance on the structured finance-mortgage related stuff would simply be buying claims, as far as I can tell, unless the entity putting up the money was the counterparty on the claims, in which case it would essentially be exactly the same as taking the assets back on balance sheet, so I don’t see the incentive for them to do that. Reinsurance on “good” municipal bonds would simply make no-loss assets on which claims almost certainly will not be paid less profitable.

I guess the long and short of it is that I can’t get my little mind around a rescue that is more than a cosmetic stop-gap, or one that doesn’t dilute current holders into oblivion.