Gillian Tett, in “Credit compass fails to work,” in the Financial Times, uses the woes suffered by monoline insurers such as MBIA and Ambac to illustrate that in our current subprime/housing credit crisis, nobody is sure where the dead bodies lie, which makes everyone suspect.
Monoline insurers provide credit guarantees for securities. They have come under scrutiny recently because their products were one of the means used by underwriters of collateralized debt obligations to enhance the credit quality of the vehicle and achieve a AAA rating for the top tranche (the other two routes were overcollateralization and credit default swaps).
Oddly, Tett does not mention that the monoline insurers’ biggest business is guaranteeing municipal bonds. Thus, if they lose their AAA ratings due to subprime-related damage, it would make it more difficult and costly for municipalities to raise money. The subprime mess continues to reach into unexpected quarters.
However, it is possible that the monoline insurers are not too deeply involved. They claim to have a mere, manageable 6% of their book exposed to subprime. And people I know who are close to Ambac tell me that the company was aggrieved to have lost market share in real estate securitization to more creative players. Unfortunately, they are now learning that their relatively conservative posture may not have been conservative enough.
From the Financial Times:
This summer a gruesome new guessing game is afoot: spotting where the subprime bodies lie….
There are rumours, for example, that some bank proprietary trading desks are nursing pain. Some specialist debt vehicles, such as collateralised debt managers, have probably taken hits too. So, have investment units that are partly attached to banks, conduits or specialised investment vehicles. On Friday night, for example, Germany staged its second bank rescue in as many weeks when SachsenLB was sunk by problems in a conduit, echoing earlier woes at IKB.
However, as the rumour mill goes into overdrive another category of companies is also being scrutinised – the so-called monoline insurers, or those financial companies such as MBIA or Ambac that insure securities (meaning that they guarantee the punctual repayment of a bond’s principle and interest if the issuer defaults.) In normal, quieter times these companies receive very little attention, since they inhabit a particularly slow-moving, obscure niche of the financial jungle. But the sector is a veritable behemoth: though Ambac and MBIA first sprang up in the 1970’s to insure American municipal bonds, they have since moved into the structured finance world, covering tranches of collateralised debt obligations (CDOs), for example. As a result, the sector insured $3,300bn worth of paper last year.
The monolines have always prided themselves on operating in an ultra-conservative manner, and that has hitherto enabled them to produce steady earnings, and maintain the all-important AAA credit rating. But what investors have now suddenly remembered this summer is that as the monolines have moved into the CDO world, they have also started handling securities related to – yes, you guessed it – subprime debt.
The monolines vehemently deny this will cause them any problems. After all, subprime assets represent just a tiny part of their book (reportedly less than 4 per cent of exposures). But this does not placate some observers, who note that even small losses could hurt their model since monolines typically use high leverage (insuring, for example, assets that are 150 times the value of their capital base). Thus, the share price of the monolines has recently tumbled, exacerbated by the fact that some hedge funds, such as Pershing Square, are gleefully shorting the sector.
Personally, I have no way of telling whether these concerns are poppycock or not. But that very uncertainty is the biggest issue of all. For what is most pernicious about the current credit storm is that the climate of confusion is so high that nobody quite knows what to believe anymore – in respect to the monolines, or anything else. The reason for this uncertainty, as this paper has repeatedly noted in recent days, is that this decade’s frenetic financial innovation has scattered subprime losses around the financial system to a degree never seen before…. As investors and credit officers confront this new risk-dispersed world, many are behaving as if they have lost their credit compass….
Thus, in this disorientated climate, banks are cutting off other banks and investors are shunning entire asset classes – sometimes to a completely irrational degree. No wonder the monolines are suffering under the curse of subprime contamination too.
Presumably this panic will eventually die down, as investors slowly adjust to this new risk-dispersed financial world. Credit officers, in other words, will find a new compass. At some point we may even discover where those subprime bodies truly lie. But don’t bet on that happening soon – or particularly smoothly. Thus for the foreseeable future, the monoline insurers have a nasty investor relations challenge on their hands. The only possible comfort is that in this respect, the monolines now find themselves in a very large financial club.