The Deteriorating Monoline Insurers and the Rating Agencies’ Dilemma

For mostly good reasons, the rating agencies have become a favorite whipping boy. One complaint it that they are typically slow to downgrade because they don’t want to tarnish an issuer by being early.

The latest credits that appear to be looking weaker than their ratings are the monoline insurers, whose business depends on them marinating their AAA ratings. The rating agencies have been criticized for being too soft on these guarantors, yet as Gillian Tett of the Financial Times points out, a downgrade of the monoline insurers would have nasty knock-on effects. As she describes, Fitch is trying to finesse a no-win situation.

From the Financial Times:

A couple of days ago, the Financial Times received a furious complaint from Fitch, the credit ratings group. The reason? The FT recently wrote that Fitch had placed the ratings of monoline insurers on “watch” for possible downgrade…. Fitch hotly objected to FT’s use of the word “watch”… my mind this hair-splitting illustrates a bigger point: namely just how sensitive – if not, paranoid – the ratings agencies have become these days….

In recent weeks, the share prices of monolines, such as Ambac, have plunged on speculation that their ratings are about to be cut. For these monolines have guaranteed swathes of structured products in recent years, and …. they typically have very small capital bases.

However, the problem that dogs the ratings agencies is that if they downgrade the monolines, this could spark a much wider chain reaction…..

Moreover, a downgrade of the monolines would mean that all the bonds they have guaranteed would be downgraded too. And that does not just affect subprime securities, but swathes of the municipal bond market as well – which in turn could hurt mainstream US investors (such as pension funds), and borrowers (such as schools or hospitals).

This is the stuff of Washington nightmares. But the US Treasury cannot afford to be seen to be pleading with the rating agencies to go softly on these monolines right now….. Thus, in a sense, the agencies are now damned whatever they do: if they tip the muni market over the edge, they could become a political whipping boy; but if they fail to act, they will face more criticism for being too lax…

Is there any solution to this tangled mess? Fitch, for its part, is bravely trying to forge one: it indicated earlier this week that it will give the monolines a period of time in which they can raise fresh capital to avoid downgrades, if its review shows that they do not have enough capital to warrant a top-notch rating (not a courtesy it always extends to ordinary issuers).

But it remains unclear if this tactic will quell investor unease. After all, what this saga shows with painful clarity is the degree to which this decade’s wild credit party has been built on a complex set of interlocking financial flows and practices, that have often been dangerously circular in nature.

Many of these interactions have been roundly ignored recently. But what they mean is that if one key component of the current financial edifice is badly damaged, there is a real risk that other parts will come tumbling down.

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  1. Anonymous

    To further split hairs, I don’t beleive that there are many US pension funds investing in municipal bonds.

  2. Yves Smith

    Oof, good catch. That might have been inapt drafting on Tett’s part, but it sure looks like she said what you think she said.

    This is her third mistake in a few recent articles. She got promoted at the FT, and it is beginning to look like her reporting is getting sloppy. This is a big shame, since she had been very early on to some of the developments in the credit markets, and far more detailed and specific too.

  3. Yves Smith

    formerly knownasJS,

    Did you read my post? It was about Lockhart getting upset at Cuomo. Nowhere did I say that Cuomo should not investigate, not did I say that Lockhart was trying to get Cuomo not to investigate.

    And I did not say “sound mortgage paper.” I said “relatively sound mortgage paper.” Per my comment above, the GSEs are widely believed to be government guaranteed, and even thought the backing is not formal, the belief that they are guaranteed appears both to have a solid legal and practical foundation.

    Lockhart has reason to object to Cuomo casting doubt about GSE paper in public is a way that is not accurate. Per the initial post, most of the public does not have the attention span to appreciate that there may be problems with the mortgages the GSEs hold (you’d have to be a moron to believe otherwise) versus imply, as Cuomo did, that it has the same risk as privately originated paper.

    And in this shaky market, the last thing we need is misplaced fear. There is more than enough well founded fear going around.

    And having read Tanta’s post, I have to beg to differ with her on her interpretation of Lockhart’s letter. She effectively accuses him of covering for agency bad behavior when he said that the GSEs had no economic incentive to buy mortgages with inflated appraisals.

    In fact, if you read the transcript of this PBS interview, Lockhart is very serious about the need to clean up Freddie and Fannie, and pretty candid about the mess. He came in only mid-2006 (I’ve had trouble getting the date he took charge, but he was only acting director as of June 2006). Recall that the really frothy period of subprime lending was third-fourth quarter 2005 through 2006. He is working to draw a very big line between the GSE’s past practices and their current policies and practices.

    Nevertheless, turning around Freddie and Fannie is like turning a supertanker. I imagine that inertially the bad practices continued in the beginning of his tenure and probably haven’t been fully rooted out.

    So that is a long was of saying Lockhart may also be touchy about Freddie’s and Fannie’s anti fraud practices being seen to be deficient. They most certainly were deficient, with intent, in the past. They may still be deficient, but to Lockhart’s point, not with intent. He is really trying to make a root and branch change in the place, and appears to be getting traction.

    And one more point: as the head of a regulatory agency, even a guy who is a relatively straight shooter still has to adhere to party line.

  4. Anonymous

    The Fed & the Treasury could give a hoot about municipal investors (individuals) or municipalities (after all, as government entities, they are part of the problem according to the Republican canon).

    CDOs are south of a 50 price even with Ambac/MBIA insurance. Draw your own conclusion.

  5. Anonymous

    US pensions are in muni’s through structured notes designed to capture the muni carry trade aka Tender Option Bond Trusts (TOB). Those notes are usually highly levered. I don’t think Tett made a mistake but it is odd she singled out pensions.

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