Bloomberg reports today that a downgrade of the monoline bond insurers MBIA and Ambac, which had been the subject of concern for some time (see here and here), may cost investors as much as $200 billion. If they lose their AAA rating, then any securitized deals that relied on them for credit enhancement will be downgraded. Note that the ratings of other credit insurers that do not have AAA ratings are also under review.
Derivative markets are putting the risk of downgrade of MBIA and Ambac at less than 50/50, so even the prices of actively traded securities do not reflect the full impact of a downgrade. But much of the paper they insured, like collateralized debt obligations, was illiquid, and those instruments probably have not been shaded downward on the owners’ books. In other words, a downgrade would force the recognition of losses.
The implications of downgrades are so dire that if the credit guarantors cannot improve their situation via capital raising or reinsurance, analysts expect either banks or the government to step in.
The crisis of confidence in bond insurers that bestow top credit ratings on debt sold by borrowers from the New York Yankees to Citigroup Inc. may cost investors as much as $200 billion.
The AAA ratings of MBIA Inc., Ambac Financial Group Inc. and their five smaller competitors are being reviewed by Moody’s Investors Service and Fitch Ratings. Without guarantees, $2.4 trillion of bonds may fall in value and some issuers would get shut out of the capital markets.
“We shudder to think of the ramifications,” said Greg Peters, head of credit strategy at New York-based Morgan Stanley, the second-biggest U.S. securities firm by market value. “You have politicians, taxpayers, municipalities, states. It just opens up a Pandora’s box. That is a huge destabilizing force.”
For more than 20 years, the safety of insurance has eased the way for elementary schools, Wall Street banks and thousands of municipalities to sell debt with unquestioned credit quality. Now, mounting downgrades on insured bonds backed by assets such as mortgages are raising doubts about the stability of the guarantors. Armonk, New York-based MBIA, the world’s largest, has a 28 percent probability of default, and Ambac’s is 40 percent, prices of derivatives show….
Moody’s and Fitch, both based in New York, are examining the insurers on concern that a slide in the credit quality of some of the 80,000 securities they guarantee has eroded their capital so much that they no longer deserve AAA ratings.
The ratings companies said New York-based Ambac, FGIC Corp. in New York, and CIFG Guaranty of Hamilton, Bermuda, have a high or moderate chance of being told to add capital or forfeit their top status. Fitch and Moody’s said MBIA has a low risk of a downgrade.
Borrowers would see their costs increase if they lose top rankings. Municipalities ranked A pay $190,000 more a year in interest on $100 million of debt than those with AAA bonds, according to index data compiled by New York-based Lehman Brothers Holdings Inc.
Lower ratings would force some investors to sell securities. About 110 municipal bond mutual funds are required to hold most of their assets in AAA debt, according to data compiled by Bloomberg.
As many as half of all municipalities have an underlying credit strength equivalent to AAA, according to Lehman Brothers strategist Peter DeGroot. If yields on half of all insured munis were to rise by 19 basis points, reflecting the difference between AAA insured yields and A rated yields, the loss in value would be $9 billion.
When home sales soared this decade, insurers increased their guarantees of securities created from mortgages, including subprime loans to people with poor credit and home-equity loans.
They now guarantee almost $100 billion of collateralized debt obligations backed by subprime-mortgage securities as of June 30, according to an Aug. 2 report by Fitch. CDOs are created by packaging debt or derivatives into new securities with varying ratings.
Banks and investors in CDOs may be forced to write down the debt by more than $30 billion if the debt became uninsured, based on the values that New York-based Citigroup and Merrill Lynch & Co. assigned to their holdings in the past month. Merrill wrote down 29 percent of its CDOs and other securities linked to subprime mortgages and Citigroup cut 21 percent.
Insurers are required by accounting rules to reflect the current market value of the guarantees on the bonds they insure through derivatives contracts.
Then there is the $1 trillion market for insured securities backed by assets such as home-equity and consumer loans. Concerns about the underlying quality of the assets and the viability of the guarantors have caused investors to price some securities relative to the credit-default swaps of the insurers, according to David Land, a mortgage-bond fund manager at Advantus Capital Management. Advantus, based in St. Paul, Minnesota, oversees about $18 billion.
Insured securities backed by home equity-lines of credit have fallen by 15 percent, based on the rise in credit-default swap rates this year on Ambac’s insurance company. If the entire insured market were to drop that far, it would reduce the value of the securities by $150 billion.
“The insurers can protect you from one unusual, idiosyncratic event, like a Hurricane Katrina,” said Daniel Castro, chief credit officer of structured finance at GSC Group in New York, which oversees more than $24 billion of debt. “What if you had 20 Hurricane Katrinas and everything is wiped out? That’s what you have right now.”
Ambac, which pioneered municipal-bond insurance in 1971, has been rated AAA since 1979. MBIA got the top rating when it was created in 1974 as the Municipal Bond Insurance Association. When backing debt, the financial guarantors, also known as monolines, agree to make principal and interest payments if an issuer can’t, allowing the debt to get the highest rankings.
Ambac, the second-biggest in the industry, guarantees $546 billion of securities. MBIA stands behind about $652 billion of municipal and structured finance bonds, while FGIC has insured $314 billion of debt, including $600 million of bonds for the New York Yankees, according to the companies’ Web sites.
MBIA, Ambac, FGIC and their competitors have paid claims on less than 0.01 percent of the total debt from all municipal bonds they’ve insured, company statements show. MBIA shares rose an average of 13 percent a year from 2000 through 2006 and Ambac gained 15 percent. The Standard & Poor’s 500 Index advanced 1.1 percent a year in the same period.
“Investors in guaranteed debt have never questioned the AAA guarantee from monolines,” said Toby Nangle, who helps oversee $37 billion at Baring Asset Management in London and avoids debt guaranteed by monolines. Given the rise in the perception of risk, they “may start to wonder if the emperor has no clothes,” he said….
Credit-default swaps on MBIA more than tripled to 410 basis points since Oct. 15, according to CMA Datavision in New York. The price suggests that investors see a 28 percent chance MBIA will default, according to JPMorgan Chase & Co. valuation models. Contracts on Ambac have climbed to 620 basis points, CMA data show. They imply a 40 percent chance of default….
What has investors so concerned is the declining value of insured CDOs and mortgage securities. Bond insurers reported combined losses of $2.9 billion last quarter after writing down the value of some of the CDOs and other securities they guarantee amid the worst housing market since 1991.
“What concerns us is the pervasiveness of the potential problems,” Morgan Stanley’s Peters said in an interview this week. “The bond insurers touch so many aspects of the financial system.”
The writedowns are so-called mark-to-market losses, reflecting the reduced value of the securities. Those losses may never be realized as the securities mature, Ambac Chief Executive Officer Robert Genader said on a conference call Nov. 7, arranged to allay investor “misconceptions” about the company’s business.
MBIA believes it has sufficient capital, spokeswoman Liz James said in an e-mail. “As future developments in the economy are uncertain, we may consider taking steps to further bolster the company’s capital position,” she said.
Ambac spokesman Peter Poillon and FGIC spokesman Brian Moore didn’t return calls. CIFG spokesman Michael Ballinger said the company, and its parent, Natixis SA of France, were committed to maintaining AAA ratings.
Fitch, a unit of Paris-based Fimalac SA, and Moody’s said last week that they would spend a month studying each insurer’s capital cushion, or the excess capital over what the ratings companies require to maintain their current rankings.
Insurers could boost their padding by reinsuring the securities they guarantee, Fitch analyst Keith Buckley said on a conference call Nov. 8.
Banks may step in to back the companies because it would be cheaper than taking more writedowns, Michael Barry and Seth Levine, analysts at Charlotte, North Carolina-based Bank of America Corp., wrote in a report.
“The securities industry, no small force, has a keen interest in the financial guarantors remaining healthy and rated AAA,” they wrote. “Financial guarantors would not have to look far for help making sure the demand was met.”
The issues facing insurers go beyond “misconceptions” referred to by Ambac’s Genader, said Geraud Charpin, London-based head of credit strategy at Zurich-based UBS AG. The firm is Europe’s largest bank by assets.?
Losses may be so big that governments would step in to prevent losses from hurting municipal bondholders, many of them retirees, and states and municipalities, which may be prevented from selling debt, he said.
“A form of bailout would probably be worked out,” Charpin said in a Nov. 6 note to investors. “A politically engineered solution will insure an acceptable way out where the innocent pensioner does not lose out and states are able to continue funding themselves and build more roads and schools.”
MBIA guaranteed $15.9 billion of CDOs backed by subprime mortgages and had excess capital of about $550 million, S&P said in an Aug. 2 report. Ambac had a cushion of about $1.15 billion on $29.3 billion of CDOs backed by home loans to people with poor credit, while FGIC had $350 million more than it needed for $10.3 billion of securities. ACA’s cushion was around $500 million for $15.7 billion of subprime-backed CDOs.
Had the insurers reduced the values of the bonds they guaranteed by the same magnitude as the writedowns at Merrill and Citigroup, MBIA would have taken a $3 billion hit, instead of $342 million, William Ackman, president of hedge fund Pershing Square Capital Management, said at a conference in Stamford, Connecticut, last week. Ambac would have had a $6.1 billion loss, rather than the $743 million it reported, said Ackman, who has short positions on MBIA and Ambac that benefit from a drop in the companies’ stocks and bonds.
“This has implications for global financial markets,” said Ackman, who has pushed for changes at companies such as McDonald’s Corp., the world’s biggest restaurant company, and Wendy’s International Inc. He first raised questions about the bond insurance industry in a 2002 research report titled “Is MBIA Triple-A?”