More Credit Guarantor Woes

Companies that provide credit enhancements to bond deals, such as monoline insurers MBIA and Ambac, as well as other type os financial guarantors, have come under a great deal of scrutiny of late as the rapid deterioration in certain types of structured finance products had made their guarantees look less solid. However, lowering their credit standing would have the effect of downgrading all the securities that they insured. As a result, ratings agencies are particularly reluctant to lower their ratings, since the knock-on effects are considerable. Hence there is already skepticism about these ratings. Some observers believe the monolines no longer belong in the AAA category, although they have not been downgraded; other guarantors, who generally do not have AAA ratings, are also at risk of having their ratings cut.

Two developments confirm the weakening of the guarantors. A Bloomberg article informs us that JP Morgan has issued a report saying that ACA Capital, 29% owned by the private equity group at Bear Stearns, is likely to be downgraded, which will force banks to take $60 billion of collateralized debt obligations on to their balance sheets. The Financial Time’s Alphaville adds that ACA was particularly active in providing credit support to collateralized debt obligations. The Wall Street Journal reports that CIFG will receive $1.5 billion of capital from its parent to prevent a downgrade.

Note that the Journal attempts to put a positive spin on the story, asserting it “provides a roadmap for other bond insurers.” Huh? CIFG is being shored up by its parent. I am not certain how many bond insurers have sugar daddy owners they can hit up for cash, but the most important players, MBIA and Ambac, do not. Indeed, the only company that the Journal identified as a candidate to follow CIFG’s lead is FGIC, a significant player in municipal bond insurance.

Ironically, however, the FT’s coverage does provide some support for the Journal’s assessment, but I don’t see it as any source for comfort. It says that ACA is likely to be propped up, albeit reluctantly, because banks and investment banks don’t want to suffer a downgrade.

How many measures can financial firms take to validate asset prices without taking on undue risk, or simply tying up so much capital that it restrict their ability to conduct business? We are entering that zone sooner than anyone anticipated.

First, from the Bloomberg piece on ACA:

S&P on Nov. 9 began considering New York-based ACA’s A rating for a downgrade after it posted a $1.04 billion third- quarter loss. ACA said in a filing this week that it won’t meet collateral requirements if its rating falls below A-.

ACA is among nine bond insurers being vetted by ratings companies after the value of the CDOs they insure fell. Moody’s Investors Service and Fitch Ratings are examining AAA rated insurers including MBIA Inc., Ambac Financial Group Inc. and FGIC Corp. to see if they have enough capital. A loss of the top ranking by the insurers would throw into doubt ratings on $2.4 trillion of debt.

“ACA is a likely candidate to get thrown to the wolves first,” Wessel said in an interview today. If ACA defaults, banks would then have to bring their ACA-guaranteed CDOs onto their books, said pJPMorgan Chase & Co. analyst Andrew] Wessel….

The private-equity investment arm of New York-based Bear Stearns Cos., the fifth-largest U.S. securities firm, bought a 29 percent stake in ACA in 2004 for about $100 million. The stake is owned by MBP II, one of the funds raised by the merchant banking unit. Bear Stearns has likely written down the declining market value of ACA in previous quarters, according to Lehman Brothers Holdings Inc. analyst Roger Freeman. Even if Bear Stearns had to write down ACA fully, it would face a $6 million charge, according to Bloomberg calculations….

Merrill Lynch & Co. may need to write down $3 billion of CDOs if ACA defaults on its obligations, Freeman wrote in a note to clients on Nov. 5…

ACA, which has claims paying resources of $1.1 billion, also has insured bonds with a par value of $7.1 billion, according to the company’s Web site. Most of that debt is for tax-exempt organizations, including $51.5 million of bonds sold to finance the construction of a jail in Pinal County, Arizona, and $4.7 million of bonds for the city of Deadwood, South Dakota

Next, the FT’s Alphaville on ACA:

ACA are a big manager of CDOs and also a leading provider of CDO default insurance policies – which strikes us a pretty shortsighted combination.

Considering that ACA’s prime line of business is in structured finance, a $1.6bn writedown is hardly surprising, but it’s still worthy of note for several reasons:

Firstly, relative to ACA’s size, it’s a very big hit.

Secondly, the writedown ACA has taken may yet be a lot worse. The main cause for concern here is the fact that ACA’s Q3 results only cover the period up to September 30. And the very worst month for CDOs was October. Testament to that the fact that Lancer [a CDO squared, meaning a CDO of a CDO]] has now entered an event of default.

And thirdly, as a monoline insurer, ACA’s problems are not just ACA’s problems. The security of their insurance – on billions of dollars of CDO paper – is dependent on the safety of ACA’s own rating. And in the light of such a big writedown and the prospect of more trouble ahead, S&P has put the group on review.

ACA has been used as a “dumping ground” by subprime securitizers says Barrons, and that might now come back to haunt them. Wall Street does indeed seem keen to prop ACA up. According to filings with the SEC, a consortium of banks has provided liquidity facilities to the company. In spite of disastrous performance, banks have also continued to take out ACA insurance, unwilling perhaps, to pull the rug from under ACA’s feet.

Next, the Wall Street Journal on CIFG:

In the first sign of relief for the troubled bond-insurance industry, financial guarantor CIFG Services Inc. will receive a $1.5 billion capital injection from controlling shareholders of its French parent so it can preserve its imperiled triple-A credit rating, according to people familiar with the matter.

The plan, which is scheduled to be announced as early as Thursday, provides a roadmap for other bond insurers whose businesses, reputations and share prices have been hit hard in recent weeks. Rating agencies have warned that they will downgrade guarantors that fall short of capital necessary to absorb potential losses in their portfolios of risky mortgage-loan pools known as collateralized debt obligations, or CDOs…

A rating downgrade could wipe out a bond insurer’s business, since most issuers only pay an insurer to guarantee its bonds because of the rock-solid financial strength implied by the triple-A rating. If any of the major guarantors lose their ratings, it could lead to widespread downgrades on the hundreds of billions of dollars in debt securities that they insure, ranging from water and sewer bonds to CDOs. In turn, bond investors such as retirees, mutual-fund holders and hedge funds would be hurt….

While privately held CIFG is smaller than its publicly traded peers such as Ambac Financial Corp. and MBIA Inc., its capital-infusion plan may serve as a potential model for other bond insurers including Financial Guaranty Insurance Co., or FGIC, and Security Capital Assurance. Less than three weeks ago, Fitch Ratings and Moody’s Investors Services named CIFG and FGIC as among the most likely to fall short of capital guidelines and face downgrades.

Privately held FGIC, which guaranteed about 15% of all new public-finance debt in 2006, has been in discussions about how much to tap its investors for capital, according to people familiar with the matter. Private-equity firms Blackstone Group and Cypress Group each bought 23% stakes in FGIC in 2003, while mortgage insurer PMI Group Inc. owns a 42% stake. General Electric, FGIC’s former owner, retained a 5% stake while CIVC Partners, a Chicago private-equity firm, owned 7%.

Some of these investors are considering injecting about $200 million and are prepared to put in more if necessary. Like CIFG, these investors are considering a mix of pure equity and reinsurance, according to people familiar with the matter. FGIC could not be immediately reached for comment.

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  1. Brian

    I agree this is not much of a model for the rest of the insurers. The cavalry riding in here appear to be two of those classically French non-public, largely unaccountable entities, controlled or heavily influenced (that is an inference) by the government.

    The terms of the rescue financing are completely opaque and are no doubt not at “market” levels. For instance, if the S&P press release is to be believed, the two parent orgs have decided to commit “as much capital as is necessary” to maintain CIFG’s AAA rating. It is hard to imagine that the recapitalization of FGIC, for example, will contain such an open ended commitment. Rather, this looks like an effort to sweep the problems under the rug and minimize any political fallout from the CFIG near implosion.

    While PMI will probably get a pop on this news on Friday, the final terms of the FGIC bailout will likely not be so benign for PMI shareholders. PMI is fighting for its life right now and doesn’t have any spare change to throw at the problem, and you can be sure the other FGIC shareholders, if they haven’t already had enough fun in the financial guarantee business, will be treating this effectively as a de novo investment. The terms of any rescue financing will reflect the risks in the business that are clear for all to see.

  2. Anonymous

    Take a guess where the credit enhancement cash comes from and why money mkts need to be watched!!

    Employee Benefit Security

    The Employee Retirement Income Security Act (ERISA) regulates employers who offer pension or welfare benefit plans for their employees. Title I of ERISA is administered by the Employee Benefits Security Administration (EBSA) (formerly the Pension and Welfare Benefits Administration) and imposes a wide range of fiduciary, disclosure and reporting requirements on fiduciaries of pension and welfare benefit plans and on others having dealings with these plans. These provisions preempt many similar state laws. Under Title IV, certain employers and plan administrators must fund an insurance system to protect certain kinds of retirement benefits, with premiums paid to the federal government’s Pension Benefit Guaranty Corporation (PBGC). EBSA also administers reporting requirements for continuation of health-care provisions, required under the Comprehensive Omnibus Budget Reconciliation Act of 1985 (COBRA) and the health care portability requirements on group plans under the Health Insurance Portability and Accountability Act (HIPAA).


    EBSA is responsible for administering and enforcing the fiduciary, reporting, and disclosure provisions of Title I of ERISA. EBSA oversees approximately 683,000 private pension plans, including 419,000 participant-directed individual account plans such as 401(k) plans, and millions of private health and welfare plans that are subject to ERISA.(1) Participant-directed individual account plans under our jurisdiction hold over $2.2 trillion in assets and cover more than 44.4 million active participants. Since 401(k)-type plans began to proliferate in the early 1980s, the number of employees investing through these types of plans has grown dramatically. The number of active participants has risen almost 500 percent since 1984 and has increased by 11.4 percent since 2000. EBSA employs a comprehensive, integrated approach encompassing programs for enforcement, compliance assistance, interpretive guidance, legislation, and research to protect and advance the retirement security of our nation’s workers and retirees.

    Disclosures to Plan Fiduciaries

    EBSA will soon be issuing a proposed regulation amending its current regulation under ERISA section 408(b)(2) to clarify the information fiduciaries must receive and service providers must disclose for purposes of determining whether a contract or arrangement is “reasonable,” as required by ERISA’s statutory exemption for service arrangements. Our intent is to ensure that service providers entering into or renewing contracts with plans disclose to plan fiduciaries comprehensive and accurate information concerning the providers’ receipt of direct and indirect compensation or fees and the potential for conflicts of interest that may affect the provider’s performance of services. The information provided must be sufficient for fiduciaries to make informed decisions about the services that will be provided, the costs of those services, and potential conflicts of interest. The Department believes that such disclosures are critical to ensuring that contracts and arrangements are “reasonable” within the meaning of the statute. This proposed regulation currently is under review within the Administration.

    Disclosures to the Public

    EBSA will soon promulgate a final regulation revising the Form 5500 Annual Report filed with the Department to complement the information obtained by plan fiduciaries as part of the service provider selection or renewal process. The Form 5500 is a joint report for the Department of Labor, Internal Revenue Service and Pension Benefit Guaranty Corporation that includes information about the plan’s operation, funding, assets, and investments. The Department collects information on service provider fees through the Form 5500 Schedule C.

    We intend that the changes to the Schedule C will work in tandem with our 408(b)(2) initiative. The amendment to our 408(b)(2) regulation will provide up front disclosures to plan fiduciaries, and the Schedule C revisions will reinforce the plan fiduciary’s obligation to understand and monitor these fee disclosures. The Schedule C will remain a requirement for plans with 100 or more participants, which is consistent with long-standing Congressional direction to simplify reporting requirements for small plans.

    In carrying out its enforcement responsibilities, EBSA conducts civil and criminal investigations to determine whether the provisions of ERISA or other federal laws related to employee benefit plans have been violated. EBSA regularly works in coordination with other federal and state enforcement agencies, including the Department’s Office of the Inspector General, the Internal Revenue Service, the Department of Justice (including the Federal Bureau of Investigation), the Securities and Exchange Commission, the PBGC, the federal banking agencies, state insurance commissioners, and state attorneys general.

    EBSA is continuing to focus enforcement efforts on compensation arrangements between pension plan sponsors and service providers hired to assist in the investment of plan assets. EBSA’s Consultant/Adviser Project (CAP), created in October 2006, addresses conflicts of interest and the receipt of indirect, undisclosed compensation by pension consultants and other investment advisers. Our investigations seek to determine whether the receipt of such compensation violates ERISA because the adviser or consultant used its status with respect to a benefit plan to generate additional fees for itself or its affiliates. The primary focus of CAP is on the potential civil and criminal violations arising from the receipt of indirect, undisclosed compensation. A related objective is to determine whether plan sponsors and fiduciaries understand the compensation and fee arrangements they enter into in order to prudently select, retain, and monitor pension consultants and investment advisers. CAP will also seek to identify potential criminal violations, such as kickbacks or fraud.

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