What Happened to the Promised S&P and Moody’s Review of MBIA and Ambac?

Why have the rating agencies failed to deliver on actions they promised to take? Remember the announcements that helped feed into the overseas market rout last Monday? This story ran January 16 on Bloomberg:

Standard & Poor’s will start a new examination of bond insurers, one month after affirming the companies’ AAA ratings, because losses on subprime mortgages will be worse than the firm anticipated.

The ratings company will examine whether insurers including MBIA Inc. and Ambac Financial Group Inc. have enough capital to withstand reductions in the ratings of the mortgage-backed securities they guarantee. The credit test will be completed within a week, said Mimi Barker, a spokeswoman in New York.

Standard & Poor’s must define a week differently than I do. If you are generous and assumed S&P started its review January 17, a week later is Thursday January 24. Even if you allow another day to draft a press release, we should have heard something by the end of last week.

You may recall that Moody’s also put MBIA on review for a downgrade on January 16, although they did not say when they expected to complete their process. From the Wall Street Journal:

Moody’s said late Wednesday that it had placed its ratings on Ambac on review for a downgrade, after the country’s second-largest bond insurer significantly stepped up its expected losses from insuring complicated securities backed in some cases by subprime mortgages. Moody’s also said it will be evaluating “in the near term” the extent to which its ratings of other firms in the industry will be affected by the sector-wide pressures that produced the losses at Ambac.

Now it goes without saying that the rating agencies don’t dare downgrade the insurers while New York State insurance superintendent Eric Dinallo’s effort to cobble together a rescue package is underway. They’d be walking into a buzzsaw of criticism for Destroying the Financial World as We Know It and Not Letting the Private Sector Devise a Solution.

So the failure to act is understandable. But what has my paranoid juices going is the failure to make a statement that the ratings reviews were being held in abeyance. Of course, that would put the onus on the agencies to declare Dinallo’s effort failed if it became evident no deal would happen but the regulator was still failing around.

But what does this behavior point to instead? An angle that should have occurred to me sooner.

Last week, I gave an initial and then a more thought-out assessment , both concluding Dinallo’s initiative was highly likely to come to naught. But I was looking at this from the “can they raise enough dough” standpoint.

That is a mistaken perspective. It assumes the agencies are the immovable object in this equation, when they are in fact the most malleable.

Remember, the markets have already given a huge vote of no confidence in the debt of Ambac and MBIA. Their credit default swaps are trading at distressed level. Distressed means “serious risk of bankruptcy.” Now even if you think the market reaction is a tad histrionic, given the rating agencies’ track record with structured credits, I would place my faith in the markets’ perception of risk. And even if you are merely democratic and split the difference, say, between an AAA and a CCC (and even CCC may be a tad generous), you get a BBB. A downgrade of that magnitude, even while still leaving the bond guarantors with an investment grade rating, makes their guarantees effectively worthless and will create chaos. Barclays estimated that a downgrade of MBIA and Ambac to a mere single A would produce $143 billion of losses to banks and brokerage firms.

Consider further that the amount Dinallo is seeking is likely to prove insufficient. His target of $5 billion now and an additional $10 billion down the road sounds very much in keeping with hedge fund Pershing Square’s estimates. But those were made based on end of third quarter data. A current requirement is certain to be lower. And other experts have come up with mind numbing requirements. Rating agency Egan Jones said the bond insurers as an industry need $200 billion to keep their AAA ratings. Even if that is high by, say, 400%, it is still a vastly bigger total than Dinallo is seeking.

But the name of the game is getting the rating agencies not to downgrade the big bond insurers. There already is evidence of a tacit understanding that there will be no downgrades while the negotiations are in play, particularly since Moody’s and S&P are participating.

And the very fact that the agencies are part of the process means that they will be subject to both subtle and explicit pressure to knuckle under and accept any package, no matter how inadequate.

Social psychologist Robert Cialdini, in his classic book, Influence: The Psychology of Persuasion, wrote about the power of social assent. One well documented finding from studies of cult members and victims of brainwashing is if you take a person and put him with a group of people who believe in something strongly that is opposed to what he believes and they keep working on him, it is almost certain he will eventually capitulate.

Now the rating agencies could easily protect themselves from that dynamic by sending a mere note-take to the sessions. Conversely, it would be a very bad sign if they senior people who could make commitments participated.

But aside from the dynamics in the room, there is every reason to expect the rating agencies to knuckle under if Dinallo can raise a modest amount of dough, even as little as, say, $2 billion. The agencies through their mistakes have now created the situation where they could be the ones to Destroy the Financial World as We Know It. They will take any route offered to keep from pushing the button, in the hopes that either the economy will miraculously recover or other events will lead to credit repricing, so that the eventual downgrade of the insurers has far less impact than one now.

I still don’t think a bailout is likely to succeed, despite the considerable costs of a bond guarantor downgrade. But the fact that the rating agencies will probably go along with any remotely plausible scheme means that a smoke and mirrors version might be put into place.

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  1. doc holiday

    Aaaah crap, Im trying to find an old post about Moody’s where they are crawling into bed with some derivatives group and the point is that they dont have models to rate the securities, but they need the market share; Ill find it later, but here are some great old stories on MCO, that point right back to great story here and now!

    Additional Opportunities in Structured Finance


    Ongoing global development of non-traditional
    financial instruments, especially credit derivatives, has accelerated in recent
    years. Increasingly complex collateralized debt obligations (“CDO”s) have been
    introduced, which should continue to support growth. Moody’s has introduced new
    services enabling investors to monitor the performance of their investments in
    structured finance, covering asset-backed finance, commercial mortgage finance,
    residential mortgage finance and credit derivatives.

    2. Tons and tons of stuff from The Enron era, where Moody’s didnt seem to understand what they were being paid to do:

    Before discussing Enron and related issues in more detail, it is important for me to note that Moodys did not have any knowledge, prior to Enron’s bankruptcy, of the existence of Enrons prepaid forward and related swap transactions. Even today, our understanding of the specifics of these transactions is restricted to what we have gleaned from press accounts and the conversations we have had with the Subcommittee staff at their request. Based on our limited knowledge, these transactions appear to have been a form of borrowing. If such transactions had been accounted for as a loan, Enrons operating cash flow would have been reduced and its debt would have been greater. The disclosure of these transactions as loans would have exerted downward pressure on Enrons credit rating.

    3. Enron again: According to the Staff Report, in some cases the rating agencies appeared simply to take the word of Enron officials when issues were raised, and failed to probe more deeply. In addition, the credit rating agency analysts seemed to have been less than thorough in their review of Enrons public filings, even though these filings are a primary source of information forthe ratings decision.

    4. Enron period again: To determine a rating, analysts will convene a credit committee. The committee will
    consist of anywhere from 4 to 12 people, including the analysts working on the company, their
    Managing Director, and other analysts, management, or staff with useful expertise. The analyst
    will make a recommendation, and the committee will vote. The deliberations of a credit
    committee, and the identities of the participants, are kept confidential. The rating is usually
    made public through a press release. Companies are generally notified of their ratings in advance
    of the publication if there is a change or if it is a new rating to allow the issuer to respond if it
    believes that the rating does not accurately reflect its creditworthiness S&P refers to this
    process as an appeal. Such an appeal, if the company requests it, is conducted within a day
    or two of the ratings announcement. S&P has indicated that it is rare that it will change a rating.
    With a company that has been rated and is being monitored, a committee will be convened
    periodically, perhaps once a year or once every eighteen months, to reaffirm or change the rating.
    Prior to a ratings change, a company may be put on a watch or review. An analyst may
    initiate a watch or review without a meeting of the credit committee.

    Sorry about length, seems to be a very long and disturbing pattern of public abuse here that goes back years, and now where are we with these boobs?

  2. dh

    More old news that is interesting; hope you dont mind.

    Committee on the Global Financial System

    Credit risk transfer Report submitted by a Working Group established by the Committee on the Global Financial System January 2003

    In the 1980s monolines entered the ABS market and in the 1990s they expanded their business to the CDO market. Today the amount insured in these areas is larger than in the initial core business. Most monolines have AAA ratings and rating agencies apply a “shadow” rating and a capital charge to virtually every transaction. Since these charges are sensitive to the rating of the obligor, monolines have a strong disincentive to insure sub-investment grade risk or take large exposures, which expose them to “event risk”. In structured finance, they typically sell protection using financial guarantees or portfolio credit derivatives on the most senior (so-called “super-senior”) AAA-rated tranches. Since insurance of these tranches only becomes effective if the junior equity, mezzanine and senior tranches are exhausted, monolines should not be exposed to idiosyncratic credit risk on companies within their portfolio. The risk profile of their exposure can be compared to a written out-of-the-money put option to protect investors against extreme market events.

    In some countries insurance firms are prohibited from entering into derivative transactions directly.They have, however, found ways to circumvent this restriction. (The restriction derives from legal and/or regulatory requirements for those purchasing insurance to have an “insurable interest” in the risk and is designed to mitigate the moral hazard underlying insurance contracts). Major insurance firms and (investment) banks have established companies, so-called transformers, often in Bermuda, where the prohibition does not apply. The transformers sell protection to the risk shedder in a derivative transaction and buy insurance from an insurance company via a conventional insurance policy.

    Although it seems clear that low interest rates induced insurance companies to move to higher-yielding assets, it is not clear whether their involvement in CRT markets has increased their overallinvestment risk or how it has changed their credit risk profile.

    New employment opportunities for college grads:
    >>> risk shedder <<<

  3. Anonymous

    Is it really unthinkable to require forebearance on rating agency downgrades, given that their initial ratings reflected criminal incompetence? Why would the downgrade landing point have more integrity than the initial rating? An ummitigagated downgrade delta based on a fictitious starting point smacks of recklessness.

  4. Lune

    Very insightful, Yves. But let me ask: does it matter what the ratings agencies do anymore? The AAA rating only means something if everyone believes it and prices insured bonds appropriately. But no one believes that rating anymore, and the losses are starting to accumulate as bonds are being repriced.

    I understand that pension funds and the such might be forced to unload bonds if they lose their AAA rating, but I suspect that many of them are starting to unload anyway, since they fully expect the monolines to go under and the bonds to get downgraded in the next few months.

    Or is that the whole point? To buy a couple of months time for a gradual transition?

  5. pillx

    Donald Light, senior analyst with Celent, a Boston-based financial research and consulting firm, comments on an estimate of how much capital banks would have to raise should bond insurers see significant downgrades to their top-notch ratings.

    For days there has been speculation on the size of the spillover impact on banks and other institutions if bond insurers continue to lose their AAA ratings.

    Now Barclays Capital has come up with a very big and scary number: a $143 billion shortfall in capital at Tier 1 and possibly other banks. Like all estimates, this one has a lot of assumptions behind it, not all of which may be supported by reality.

    But if the Barclays Capital estimate is even remotely in the ballpark, it indicates that the cost of a bond insurer bailout is a lot less than the cost of shoring up banks’ mark-to-market losses. And that, oddly enough, is good news because it means that these banks suddenly look more likely to throw some capital at the bond insurers. Then the only rain cloud threatening this parade will be whether the ratings agencies think all the balance sheets have actually become stronger.

  6. donebenson

    I disagree with the comments of Pillx. If the embedded losses are close to Barclay’s $143 billion [or Egan-Jones $200 billion estimate], then $15 billion+ of capital is not going to save the day, but only put off the inevitable, and guarantee that the U.S. follows the Japanese example of deferring the losses in their ‘lost decade’ of the 1990’s.

  7. pillx

    Efforts to shore up US bond insurers gathered pace yesterday as New York state regulators appointed investment bankers to advise on a rescue plan that could include back-up credit lines for the troubled guarantors.
    The efforts are being spearheaded by Eric Dinallo, the New York state insurance superintendent, who is being privately supported by the New York Federal Reserve Bank and other regulators, people familiar with the matter said.
    Perella Weinberg, an advisory firm based in New York, has been hired as a financial adviser by Mr Dinallo’s department. The company is led by Joseph Perella, the former Morgan Stanley mergers and acquisitions executive, and Peter Weinberg, who previously ran Goldman Sachs’s European business.
    The discussions on a rescue plan are understood to be proceeding on two tracks.
    Regulators are talking to banks about providing back-up credit lines for the bond insurers. They are also speaking with other parties, including private equity firms and billionaire investors like Wilbur Ross and Warren Buffett, about providing fresh equity capital for insurers such as Ambac and MBIA.
    Mr Dinallo met about a dozen banks last week, asking them to provide up to $15bn for the bond insurers. Mr Weinberg said: “Both at the meeting last Wednesday and since that time, the [insurance] department has been promoting a broad range of solutions that protect policy holders.”
    He added that these included both the provision of credit lines by banks and separate moves to shore up the capital bases of the insurers.
    While there was no indication that any banks had agreed yet, credit lines could help the insurers stave off credit rating downgrades. Some bankers hope the discreet involvement of the Fed will give the initiative greater momentum, because of its influence on Wall Street. The Fed has, for example, been discreetly urging big US banks to shore up their capital bases – with considerable success.
    The rescue efforts come amid concerns that bond insurers are running out of time to reassure rating agencies they have enough capital to deal with losses related to guarantees of bonds exposed to subprime mortgages.
    Debt markets are pricing in the likelihood that bond insurers will lose their triple-A status – in sharp contrast to the stock markets, which rallied sharply last week after news of a potential bail-out emerged.
    The withdrawal of the triple-A ratings could lead to losses for banks, some of which have large exposures to hedges, derivatives contracts and bonds whose value depends on the insurers maintaining the highest credit rating. Banks have already written off more than $100bn of exposures related to subprime mortgages.

  8. foesskewered

    Yves, the answer actually might lie in what is left unspoken in the FT article quoted by pillx and that is the point about them being unsure how long the ratings agency are going to wait . Perhaps an unspoken deal on the ratings agency waiting till some deal is finalised? After all the ratings agency woulldn’t like to be the scapegoat should the bond insurers be downgraded and therefore set off a spiral in the markets.

  9. Anonymous

    S&P did follow through and release its revised stress test results just a couple days after they came out with the higher subprime loss assumptions:

    S&P Updates Results of Bond Insurance Stress Test for Revised Assumptions

    As for Moody’s, a typical review lasts for three months so I wouldn’t necessarily expect a resolution anytime soon. I do agree that given the actions they took on Ambac and MBIA (which were pretty inconsistent with the previous Moody’s analysks), Moody’s seems overdue for some ratings actions on SCA and FGIC.

    To the last comment: If the agencies were that mindful of not setting off a spiral in the markets, Moody’s would not have placed Ambac on review for downgrade after Ambac announced its plans to raise equity. If you recall, the Moody’s review sent ABK stock down 50%, therefore rendering it impossible for ABK to raise that equity. Given that Moody’s affirmed Ambac and Aaa/Stable less than a month earlier, a more consistent action would be a negative outlook rather than a review for downgrade. That was a clear case of a rating agency action directly impacting the rated company’s operating ability.

  10. Yves Smith

    Anon of 11:49 PM,

    Thanks for the link to the Insurance Journal article. Obviously, I missed it, and that was despite looking around for it more that a bit. Wonder why none of the logical suspects picked it up.

  11. S

    Sorry, there’s no public link anywhere. But I can tell you that the loss forecasts surprisingly didn’t go up that much. ABK total after-tax losses from $1.85bn to $2.25bn. MBI $3.18bn to $3.52bn. FGIC $2.17bn to $2.55bn. SCA from $884mm to $973mm. S&P implied in the writeup that the increased loss assumptions don’t materially change their assessment of the insurers’ capital positions.

    To date, the market has paid the most attention to the most dire forecasts, including vague numbers thrown out by Fitch such as ABK and MBI need $1bn and SCA needs $2bn, while not providing any details on how they came up with those numbers. Moody’s analysis was even more vague – though they provided a 19% 2006 subprime cumulative loss assumption, they didn’t disclose loss estimates or how much capital the insurers would need to raise.

    S&P’s analysis was by far the most transparent and provided many details on the process, as well as the actual numbers of their loss projections. Until the revised results, the biggest criticism for S&P was that they were still behind the market on their mortgage loss assumptions, namely 15.5% cum losses compared to Moody’s 19%. Having now raised that loss assumption to 19%, S&P’s analysis should be the most valid in the market, since S&P has access to much more detail about the insured portfolios than any analyst in the Street attempting to make projections. Street analysts can model potential losses all day long, but without the detail that only the insurers and the rating agencies have about the underlying collateral, analysts have to apply broad vintage, ratings and collateral assumptions that can cause huge variances in loss estimates.

    However, as a caveat, the S&P analyst did tell me that the stress test results were updated only for increased subprime loss assumptions. So if the S&P mortgage team decides to raise loss assumptions on other asset classes such as Alt-A, HELOCs, CES or NIMs then they would update the bond insurance stress test results once more. For reference, S&P’s 2006 loss assumptions for those asset classes were: Alt-A 3.50%, HELOC 15.75%, CES 40%, NIM 15.5%.

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