Monoline Update: Are the Rating Agencies Moving the Goalposts?

We have been skeptical about the possibility of a private-sector rescue of the troubled bond insurers. Nevertheless, both the Wall Street Journal and the Financial Times reported progress on discussions to shore up Ambac, the number two insurer, and that efforts were underway to assist the smaller fry. From the Financial Times:

US and European banks are joining forces to try to solve the crisis among US bond insurers that could exacerbate the impact of the credit squeeze.

One group, including Citigroup and Barclays, is examining options for supporting Ambac Financial, the bond insurer. Separate teams are working with other bond insurers, according to people close to the process.

Note that the worst outcome for Wall Street isn’t that the insurers are downgraded; it’s that they spend money trying to salvage them up and they nevertheless lose their AAAs later. What we find surprising is that Wall Street is willing to stump up cash, worse, at least some equity funding, at a time when money is tight and more writeoffs are likely. And this is also taking place despite the fact that the majority of Wall Street analysts who have taken a look at the bond insurers are putting out even bigger loss estimates than Bill Ackman, the head of Pershing Square who has been saying that the monoline business model is unworkable since 2002.

What gives? Two things: the investment banks’ assumptions and the rating agencies actions.

A mere patching of the leaks at the bond guarantors is not a sensible move unless you have a very optimistic set of assumptions. If you believe that the economic downturn is only a two-quarter event and that a rising economy will take pressure off the insurers, investing would be attractive.

The problem, of course, is that the bond insurer troubles are driven primarily by the housing market. The last housing recession, which started in 1989, lasted 15 quarters and had less unsold home inventory (as a percentage of outstanding) than we have now. Even if you date the start of this housing slump at end of second quarter 2007, we have a long way to go. Thus the idea that this charade can be kept gong beyond two or three quarters is highly questionable.

Or is it? The mistake is believing, as we perhaps have too much, that the rating agency saber rattling means they have the will to downgrade. They don’t. The very last thing they want to do is be accused of causing The End of the Financial World as We Know It.

Even thought anyone who has looked at these companies in a serious way knows the AAA ratings for MBIA and Ambac are a sham, they are coming to resemble guys on death row that it takes 20 years to execute. The rating agencies, while threatening that downgrades are imminent, keep allowing the timetable for fundraising to be extended. According to the Wall Street Journal:

Moody’s prepared investors for bond-insurer downgrades in a research note Thursday and subsequent investor call Friday.

Some firms “may be unable to restore financial strength to levels consistent with a Aaa rating,” the firm wrote. Moody’s is likely to make decisions on downgrades this month, it said, possibly sooner in the month for insurers having trouble raising capital.

While this sounds like the heat is on, the reality is more nuanced. If the rating agencies believe serious negotiations are underway for specific firms, the decisions on downgrades “this month’ probably means that they have until at least the end of February.

The focus on Ambac makes sense too. Its troubled exposures are primarily CDOs, which will come a cropper sooner than other instruments might, and will also inflict damage on Wall Street firms. MBIA’s guarantees, by contrast, are spread across more types of instruments. The cost of an MBIA downgrade is likely to be shared more broadly, making it harder to round up interested parties to write checks.

Also note that despite the continuing deterioration in the credit markets, the rating agencies have not increased the required fundraising for the bond insurers. That seems highly inconsistent with recent developments, most notably S&P saying that it will either downgrade or put on review $534 billion of debt, and estimated that this move could increase bank and investment bank losses from $130 billion to $265 billion.

Pray tell me how this has no impact on MBIA and Ambac? This confirms that Moody’s and S&P will take advantage of any route open to them to avoid downgrading the insurers. If they raise remotely adequate amounts of money (or can use some reinsurance hocus-pocus), the game will go on until events, or a big disparity between the top two agencies and Fitch, make the charade untenable.

A jaded and informed view comes from reader Scott, an institutional investor who has been on this beat for some time (and is holding his short position):

I have two problems with the concept. One, the size of the help involved, particularly given the rumored rescuers. Certainly Citi and UBS, and to a lesser extent WB, who in any event doesn’t to my understanding have tons of exposure on their own books, just don’t have the wherewithal to do more than pay lip service to a real bailout, so it will be almost totally cosmetic if they’re the real players–just enough to allow Moodys and S&P maintain the charade that ABK’s a triple A credit.

And perhaps more importantly from an investor’s viewpoint, Dinallo’s only interest here is in making sure insured claims get paid, and mostly muni ones at that, I suspect, so that from an investor’s viewpoint the money will remain at the insurance subsidiary, and will not get upstreamed to the public holding company. Maybe that will allow these guys to stay open, but in terms of competing for future business, they’ll clearly be left with the worst stuff available–anybody in their right minds, assuming anybody in their right minds will be buying this insurance going forward in the first place, will place their business with Buffett, so they’ll be competing for business he doesn’t want–adverse selection of the worst sort.

I’m sure that somebody like 3rd Avenue believes that they’ll be able to negotiate some sort of anti-dilution deal alongside of Warburg, and it strikes me as possible that they’re sitting at table with the rescue party, and will be able to. But anybody later to the game, or less savvy than Marty Whitman in this kind of investing, will get killed by the dilution involved even in a cosmetic rescue, I’d think. And even a reinsurance deal will make them less profitable going forward, although I’m not sure what would get reinsured–reinsurance on the structured finance-mortgage related stuff would simply be buying claims, as far as I can tell, unless the entity putting up the money was the counterparty on the claims, in which case it would essentially be exactly the same as taking the assets back on balance sheet, so I don’t see the incentive for them to do that. Reinsurance on “good” municipal bonds would simply make no-loss assets on which claims almost certainly will not be paid less profitable.

I guess the long and short of it is that I can’t get my little mind around a rescue that is more than a cosmetic stop-gap, or one that doesn’t dilute current holders into oblivion.

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  1. RK

    I would be grateful to see some information on where all the RMBS and CMBS CDO’s are buried. The commercial and investment banks have already written down over 100B. They no doubt have more. But where is the “missing matter” as they say in physics. Is it in public and private pensions funds? Corporations cash balances?
    Institutional money market funds? Hedge funds?
    All of the above? It seems, at least to me, that
    until all the severely infected patients are identified, it will be hard to get a few to bail out the rest.

  2. insurance guy


    “anyone who has looked at these companies in a serious way knows the AAA ratings… are a shame”.

    I know this is now the conventionaal wisdom. That said, I have yet to see an actual discussion of defaults in the monoline portfolios that would lead to their becoming insolvent.

    I’m not saying they are healthy. I’m just saying I would like to see the actual analysis backing up these statements. I’ve read certain PPershing reports in the past thaat I have found unconvincing. Certain reports, unfortunately not for public consumption, have been discussed on this blog. I would be grateful if you could point your readers to some analysis that is publicly available. I value the views expressed on this blog very highly, but there is no substitute actually judging the analysis for one’s self.

  3. Anonymous

    >> information on where all the RMBS and CMBS CDO’s are buried

    Look A Fed Slosh information:

    This guy has posted a few things of interest:

    These “repos” have a relatively short term (typically from one to 30 days) and when they expire, you are required to give The Fed back the cash, with, of course, interest. These “TOMOs” (or “Temporary Open Market Operations”) are conducted daily in the normal course of operation of the banking system. If the actual “trading rate” of overnight money between banks is too low, The Fed will either refuse to “roll over” some of the expiring TOMOs (thereby reducing the amount of “sloshing”, or free cash, in the system) or, if necessary, will actually do a reverse TOMO, effectively “putting” some of its Treasuries (that it holds itself) out into the marketplace.

  4. David Pearson


    What is the deal with the non-monoline OTC CDS? Presumably writers of CDS written on ABS-backed CDO’s ($14tr notional?) are deep underwater. Who are these guys? The investment banks show very little net exposure, so it has to be hedge funds and CDO’s of CDS (“synthetic CDO’s”). The latter, in turn, is owned by whom?

    It seems to me that with all the focus on the monolines, the real insurance crisis — that of the OTC CDS market — is virtually ignored. Most of this insurance is on junk corporates, its true, but a bigger chunk was written on ABS-backed intstruments than MBIA and Ambac combined.

    We’ve heard nothing on CDS write downs at hedge funds. Is this because they are not the writers of the insurance?

  5. Anonymous

    The rating agencies might be trying like mad to postpone the downgrades but absent a genuine capital infusion, they’ll have to eventually or they’ll be first in line for the shareholder lawsuits when the first monoline goes under. There’s been far too much serious discussion of the unsustainability of the business model for the agencies not to lose that lawsuit.

  6. Yves Smith

    Insurance guy,

    I’ve provided links in other posts to Ackman’s 145 page Powerpoint presentation in late November, a 20 letter to regulators largely based on the analysis in the slideshow, and a 30 page January letter based on the model provided/developed by an unnamed Global Bank plus a listing of MBIA’s and Ambac’s 2005-2007 RMBS and ABS CDO. exposures. If you need the links again, let me know.

    As for the substance of the argument: the banking industry once had accounting rules that gave them considerable latitude in how they marked their loans. In the stone ages of finance, pretty much the only reason to mark down a loan was default or serious arrearage, and regulators made banks report on past due account to make sure the reserves and writedowns were reasonable. But then we started having inflation, which introduced new risks, and the banks started writing more complicated loans and getting into more complicated instruments, such as swaps and derivatives. The accounting has always been playing catch-up to the regulation.

    My impression, and it seems borne out by Ackman’s work, is that the accounting standards in insurance give companies vast latitude in how they value their risk exposures. In the case of the bond guarantors, they have entered into insuring instruments they clearly don’t understand (the rating agencies didn’t understand them, and I strongly suspect the insurers, like most market participants, relied unduly on the rating agency models). If the bond insurers didn’t and likely still don’t understand the risks (in fact, now they have an incentive not to; if they understood them, their failure to mark their values down would constitute fraud), it is a no-brainer that the regulators don’t either, hence the misleading accounting isn’t challenged.

    Why do I assert that the accounting is misleadling, and the triple A is a fraud? Nowhere do you have an entites in such risky markets (look at the ABX indices) with so little equity (less than 0.7% of exposures). Even if the ABX indicies overstate how bad things are now, every informed real estate analyst projects that things will get worse.

    So what is the insurance industry response to Ackman’s charges? Completely unconvincing. They basically say, “We’ve had very few losses to date, he’s an evil hedge fund guy with a short interest who doesn’t understand our industry.” The risks they held historically bear no resemblance to the business they’ve written in recent years, so the first argument is bogus. The second part is an ad hominem attack. There is no response to the substance, when Ackman marshals persuasive evidence. If he is so off base, it ought to be possible to say why.

    The insurers are so unwilling to engage in facts that MBIA barred all critics from its latest conference call and took only questions submitted in advance.

    Let me quote investor Scott, who is admittedly short, but has also sat in on company calls over the years:

    ….with regard to the WSJ article about MBIA, you certainly hinted at a key issue, but were perhaps a little more circumspect that I would have been.

    I looked at the timeline the article portrayed, particularly with regard to those points at which the deterioration in their credit portfolio came more and more to management’s attention, and then thought back over their statements, both public ones, and ones made to analyst/investor friends, hedge fund buddies, in one on one meetings, and their management has been more or less lying through their teeth from early on in this whole unraveling….But in terms of the relative credibility of the two parties, I don’t have any question that Ackman has acted certainly with self-interest, but also with absolute integrity, and the MBIA’s been spinning, to be charitable about it, from the get-go.

  7. insurance guy


    Thank you for pointing me to the various sources. I had missed the January 30th letter. It certainly provides some corroboration for Ackman. I wish all of the assumptions behind the “Global Bank” loss analysis were outlined, but the security by security analysis is pretty convincing.

    Thanks again.

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