Standard & Poor’s issued a research report today that stresses that bond insurer downgrades would hurt banks and in some cases could lead to reductions of their debt ratings. This report is in contrast to the comparatively cheery view of Morgan Stanley yesterday, that bond guarantor downgrades (presumably to AA; note further downgrades are possible) would lead to bank writedowns of $5 to $7 billion, hardly worth lot of fuss in an industry that has written off over $130 billion so far.
The report points to an issue apparently not considered in earlier analyses: hedges to CDO exposures provided by the bond insurers. S&P estimates that these hedges total $125 billion and while it isn’t clear who bought the protection, the rating agency says some it likely to be on the books on investment banks. And what they don’t say is the second most likely candidate is hedge funds. If hedges on CDOs turned out to be less valuable that previously assumed, investment banks may be holding insufficient collateral on margin loans to hedge funds. That too could lead to writedowns.
Interestingly, this S&P report follows an earlier slap at MBIA over its CEO Dunton’s claim that the insurer had enough capital. The rating agency shot back the next day to disabuse Danton of that notion. While today’s report does not appear to be in response to the Morgan Stanley conference call, its relatively short length (1477 words) doesn’t eliminate that a a possibility. More likely is that the release was triggered by news stories that some participants in the industry rescue talks lead by New York state insurance superintendent Eric Dinallo.
Regardless, S&P is making it abundantly clear that both the threat of downgrades and the implications are serious.
From Research Recap:
Downgrades of monoline bond insurers could lead to downgrades in the credit ratings of banks, Standard & Poor’s says in a new report, Downgrades Of Bond Insurers Can Add To Subprime Woes For Banks.
Downgrades of bond insurers (Financial Guaranty Insurance Co. was downgraded to ‘AA’; ACA Financial Guaranty Corp. to ‘CCC’; and ‘AAA’ rated MBIA Inc., Ambac Assurance Corp., and Security Capital Assurance Ltd. are on CreditWatch Negative) prompt questions about the effect on both commercial and investment banks, S&P says. “Of course, successful capital-raising efforts would eliminate the need to focus on the potential effect of downgrades on financial institutions. In the absence of additional capital, however, it is useful to think about the possible ramifications of downgrades, which could affect the $2.5 trillion of obligations guaranteed by the bond insurers.”
Bond insurers are suffering as a result of their roles as guarantors of mortgage-related securities, and downgrading them could affect all markets in which they are active, including the municipal bond, commercial mortgage-backed securities (CMBS), and other structured finance areas. In turn, dislocation in those markets could affect banks, S & P says.
Standard & Poor’s Ratings Services believes that the specific, identifiable effect on banks may be significant and, in a few cases, could lead to downgrades.
The area that represents the potential for the highest losses is the hedges that the bond insurers provide for the so-called “super-senior” CDO tranches. To date, losses that banks have reported on their CDO exposures have predominantly been on unhedged exposures. However, $125 billion of subprime-related CDOs hedged by bond insurers remains concentrated in the hands of a relatively small number of banks. Few banks have disclosed how much that exposure is.
Citigroup Inc. reported that it had bought protection on $10 billion of super-senior tranches of high-grade CDOs (not necessarily all from bond insurers), Merrill Lynch & Co. Inc. reported $19.9 billion of hedges with bond insurers, and Canadian Imperial Bank of Commerce (CIBC) $9.9 billion. The value of those hedges has increased as the values of the underlying CDOs have fallen and now can be presumed to be 40%-60% of the notional amounts. In some cases, banks have taken reserves against the increased counterparty risk represented by their own assessment of the credit deterioration in bond insurers. Citigroup added $900 million to reserves, Merrill Lynch added $3.1 billion, and CIBC announced $2 billion, with the majority of that related to ACA’s severe downgrade to ‘CCC’ from ‘A’.
More reserving may be necessary to reflect the increase in counterparty risk, if the ratings on guarantors are lowered.
Separately, Bloomberg reports that Fitch has put MBIA on review for a downgrade as a result of updating its assumptions on subprime losses. The rating agency rather bluntly said that current capital levels may be insufficient to warrant an AAA rating:
MBIA Inc.’s AAA bond insurance ranking was placed back under review for a downgrade by Fitch Ratings less than a month after being affirmed with a stable outlook.
Fitch, which also put CIFG Financial Guaranty back under review, is updating its assumptions for higher losses on U.S. subprime-mortgage securities, the New York-based ratings company said today in a statement. If loss projections rise materially, the AAA ratings on bond insurers may no longer be appropriate regardless of how much capital they hold, the company said.
Fitch will likely raise the amount of capital it requires, a move that would put “further downward pressure on the ratings” of Ambac Assurance Corp., CIFG, Financial Guaranty Insurance Co., MBIA and Security Capital Assurance Ltd., according to the statement. Ratings on $2.4 trillion of debt the industry guarantees would be thrown into doubt if the downgrades expand.
“Right now the AAA ratings for MBIA, Ambac and FGIC simply aren’t justified,” said Janet Tavakoli, president of Chicago- based Tavakoli Structured Finance, said in an interview with Bloomberg Television. “They simply don’t have the capital.”
Fitch has already cut the AAA insurer ratings of New York- based Ambac Financial Group Inc., FGIC Corp., and Security Capital, and they remain under review for further downgrades.
“A sharp increase in expected losses would be especially problematic for the ratings of financial guarantors — even more problematic than the previously discussed increases in AAA capital guidelines, which has been the primary focus of recent analysis of the industry,” Fitch said.
Bloomberg also tells us that Bermuda-based insurer XL Capital took a $1.1 billion loss due to its writedown on its 46% stake in bond insurer Security Capital, which lost its AAA rating from Fitch:
XL Capital Ltd., the Bermuda-based business insurer, said it lost $1.06 billion in the fourth quarter as it wrote down the value of investments including a stake in bond insurer Security Capital Assurance Ltd.
XL lost $6.01 a share, compared with net profit of $481.1 million, or $2.62 a year earlier, the company said today in a statement. Excluding investment losses, XL earned 66 cents a share, lagging the $1.45 average estimate of 14 analysts surveyed by Bloomberg. The results wiped out the two prior quarters of earnings and exceeded the $1.04 billion loss XL posted in the third quarter of 2005, after Hurricane Katrina.
Chairman Michael Esposito resigned from XL’s board in December to focus on his duties as chairman of Security Capital, which is 46 percent owned by XL. Security Capital declined more than 80 percent in the past year and lost its AAA bond insurer grade at Fitch Ratings after saying Jan. 23 it wouldn’t raise new capital because of market conditions. The same day XL said it could lose as much as $1.2 billion in the fourth quarter.