Who Will Insure the Bond Insurers?

It all started with the mortgage lenders accepting billions of dollars of new mortgages from borrowers with questionable credit ratings … much of this risky debt was rolled into a multitude of collateralized debt obligation (CDO) instruments thus hiding the true source of the underlying debt … the rating services assigned most of this issue as investment grade despite the fact that the debt was mostly subprime in nature … the CDOs were sold to a wide-range of investors including major banks and other financial institutions … many of the investors turned to the bond insurers for insurance in order to protect their investment … as the subprime mortgage losses grew and the truth as to their value became public, the CDOs lost value, thus triggering massive insurance payments … the insurance brokers began bleeding funds as the payouts increased … as the balance sheets of the insurance brokers turned red with mounting losses, the rating services downgraded the insurance brokers themselves … once the insurance brokers lost their top ratings, they could no longer underwrite debt to the same level of security they could previously so attracting new business to offset their current losses was practically impossible … as a result, it now appears that several of the large bond insurers could fail … if the bond insurers fail, then the insurance policies on all those worthless CDOs the banks hold, will also be worthless.

Got all that? Well, just in case you got a little lost trying to follow all the twists in this saga, let’s cut to the chase:

• Point 1 – the subprime mortgage conundrum has already cost the global economy billions in the markets and the U.S. economy is teetering on the brink of a recession.

• Point 2 – many of the major banks have already written off billions in direct subprime losses with more losses to come.

• Point 3 – if the bond insurers fall into bankruptcy and cannot meet the insurance payouts, then many financial institutions will be forced to take additional write-offs on the CDOs they thought were protected through third party insurance.

In short, if you think that prospects for the economy in the near term are already rather grim as the global credit crunch grows and consumer confidence around the world continues to plummet, then you probably won’t feel better as the latest financial industry “gotcha” prepares to take center stage.

Monoline Insurers Face Greatest Risk

It is estimated that the two largest monoline bond insurers – Ambac and MBIA – together have over $60 billion tied to subprime assets that they will be required to cover.^[1] These pending payouts have forced the ratings agencies to closely monitor the situation with both Moody’s and Standard and Poor’s putting Ambac and MBIA on a ratings review watch. Fitch Ratings actually took the matter one step further last week and followed through with a cut to Ambac’s rating, dropping it from AAA to AA.

Bond insurer ACA Capital Holdings Inc. suffered a rating drop earlier, and this forced banks in both Canada and the U.S. to write-off losses.^[2] Canadian Imperial Bank of Commerce (CIBC) wrote down $2.75 billion on losses that can be attributed to ACA’s downgrade, and Merrill Lynch announced a write-off of $2.6 billion.

For a monoline insurer – as well as for clients holding securities guaranteed by the monoline – a rating downgrade is catastrophic. When a bond insurer guarantees a bond, it is essentially supplying its rating to the debt it underwrites, so a reduction in the insurer’s rating is automatically applied to the bond itself. This means that those investors that are restricted to dealing in only the highest investment grade securities – like many pension funds for instance – will be forced to eliminate any bonds insured by the down-graded insurer from their portfolios. This also reduces the investor pool willing to accept bonds underwritten by the insurer, thereby compounding the monoline’s problems.

To put some context around the size of the problem, Meredith Whitney of CIBC World Markets – ranked by Forbes as the number 2 stock selector for her sector – covers the main players in the financial services industry including Goldman Sacs, Morgan Stanley, Bear Stearns, and Lehman Brothers. She recently stated that “in aggregate, we believe the collateral damage to financial institutions caused by potential rating-agency downgrades of the monolines is at least $40 billion and could be as high as $70 billion”. ^[3]

There has been speculation in the past few weeks that some kind of bailout package is being worked on to help the bond insurers most affected. One thing that is clear is that it is unlikely that the monolines will be able to raise sufficient equity on their own to cover these losses. Ambac announced that it intended to raise $1 billion through the selling of shares but this was quickly cancelled as Ambac’s shares dropped from a high of $96.10 in May 2007 declining steadily to a low of just $4.50 by mid-January of 2008. ^[4]

So who’s to blame for all this? In actuality, there is enough blame to be shared by everyone involved. The initial mortgages were made available to individuals that simply did not qualify – hence the term “subprime”. The rating agencies certainly deserve to be called up on the carpet – at worst, their ratings were misleading, at the very least, they were reckless as they did not reflect the true value of the underlying securities.

And clearly, the bond insurers themselves contributed to their current misery. When monolines first hit the scene over thirty years ago, their core business was insuring the relatively “safe” ventures – mostly bonds issued by municipal governments seeking to raise funds for infrastructure investments. Not overly exciting perhaps, but definitely solid with vey low risk. In the end, maybe the tremendous profits available for plucking as the subprime-fuelled housing bubble was starting to expand proved too tempting.

Nevertheless, the fact remains that it is the cumulative effect at each hand-off along the path that enabled this debacle. Look back at the opening paragraph of this article and ask yourself how so many participants could have been oblivious to all the warning bells that were sounding in the background. It was this convergence of poor judgment that gave rise to this crisis – poor judgment in issuing many of the initial subprime mortgages, ineffective risk assessment of the securities derived from these mortgages, and a shift away from insuring safer municipal bonds in order to increase revenues that provided the environment for this predicament.

The real elephant sitting in the corner that nobody is willing to acknowledge right now is just how much more bad debt is due to surface. Until this becomes clearer, the bond insurers have very little chance of a private equity arrangement solving their liquidity problems – quite simply, there is no white knight waiting in the wings to save the day. Some quiet proposals floating in the background hint at a major bank cooperative to provide the funds to prop up the bond insurers but this is far from a certainty.

David Havens, an analyst with UBS in Connecticut, throws cold water on this idea suggesting that such an arrangement would be akin to “herding cats”.

“If you’re a bank in good shape, with limited exposure to monolines, why do you want to be forced to make a contribution that will prop up a competitor that’s overdosed on monoline protection?” Havens asks.^[5]

This is a very good question. And more and more, it looks like any real bailout will only come from the government. The monolines, cannot raise the money themselves, there is no one willing to buy them and assume the liabilities, and the only group with enough money to save them, are the ones they owe the money to in the first place.

References

1. ↑ Time Online, January 25, 2008
2. ↑ Bloomberg News – January 17, 2008
3. ↑ Marketwatch.com – January 31, 2008
4. ↑ Symbol ABK – New York Stock Exchange
5. ↑ Time Online – January 25, 2008