MBIA/Ambac, Why They Matter – Bianco Research

The Economist – Buttonwood: Recovery? What recovery?
The credit crunch looks far from over
Of enduring concern are the monoline insurers, the institutions that agreed to guarantee some classes of debt against default. On June 4th Moody’s, a rating agency, said it was thinking again about downgrading the AAA ratings of MBIA and Ambac, two of the main monolines. The pessimists (who are betting on a further fall in the price of the shares) reckon their losses on subprime-related debt will turn out to be many times bigger than the monolines’ present capital. If the theme of last year was turmoil in financial services, then 2008 could be the year when financial stress goes on to harm the economy. And it is not too fanciful to imagine a vicious circle: as the economic downturn causes more financial pain, so confidence will crumble further. It seems far too early to say the financial world has seen “the beginning of the end” of the credit crunch. Indeed, the rest of Winston Churchill’s quote about the progress of the war may even be too optimistic. The world may not even have seen “the end of the beginning”.
The Wall Street Journal – MBIA, Ambac Lose Top Bond Ratings
It finally happened. One of the major credit-rating firms stripped bond insurers MBIA Inc. and Ambac Financial Group Inc. of their vital triple-A ratings. Thursday, Standard & Poor’s dropped the bond insurers’ ratings to double-A and warned of further downgrades, just one day after Moody’s Investors Service warned that it would likely knock down the ratings of the two companies. But despite the turbulence that buffeted the markets in the fall at just the idea of such a downgrade, the actual deed resulted in a muted reaction in the markets.
The Financial Times – Lex: Bond insurers
Wednesday’s announcement by Moody’s that it would downgrade Ambac and MBIA was a surprise only in its timing – months after markets first doubted whether these were going concerns. How can a company earn a triple A rating if it struggles to sell its product, is facing mounting losses and cannot raise any capital? There is no compelling reason for either insurer to remain in existence. New issuance in structured finance – responsible for about a third of Ambac’s insured portfolio – has almost ground to a halt. Municipalities, meanwhile, have been turning to more stable outfits such as FSA, Assured Guaranty and Berkshire Hathaway. At this stage, a co-ordinated bailout by the banks – which struggle to co-ordinate on anything – looks a distant prospect. Cherry-picking of the insurers’ assets seems the most likely outcome.
The Financial Times – Moody’s downgrade priced in
This week’s move by Moody’s, followed on Thursday by Standard & Poor’s cutting the bond insurers’ triple A ratings to double A, was largely ignored by the wider markets. This is partly because concerns have moved to other areas. Investors are focusing more on the US economy, the extent of further housing losses and whether banks are adequately capitalised. However, the lukewarm response is also because a downgrade had largely been priced in and, in many cases, prepared for. Indeed, in the credit derivatives market, Ambac and MBIA have long been trading as distressed credits. Fitch pulled its triple A rating for both insurers earlier this year.
The Financial Times – The Short View: Credit crisis returns
On Thursday, the market’s worst fears were realised. MBIA and Ambac Financial, the two biggest monoline bond insurers, lost their triple A credit rating from Standard & Poor’s. Had this happened at any point in the first three months of this year, when the entire stock market appeared to be ebbing and flowing on the fortunes of the monolines, it would have started a rout. But thankfully, the markets’ fears have moved on. The monolines were no longer the apex of worry. They have an important role in the financial system, as the guarantors of a range of asset-backed securities, but banks and financial groups have used the last few months to reduce exposure to those securities…But the recovery in credit since then, on both sides of the Atlantic, has petered out and gone into reverse in recent weeks. Financial stock indices, meanwhile, have hit fresh lows for the crisis. They are even lower than in March. So the market seems now to believe that credit problems will not go away, but will damage financial companies’ profits (and their shareholders), rather than cause the collapse of a major bank. So credit declines slightly, bank stocks fall sharply – and the monolines get downgraded without sparking a rout.

Comment It still seems a lot of the financial media has either forgotten why the monolines were important (they learned it last January/February when it was the big issue in the financials markets) or never really understood it in the first place.

A good sign that someone does not understand why the monolines are important is they ask someone in a municipal bond department for an opinion. While the monolines do guarantee a good deal of munis, it is their activity in structured securities that are at issue, not munis. If they only rated munis and lost their Aaa rating, it would not be that big a deal. (If they only rated munis, their Aaa rating would have never been in doubt.)

So let us re-write our comments from yesterday to try to explain their importance.

The monolines have written guarantees (or wraps) on hundreds of billions of structured securities. As long as these guarantees are from Aaa-rated insurance companies, financial firms holding these claims do not have to realize any losses on these securities. When/if the ratings agencies start to get downgraded, then payment of these policies is not assumed to be 100% as it would be with a Aaa guarantee. This means that some of those losses would have to be realized.

According to Barlcays, the monolines are believed to have guaranteed $600 billion of structured securities with the banking system ($820 billion in total). In other words, the banks have hedged $600 billion with the monolines. Once monolines are downgraded, these hedges are worth less than face value. Barclays estimates that if the entire industry was downgraded, banks would have to write down as much as $143 billion in hedges. UBS estimates it will cost the banking system $203 billion in additional writedowns. Oppenheimer estimates that $40 to $70 billion of this would be concentrated in just three firms: Merrill, Citi and UBS.

So, don’t look at MBIA (MBI) and Ambac (ABK) for the reaction to the downgrade alone. Look at the Bank Stock Index (BKX). Banks stocks are back to their mid-March panic low. This is in part because the downgrades mean even more Q2 losses for the banking sector. Now maybe these losses have been discounted, but for all the talk that the credit crisis is over, the bank stocks are in worse shape now than the day Bear failed. What changed? Maybe (again, in part) anticipation of the monoline downgrades.

Once the insurer is no longer Aaa, it is really hard for management/auditors to argue their structured securities are still worth 100. How much less than 100 should they be worth? It depends on management and auditor judgment and how far below Aaa they get downgraded. Barclays suggested Aa wraps are worth 75 cents on the dollar. Merrill in their Q4 statement wrote down their ACA wraps to zero when they were downgraded below A.

So, all the Aaa-rated wraps carried 100 cents have to get marked down. This is the conversation happening right now. Management/auditors have until July to make their decision (to be reflected on Q2 statements).

Final note regarding ratings: An insurer’s rating is based on “2 of 3” of the rating agencies. In the case of Ambac, they were downgraded by Fitch in January to Aa and by S&P today. Even though Moody’s still has them at Aaa (for the moment?), they are no longer a Aaa insurer. MBIA, on the other hand, still has their Aaa rating from Fitch (because they stopped paying for it before Fitch could downgrade them) and Moody’s. So even though they were downgraded by S&P today to Aa, nominally they are still a Aaa insurer.