CREDIT BUBBLE BULLETIN
Structured finance under duress
By Doug Noland

COMMENTARY

The market may be been perfectly content to brush it aside. It was, however, a brutal week for "contemporary finance." Merrill Lynch, a kingpin of structured Credit products, shocked the marketplace with a $7.9bn asset write-down – up significantly from the $4.5bn amount discussed just two weeks ago. Much of the write-off related to the company’s CDO (collateralized debt obligations) portfolio, the size of which was reduced in half to $15.2bn during the quarter. But with proxy indices of subprime and CDO exposures down between 15% and 30% since the end of the quarter, Street analysts have already warned of the possibility for an additional $4bn hit. Merrill is not alone.

Also hit by sinking CDO fundamentals, Credit insurer Ambac Financial reported a third-quarter loss of $361 million - it’s first-ever quarter of negative earnings. The company posted a $743 million markdown on its derivative exposures, "primarily the result of unfavorable market pricing of collateralized debt obligations." Credit insurance compatriot MBIA also reported its first loss ($36.6 million), on the back of a $352 million "mark-to-market" write-down of its "structured Credit derivatives portfolio." These two Credit insurance behemoths – and the "financial guarantor" industry generally – would have been a whole lot better off these days had they stuck to insuring municipal bonds and fought off the allure of easy ("writing flood insurance during a drought") profits guaranteeing Wall Street’s endless array of new structured Credit products.

October 26 – Financial Times (Stacy-Marie Ishmael): "The perceived creditworthiness of two of the largest financial guarantors in the US on Thursday plunged to lows not seen since the worst of the credit squeeze in August. MBIA and Ambac are specialist companies that guarantee the repayment of bond principal and interest in the event of an issuer default - including bonds backed by subprime assets. After both companies this week reported third-quarter losses, investors have begun to speculate that the monolines, as they are known, might themselves in default on their outstanding debt. Spreads on five-year credit default swaps written on Ambac’s debt widened by 50 bps to 300bp, according to Credit Derivatives Research… In other words, the annual cost of insuring a $10m portfolio of Ambac’s debt over five years has risen by $50,000 to $300,000. The previous record of $238,000 was set on August 16…"

It is worth noting that MBIA and Ambac combine for about $1.9 Trillion of "net debt service outstanding" – the amount of debt securities and Credit instruments they have guaranteed, at least in part, to make scheduled payments in the event of default. Throw in the Trillions of Credit insurance written by the mortgage guarantors and you’re talking real "money." Importantly, the marketplace is beginning to question the long-term viability of the Credit insurance industry, placing many Trillions of dollars of debt securities in potential market limbo. [These stocks have dropped sharply beginning mid - October!] [ AMBAC Financial Group Inc (ABK) opened at $70 on Oct 12 and closed at $36.8 on Oct 31 !!!] [MBIA Inc (MBI) closed at $67.1 on Oct 12 and closed at $43 on Oct 31!!!]

With recent developments - including the monstrous write-down from Merrill Lynch, the implosion in the mortgage insurers, and the losses reported by the "financial guarantors" - in mind, I’ll revisit an excerpt from a January article by the Financial Times’ Gillian Tett: "…Total issuance of CDOs…reached $503bn worldwide last year, 64% up from the year before. Impressive stuff for an asset class that barely existed a decade ago. But that understates the growth. For JPMorgan’s figures do not include all the private CDO deals that bankers are apparently engaged in too. Meanwhile, if you chuck index derivative portfolio numbers into the mix, the zeros get bigger: extrapolating from trends in the first nine months of last year, total CDO issuance was probably around $2,800bn last year, a threefold increase over 2005. These startling numbers will certainly not shake the world outside investment banking. For, as I noted in last week’s column, the CDO explosion is occurring in a relatively opaque part of the financial system, beyond the sight - let alone control - of ordinary household investors, or politicians."

Subprime and the SIVs are peanuts these days in comparison to the gigantic global CDO and Credit derivatives markets. CDOs may lack transparency, trade infrequently, and operate outside of market pricing ("mark-to-model"). Nonetheless, CDO exposure now permeates the entire global financial system – exposure that regrettably mushroomed in the midst of the most reckless end-of-cycle mortgage excesses imaginable. Rumors this week had major insurance companies suffering huge CDO losses. To what extent the big insurance "conglomerates" have exposure to CDOs and other Credit derivatives is unclear today, but there is no doubt that the global leveraged speculating community is knee deep in the stuff. Importantly, as goes the U.S. mortgage market, so goes the CDOs. I’m not optimistic.

I don’t want to place undue weight on one month’s data, but the California statewide median home price sank $58,140 over the month of September (down 4.7% y-o-y to $530,830). This was by far the largest monthly decline on record and the first year-over-year fall "in more than 10 years." September California sales were down 39% from a year earlier. Weakness was statewide, led by a 63% y-o-y collapse in the "High Desert." But even San Francisco "Bay Area" sales dropped 46% y-o-y. Ominously, the California Association of Realtors "Unsold Inventory Index" surged to 16.6 months, almost double the level from just six months earlier and compared to 6.4 months in September ’06. "The impact of the credit crunch spread throughout all tiers of the market in September," said California Association of Realtors Chief Economist Leslie Appleton-Young. As far as I’m concerned, there is sufficient evidence at this point suggesting the Great California Housing Bust has begun in earnest.

We’ve definitely reached a critical point worthy of the question: Can "structured finance," as we know it, survive the California and U.S. mortgage/housing busts? I don’t believe so. For one, the historic nature of the Credit Bubble virtually ensures the collapse of the Credit insurance "industry" (companies, markets, and derivative counter-parties). The mortgage insurers are now in the fight for their lives, while the "financial guarantors" today face an implosion of their "structured Credit" insurance business. Worse yet, major problems in municipal finance (certainly including California state and municipalities) are festering and will emerge when the economy sinks into recession. It is worth noting that California revenues were $777 million short of expectations during the first fiscal quarter (see "CA Watch" above).

Returning to the vulnerable CDO market, some key dynamics are in play. With California now at the brink, uncertain but huge losses are in the pipeline for jumbo, "alt-A," and "option-ARM" mortgages – loans that were for the most part thought sound only weeks ago. The market began to revalue the top-rated CDO tranches this week, a process that should only accelerate. "AAA" is not going to mean much. If things unfold as I expect, a full-fledged run from California mortgage exposure could be in the offing. And as the dimensions of this debacle come into clearer market view, the viability of the Credit insurers will be cast further in doubt – with ramifications for Trillions of securities and derivatives. General Credit Availability would suffer mightily.

With global equities markets in melt-up mode, it might seem absurd to warn that a troubling global financial crisis is poised to worsen. But Structured Finance is Under Duress. The entire daisy-chain of liquidity agreements, securitization structures, Credit insurance and guarantees, derivatives counterparty exposures and, even, the GSEs is increasingly suspect. Trust has been broken and market confidence is not far behind.

The big global equities and commodities surge over the past few months certainly has been instrumental in counteracting what would have surely been a problematic "run" from the leveraged speculating community. How long this spectacle can divert attention from the unfolding mortgage/CDO/"structured finance" debacle is an open question. I can’t think of a period when it has been more critical for stocks to rise - and rise they have. Yet I suspect recent developments will now encourage the more sophisticated players to begin reining in exposure.

The nightmare scenario - where the market abruptly comes to recognize that the leveraged speculating is hopelessly stuck in illiquid CDO, ABS, MBS, derivative and equities positions - doesn’t seem all that outrageous or distant. Unfortunately, today’s Ponzi-style acute fragility (as was demonstrated this summer in subprime, asset-backed CP, SIVs and the like) and speculative dynamics dictate that he who panics first panics best. I don’t expect the sophisticated players to hang around and wait for securities to be properly priced and the full extent of illiquidity and the unfolding Credit debacle to be recognized. And while Bubbling markets do delay the inevitable reversal of speculative flows from the leveraged speculating community, they only compound the risk of an inevitable ravaging run from illiquidity. We’ll see to what extent the Fed is willing to spur increasingly destabilizing global stock market speculation and dollar liquidation in false hope that lower rates can somehow mitigate Structured Finance Under Duress.

WEEKLY WRAP

For the week, the Dow gained 2.1% (up 10.8% y-t-d), and the S&P500 rose 2.3% (up 8.2%). The Utilities surged 4.8% (up 12.5%), and the Morgan Stanley Consumer index gained 2.0% (up 6.8%). The Morgan Stanley Cyclical index advanced 1.5% (up 18%) and the Transports 1.4% (up 6.7%). The broader market rallied sharply. ..................................

Credit Market Dislocation Watch
October 24 – Financial Times: ...... rising share prices, on the assumption that the worst was now out in the open. Merrill Lynch appeared to take a ‘kitchen sink’ approach............ it is clear that a large bathtub would have been more appropriate. .........How could Merrill .............

October 26 – Financial Times (Ben White and Michael Mackenzie): "Subprime mortgage anxiety continued to spread on Thursday.................Trading in the riskiest slice of the ABX index of bonds backed by home loans made in the second half of last year hit a new low of 18 cents. The risky slice of the index is down about 30% since the end of September .............The ABX decline..........[Merrill Lynch..........additional $4.5bn of writedowns ...........the TABX index, which we have been using as a proxy for CDO assets, has also deteriorated 18-35% across all of the tranches with the most significant deterioration coming at the most senior levels.’"

October 25 – ........... more cautious about the prospects of bond insurers and financial institution American International Group Inc. Troubling data on subprime mortgage delinquencies and defaults released Thursday pushed the riskiest, BBB- portion of the closely watched ABX index based on mortgages made in the second half of 2006 to record lows…Even the less risky tranches of the index are much weaker, with the A and AA tranches hit the most. The single A slice of the index based on loans from the second half of 2006 is quoted at 28.5 cents, down from a close of 32.42 cents… ‘After seeing the remit reports, people are saying it’s time to go back into bomb shelters because the war continues unabated,’ said ......ABS portfolio manager .......

October 26 – Associated Press: "Moody’s…expects to complete a report by the middle of next week assessing how much damage decaying mortgage quality will wreak upon a type of investment known as a collateralized debt obligation, a person familiar with the review said… In the meantime, reports cutting credit ratings on CDOs will trickle out as they are completed, according to the person, who spoke on condition of anonymity… When Merrill Lynch wrote down the value of its portfolio by $7.9 billion this week, much of that was from investments in CDOs that lost value during the credit crisis this summer. At least 40 reports downgrading or considering downgrading billions of dollars in CDOs were issued Friday, though the agency declined to estimate the value of downgraded CDOs."

October 26 – Bloomberg (Jody Shenn and Shannon D. Harrington): "Moody’s…cut the ratings of collateralized debt obligations tied to $33 billion of subprime mortgage securities that were downgraded this month, a decision that may force owners to mark down the value of their holdings. Securities with ratings as high as AAA from at least 45 CDOs were either cut or put on review for a downgrade…"

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October 26 – Financial Times (Saskia Scholtes and Francesco Guerrera): "US companies are becoming increasingly risk-averse with their investments, holding on to record levels of cash as a buffer against turmoil in financial markets, according to a survey of chief financial officers and corporate treasurers. Corporate America’s increased caution with its investments will make it more difficult for banks and hedge funds to restore normality to troubled markets such as the one for asset-backed commercial paper."

October 24 – Financial Times (Ben White): "Poor quarterly results from banks across the US over the past two weeks ..........consumers will be increasingly unable to make payments on a variety of loans. Banks are adding to reserves not just for defaults on mortgages, but also on home equity loans, car loans and credit cards. ........................

Bubble Economy Watch
October 22 – Bloomberg (Thomas R. Keene): "Corporate-tax receipts in the U.S. have slowed along with profit growth, and that means the federal budget deficit is likely to widen next year, according to FTN Financial economists. Job growth may suffer as well, they say. 'Just when it seemed the federal deficit was melting away to nothing, growth in federal receipts has collapsed,' writes Christopher Low… Lower corporate tax receipts imply less job creation, he says."

.....

Central Banker Watch
October 25 – Bloomberg (Patrick Harrington): "Mexico's central bank unexpectedly raised its benchmark interest rate by a quarter percentage point after a report showed core inflation quickened more than expected. The five-member board lifted the benchmark rate to 7.50 percent…"

California Watch
October 24 - California Association of Realtors (CAR): "Home sales decreased 38.9% in September in California compared with the same period a year ago, while the median price of an existing home fell 4.7%... this decline -- which was both the largest month-to-month percentage decline on record and the first year-to-year decline in more than 10 years -- was mainly the result of the credit or liquidity crunch..." said ............

Structured Finance Earnings Watch
October 25 – Bloomberg (Christine Richard): "MBIA Inc., the world's biggest bond insurer, plunged the most in 20 years after the company reported its first loss, ended a share buyback and failed to quell speculation it will write down more of its mortgage portfolio. The company today reported a $36.6 million loss after reducing the value of the securities it guarantees by $342 million… MBIA…and Ambac Financial Group Inc…both reported their first losses… The insurers write derivative contracts promising to pay holders in the event of a default. The value of the securities plummeted after subprime delinquencies soared. 'People began to question the viability of the business model and the tremendous credit exposure that MBIA has taken on to a wide range of structured credit risks,' said David Einhorn, president of Greenlight Capital…"

October 24 – Bloomberg (Christine Richard): "Ambac Financial Group Inc., the World's second-largest bond insurer, reported its first quarterly loss after reducing the value of subprime mortgage-linked securities by $743 million. The shares fell the most in 2 1/2 years after…it had a third-quarter net loss of $360.6 million... Ambac, MBIA Inc. and other bond insurers have guaranteed billions of dollars of AAA rated collateralized debt obligations that are backed by low investment-grade rated portions of mortgage-backed debt… 'They have to show that they can survive a rough patch,' said Scott MacDonald, head of research at Aladdin Capital Management… 'They have to demonstrate that their business model is sustainable.'"

October 25 – Bloomberg (Christine Richard): "Security Capital Assurance Ltd., the Hamilton, Bermuda-based financial insurer and reinsurer, reported a third-quarter loss because of a $131.7 million markdown on credit derivatives."

GSE Watch
Fannie Mae and Freddie Mac's combined "Book of Business" (mortgages retained and MBS guaranteed) expanded a notable $67.1bn during September, a 17% annualized rate, to $4.784 TN. Through nine months, their "Books of Business" have expanded $430bn, or 13.2% annualized. By category, their combined Retained Portfolio has expanded $8.6bn to $1.437 TN, while their guaranteed MBS exposure has increased $421bn to $3.347 TN.

MBS/ABS/CDO/CP/Money Funds and Derivatives Watch
October 24 – Bloomberg (Jody Shenn): "European and Asian investors will avoid most U.S. mortgage-backed securities for years without guarantees from government-linked entities, creating 'an enormous drag on the U.S. housing market,' according to UBS AG. During the current 'shutdown' of the subprime and Alt-A mortgage-securities markets, it's been 'virtually impossible' to find buyers for anything but the safest classes of such bonds…UBS analysts led by Laurie Goodman wrote… Surging losses on the loans will worsen as the credit crunch makes it harder for borrowers with adjustable-rate mortgages to lower their payments by refinancing, they wrote. Foreclosures started on U.S. loans rose at the highest rate on record in the second quarter, the Mortgage Bankers Association says. 'The `virtuous' cycle of the past few years has evolved into a 'vicious' cycle,' the UBS analysts wrote."

October 22 – Bloomberg (Andrew Blackman): "Californian homes are overvalued by as much as 40% and stricter lending standards will probably contribute to 'material' price declines, according to analysts at Goldman Sachs. Prices in the state 'have proven surprisingly resilient, given the severe curtailment of credit availability and rising unemployment,' the analysts said… 'However, ......

Mortgage Finance Bust Watch
October 24 – The Wall Street Journal (Ruth Simon and James R. Hagerty): "Subprime mortgages aren't the only challenge facing Countrywide Financial Corp., the nation's biggest home-mortgage lender. Some loans classified as prime when they were originated are now going bad at a rapid pace. These loans are known as option adjustable-rate mortgages, or option ARMs. They typically have low introductory rates and allow minimal payments in the early years of the mortgage. Multiple payment choices include a minimum payment that covers none of the principal and only part of the interest normally due. If borrowers choose that minimum payment, their loan balances grow – a phenomenon known as 'negative amortization…' Among option ARMs held in its own portfolio, 5.7% were at least 30 days past due as of June 30, the measure Countrywide uses. That's up from 1.6% a year earlier. Countrywide held $27.8 billion of option ARMs as of June 30, accounting for about 41% of the loans held as investments by its savings bank. An additional $122 billion have been packaged into securities sold to investors, according to UBS… It now appears that many borrowers who moved into option ARMs were attracted by the low payments and may have been staving off other financial problems. More than 80% of borrowers who are current on these loans make only the minimum payment, according to UBS… Of the option ARMs it issued last year, 91% were "low-doc" mortgages in which the borrower didn't fully document income or assets, according to UBS, compared with an industry average of 88% that year. In 2004, 78% of Countrywide's option ARMs carried less than full documentation. Countrywide also allowed borrowers to put down as little as 5% of a home's price and offered 'piggyback mortgages,' which allow borrowers to finance more than 80% of a home's value without paying for private mortgage insurance. By 2006, nearly 29% of the option ARMs originated by Countrywide and packaged into mortgage securities had a combined loan-to-value of 90% or more, up from just 15% in 2004, according to UBS."

October 24 – Bloomberg (Laura Cochrane): "Collateralized debt obligations with investments related to U.S. home loans taken out in 2006 and this year will probably have their ratings cut by credit assessors, according to Barclays Capital. Some securities with the highest investment-grade rating of AAA may be lowered by two levels because of the 'tsunami' of ratings cuts to U.S. residential mortgage-backed securities that underlie the debt, Barclays's analysts said…"

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Real Estate Bubbles Watch
October 25 – Bloomberg (Kathleen M. Howley): "A record 17.9 million U.S. homes stood empty in the third quarter as lenders took possession of a growing number of properties in foreclosure. The figure is a 7.8% gain from a year ago…the U.S. Census Bureau said… About 2.07 million empty homes were for sale, compared with 1.94 million a year earlier, the report said."

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Doug Noland is a market strategist for the Prudent Bear Funds.

(Republished with permission from PrudentBear.com. Copyright 2005-2007 David W Tice & Associates. All rights reserved.)

Top News November 1, 2007, 12:30AM EST text size: TT

The Next Worry: Bond Insurers

Wall Street is fretting that the subprime carnage could spread to bond insurance firms. A key concern is CDO exposure

by Matthew Goldstein

An exotic form of bond insurance could be the next hidden hazard to blow up in the global credit minefield. An obscure company called ACA Capital might spark the explosion.

The carnage on Wall Street has already been brutal. On Oct. 30, Merrill Lynch (MER) ousted CEO Stanley O'Neal after the bank took an $8.4 billion hit, largely from securities backed by risky home loans. The same day, UBS (UBS) cut earnings by $3.6 billion. Citigroup (C), which has suffered its own $1.6 billion wound, may face a fresh billion-dollar disaster.

Now the crisis is spreading from Wall Street—which has taken $35 billion in subprime-related write-downs and lost more than $220 billion in stock value—to a less well known corner of the financial world, that of the bond insurers. These firms sell insurance to banks and other major investors for bonds backed by mortgages and the complicated investments that hold the bonds, known as collateralized debt obligations (CDOs). The policies are designed to protect investors in case the securities default. As CDOs grew into a trillion-dollar business, bond policies (called credit default swaps) became a lucrative source of revenue for companies such as American International Group (AIG), MBIA (MBI), and Ambac Financial Group (ABK).

Stock Tailspin

But a flurry of downgrades on mortgage-backed securities and CDOs has started to affect insurers' earnings. Anxiety has focused on ACA Capital (ACA), a small player with big exposure to CDOs.

A New York company with less than $500 million in annual revenue, ACA has just $326 million in BASE capital. The company claims it has $1 billion in capital it could use for potential payouts if the CDOs it insures go bad. Yet it has sold coverage worth nearly $16 billion, with most policies written for CDOs created in the past couple of years. Those are especially problematic vintages because lending standards grew so lax in 2006 and 2007.

Troubled ACA shareholders have pushed the stock price down 80% since the start of the year, to $3.46. "The worry is that they are going to get hit with all these losses and will have difficulty making good [given the low level of reserves]," says Sean Egan of Egan-Jones Rating.

In an e-mail, ACA says its "financial strength and capital adequacy are at the strongest level in history. That was recognized the other day when Standard & Poor's confirmed ACA's single-A rating and Stable Outlook, acknowledging that ACA has sufficient capital to withstand losses and higher capital charges on our subprime related exposures."

MBIA's Troubles

But many believe the subprime debacle has yet to run its course. "There was a perception that the worst was over," says Timothy M. Ghriskey, a co-founder of the $250 million Solaris Asset Management in Bedford Hills, N.Y. "But there's no question this is going to go on for a while."

MBIA, the world's largest bond insurer [This stock, MBI, had dropped dramatically beginning mid - October!] , with nearly $3 billion in revenues, is at the center of the growing mess. In late October the Armonk (N.Y.) firm announced a $36.6 million loss for the third quarter. MBIA blamed markdowns on CDOs and similar securities, which forced it to cut the value of policies it wrote on those products. MBIA pointed out that the value of those assets could bounce back.

Meanwhile, MBIA and its rivals may have to set aside more capital to cover potential losses from CDOs or risk a possible downgrade on their own corporate debt. On Oct. 29, S&P, which, like BusinessWeek, is a unit of The McGraw-Hill Companies (MHP), announced that it is "reviewing new data in order to test the bond insurers' ability to withstand further subprime stress," although so far S&P sees no need for more capital.

Others are more skeptical. Kathleen Shanley, an analyst at bond research service Gimme Credit, says it's likely that MBIA will need to raise capital to keep its AAA rating, given the insurer's position "on the front lines of the credit crunch." MBIA's stock has fallen 23% since early September, which could make it more costly to raise money.

In an e-mail, MBIA says it "has a very healthy capital position and does not foresee the need to raise capital. The company also believes that if the need arises, it will be able to raise capital."

Low Yields, Tricky Valuations

It's difficult to assess the extent of the danger. Bond insurers argue that the worst-case scenario—mass CDO defaults, forcing tens of billions in insurance payouts—is highly remote, given the limited downgrades to date. Insurers also note that many of their policies provide coverage for the highest-rated slices of CDOs, which are the least likely to default.

But those are exactly the CDO segments that have spooked Wall Street. Many banks haven't been able to sell the securities, which are low-yielding and difficult to value. This situation prompted the write-downs by Merrill and others when the value of the investments collapsed.

Insurance issues may have contributed to Merrill's enormous loss. AIG was once one of the biggest CDO insurers, selling some $79 billion in coverage to Merrill, UBS, and other banks. But AIG left the business in 2005, around the time subprime lending standards began to deteriorate. When that happened, says a person familiar with Merrill's insurance, the firm had difficulty finding coverage for the new CDOs on its balance sheet. With little insurance, Merrill felt most of the pain when it marked down the securities. Merrill declined to comment.

ACA: Why It's Vulnerable

AIG's pullback provided ACA with an opportunity to expand its insurance business. The prospect of the tiny insurer now failing to live up to its promises could affect a wide range of banks—and get scary. Banks that bought its policies would have to take the risk from CDO assets back ontheir balance sheets, promptingfurther writedowns.

ACA won't reveal its clients, but one is Bear Stearns (BSCC), one of the biggest underwriters of CDOs and home of the two subprime-related hedge funds that imploded this summer. Bear and ACA have close ties. In 2004 the investment bank's private equity arm invested $105 million in ACA, and Bear remains the company's largest shareholder, with some 27% of its stock. ACA Chairman David E. King is a senior managing director at Bear and an executive vice-president of Bear's private equity group.

A recent regulatory filing by Bear reveals that in March and again in May ACA "entered into an insured credit swap" with a Bear affiliate. The precise nature of the deals couldn't be determined, although a person familiar with Bear says its coverage with ACA is "minimal." Depending on various banks' level of reliance on ACA, the insurer's policyholders might now have at least some reason to worry. [ ACA Capital Holdings Inc (ACA) was at $6 on Oct 12 and at $3.4 on Oct 31 !!!]

Goldstein is an associate editor at BusinessWeek, covering hedge funds and finance.
With David Henry.

Fears are growing that the rating agencies could soon be forced to downgrade one of the so-called “monolines”, companies that insure corporate bonds and structured products. MBIA, the largest of these, has just reported its first-ever quarterly loss after cutting the value of its own mortgage holdings and setting aside money to pay clients who had wisely taken out cover on CDOs.

If one of the monolines were to lose its cherished AAA rating—a prospect that no longer looks far-fetched—huge numbers of securities would be adversely affected, since they cannot have a higher rating than the company insuring them. Moreover, monolines will have to raise more capital if a sizeable chunk of their holdings falls below investment grade, as looks painfully possible.

The FT also reports that investor worries are mounting that the next big casualties from the credit squeeze might be the specialist companies that act as guarantors for bond issuers.

These companies, which write insurance to boost the credit ratings of various kinds of bonds, have seen their share prices pummelled and the cost of protecting their debt against default soar. Over the past week, sector leaders such as MBIA, Ambac, XL Capital Assurance, Radian and MGIC have all been hit hard.

In recent years, these companies, known as monolines, have moved away from their role of guaranteeing, or wrapping, bonds issued by US municipalities towards writing business related to structured asset-backed finance deals, such as mortgage-backed bonds and collateralised debt obligations.

Following the turmoil in structured credit markets, this business has turned sour,

Bond Insurers == Monolines – Monoline insured securities range from general obligation bonds, municipal and structured finance bonds to collateralized debt obligations (CDOs) domestically and abroad. About half of municipal bonds – of which some $400bn are issued each year – are insured by monolines. (Only 13 companies belong to MICA. They are the closely regulated “monoline” mortgage insurance firms that only guarantee mortgage loans, with state laws forbidding them to enter any other insurance business. ) The monolines are regulated by state insurance regulators

Monolines left reeling by domino effect

Men like Jim Chanos and Bill Ackman will be watching the collapsing share prices of companies such as Ambac and MBIA with a sense of triumph – and the warm glow that comes from turning a fine profit.

Both hedge fund managers have long held short positions on the equities of one or other of these bond insurers – known as monolines – and have not been shy about condemning their business models or risk positions.

The equity market value of the sector has been pummelled, particularly in the past month. Ambac, for example, has lost more than 60 per cent of its value since October 5, while MBIA has lost 42 per cent.

The big worry is that developments in the structured credit markets could eventually lead to one of them going under – an event that is almost unthinkable. Just a ratings downgrade for one of the monolines would have a massively detrimental impact on the $2,500bn “muni bond” market, which exists mainly to fund local US county and state authorities.

Ambac, MBIA and FGIC are among the biggest names in this sector. In recent years they have grown and – like many investors – pursued better returns by devoting increasing attention to the world of structured credit. This is the complex and – until recently – booming sector that encompasses bonds backed by mortgages and other debt as well as collateralised debt obligations in their various forms.

These markets have seen a huge draining of liquidity in recent months as investors have headed for the exits over fears about losses related to US subprime mortgages and the broader mistrust of structured credit this has created.

The monolines insist they are in no real danger. The huge credit market disruptions that have led to industry losses in the third-quarter will not, they say, mean they are likely to pay out significant sums in insurance claims.

As Gary Dunton, chief executive of MBIA, said at his results last week: “Spreads widened significantly across the market in the third quarter and caused our insured credit derivatives portfolio to generate a large ‘mark to market’ loss, which we do not believe accurately reflects the economics of our business.”

In fact, many in the industry are rubbing their hands with glee at the blow-out in credit spreads because it translates directly into higher premiums they can charge to write new insurance contracts.

The rating agencies have begun to come out in support of the industry, too. Standard & Poor’s said on Wednesday that the writedowns experienced by some of the bonds insurers in the third quarter were unlikely to lead to any changes in credit ratings. However, independent specialist analysts at GimmeCredit have downgraded MBIA and Ambac, advising investors to sell out of positions in the debt of these companies.

Meanwhile, the cost of protecting their debt against default in the [very same!] credit derivatives market [which it is MBIA and Ambac's business to support!]has hit extremely high levels compared with their ratings. The AAA-rated debt of Ambac and MBIA [themselves] commands protection rates of 345 basis points and 310bp respectively. That of XL Capital, another monoline, is at 445bp.

In the US credit derivative indices, the basket of investment grade debt, which includes companies rated below AAA, currently trades at about 66bp, while the index of crossover debt, or companies rated around the BBB range trades at about 225bp.

“The problem now is that investors fear the relationship between the rating agencies and the guarantors [monolines] is so incestuous, that the rating agencies cannot issue downgrades without implicitly conceding that their proprietary [proprietary?! WTF?] capital models are flawed,” Kathleen Shanley, analyst at Gimme Credit.

Downgrades for the monolines would have a dramatic impact on the US municipal bond market – a key source of funding for a broad range of borrowers.

“If there is a problem with any of the monoline insurers, that would be crushing blow for muni markets,” says Matt Fabian, senior analyst at Municipal Market Advisors, a research firm.

That is because about half of municipal bonds – of which some $400bn are issued each year – are insured by monolines, he says. The value of the bonds are intimately tied to the credit ratings of the insurers. In effect, many municipal bonds base their trade on the credit rating of the relevant bond insurer.

If a monoline insurer were to see its rating slashed, many of the municipal bond mutual funds, which can only hold top-grade or very highly rated paper, would be forced to sell, potentially leading to billions of dollar worth of bonds being dumped into the market.

“It’s all connected to the insurers,” says Mr Fabian. “A downgrade of an insurer does not necessarily mean that a default risk of an issuer, say a Pennsylvania school district, has increased, but no one would know how to value A rated paper from a Pennsylvania school district.”

“I have never seen a crisis of confidence in insurers like this before and the implications of the muni market is enormous.”

NEW YORK, Nov 2 (Reuters) - The risk of owning credit and bonds of Citigroup Inc (C.N: Quote, Profile, Research) and Merrill Lynch (MER.N: Quote, Profile, Research) weakened on Friday, matching its weakest levels in at least a year and Merrill credit default swaps are now trading like junk, Moody's Investors Service said.

Merrill credit default swaps have a market implied rating of "Ba1," or six levels below its current Moody's rating at "A1," the fifth highest rating, said David Munves, a managing director and head of Moody's credit strategy group.

When the market for mortgage securities entered a meltdown over the summer, financial firms holding billions of dollars of hard-to-trade assets used mathematical pricing models that were heavily dependent on credit ratings. When the credit-rating firms began a massive downgrade campaign last month, firms such as Citigroup Inc. and Merrill Lynch & Co. saw the value of their holdings plummet.

Citigroup's struggles to put an exact number on its losses demonstrate just how fallible the models can be, and how serious the consequences. Last night, Citigroup said that the downgrades will result in a reduction of fourth-quarter net income of $5 billion to $7 billion. That follows a third quarter when Citigroup recorded mortgage-related write-downs of $2.2 billion, including losses on subprime securities and fixed-income trading.

The source of Citigroup's write-down is at least as significant as its size. The bank's estimate of its losses has changed so rapidly in large part because the models it used to value hard-to-trade securities relied heavily on credit ratings, according to people familiar with the models.

That made the bank highly vulnerable when, in October, ratings firms Moody's Investors Service and Standard & Poor's slashed, or put on watch for downgrade, the ratings on tens of billions of dollars in securities.

It is unlikely that Citigroup is alone. Ratings play a big role in valuation models used by many banks, investment funds and insurance companies. Meanwhile, the market for securities linked to subprime loans has deteriorated in recent weeks as defaults have confirmed some of analysts' most dire forecasts, increasing the likelihood of further ratings downgrades.

Citigroup's subprime exposure -- and source of its problems -- is found in two big buckets that together total $55 billion in its securities and banking unit, the bank said. The first bucket totals $11.7 billion, including securities tied to subprime loans that were being held, or warehoused, until they could be added to debt pools for investors. The second, totaling $43 billion, covers so-called super-senior securities.

These highly rated super-senior securities are portions of collateralized debt obligations, or CDOs. ..... Analysts estimate that $60 billion in such super-senior tranches are sitting on the books of banks, insurers and investment funds.

When trading in the subprime-linked securities all but dried up amid this summer's credit-market turmoil, Citigroup and other banks suddenly faced the difficult task of putting a value on securities that investors no longer wanted to trade.

For lack of any market pricing, Citigroup used credit ratings as a key input in figuring out the value of the future payments it expected to receive on the securities, according to a person familiar with the bank's valuation models. For example, in valuing the payments on pieces of subprime-backed CDOs with the highest triple-A rating, the bank would look to how the market was valuing payments on corporate bonds with the same rating.

The problem with the ratings-based approach was that it ignored a key difference between corporate bonds and subprime-backed bonds: Defaults on the latter were growing at a fast rate, which would likely lead to ratings downgrades.

The downgrades began in earnest Oct. 11 when, in a little-noticed announcement, Moody's Investors Service said it had slashed credit ratings on about 2,000 bonds backed by subprime home loans that originally carried a total value of $33.4 billion. It also flagged bigger problems ahead, saying that 502 CDOs had direct exposure to the mortgage securities that had been downgraded.

Nov. 5 (Bloomberg) -- Fitch Ratings may lower the AAA credit ratings on one or more bond insurers after a new review of the companies' capital takes into account downgrades of collateralized debt obligations that they guarantee.

Fitch said it will spend the next six weeks reviewing the capital of insurers including MBIA Inc., Ambac Financial Group Inc., CIFG Guaranty and Financial Guaranty Insurance Co. to ensure they have enough capital to warrant an AAA rating. Any guarantor that fails the new test may be downgraded within a month unless the company is able to raise more capital, New York- based Fitch said today in a statement.

CIFG and FGIC, the bond insurer whose owners include Blackstone Group LP, have the highest probability of suffering erosion in the capital because of the falling value of CDOs, Fitch said. Ambac has a ``moderate probability'' and MBIA is at ``low'' risk, Fitch said.

``It's safe to say our expectations have taken a turn for the worse,'' said Thomas Abruzzo, an analyst with Fitch in New York. ``What we thought was hypothetical based on analysis done in the summer has become the base case.''

In September, Fitch announced the results of a stress test of the bond insurers' capital to demonstrate how much capital insurers would need if conditions in the market were to significantly worsen. The test indicated that FGIC and CIFG would need to raise additional capital under the hypothetical scenario.

Fitch said it decided to review the bond insurers after ``broader and deeper'' downgrades of CDOs, which package debt such as subprime mortgage securities and loans.

The bond insurance industry has guaranteed more than $1 trillion of bonds issued by U.S. cities and states as well as bonds backed by mortgages, credit cards and other assets, and the guarantee allows borrowers to use the insurers' AAA rating. Shares and debt of the insurers has tumbled on concern the sliding value of subprime mortgages may erode their credit ratings.

Merrill Lynch & Co. last month doubled the size of its anticipated writedowns on subprime debt to more than $8 billion and Citigroup Inc. yesterday said it may reduce the value of its holdings by $11 billion.

Buyers of bond insurers' credit default swaps are betting the credit ratings will be lowered.

Credit-default swaps linked to MBIA, the world's biggest bond insurer, rose 41 basis points to 521 basis points, according to CMA Datavision in New York. Contracts linked to Ambac, the second-largest, climbed 29 basis points to 718 basis points, CMA prices show.

A basis point on a credit-default swap contract protecting $10 million of debt from default for five years is equivalent to $1,000 a year.

``Fitch recognizes that financial guarantors view maintenance of their 'AAA' ratings as a core part of their business strategies, and management teams will take any reasonable actions to avoid a downgrade,'' the statement said. ``However, Fitch also recognizes that recent capital markets volatility, including sharp declines in the share prices of the publicly traded financial guarantors, may make capital raising efforts difficult unless market conditions improve.''

Standard & Poor's said in a report released last week that it was reviewing how recent downgrades of subprime mortgage- backed securities and CDOs might affect the capital position of bond insurers. In August, Standard & Poor's said after running its ``worst case'' scenario for the subprime mortgage market that all of the insurers had sufficient capital to keep their ratings.

To contact the reporter on this story: Christine Richard in New York at crichard5@bloomberg.net

Tuesday, November 6, 2007

Ambac News... It's Crazy Out There

(update: added presentation by Pershing Square at the bottom)

Well, it has certainly been a wild ride for monoline insurers lately. I'm not sure how shareholders of Ambac and other monlines are coping these days. Here are some happenings in the world of Ambac...

Conference Call

I'm not sure where to start but Ambac management will be holding a conference call on Wednesday. The call is supposed to shed some light on CDOs and how the mark-to-market process impacts Ambac. I believe this is a prudent move by management to clarify the situation. There is certainly a lot of rumours swirling around.

I'm not an expert but I think a lot of people are making the mistake by looking at these monolines as if they were a typical investment bank or hedge fund. In particular, a lot of people just seem to take the outstanding par value and divide it by the capital and end up with some ridiculously scary number. There is between $1 trillion and $3 trillion of debt that is insured by all the monlines (there are only like 5 stand-alone companies of any size) but the total net capital of all these firms probably isn't even $100 billion (but these monolines have assets that are worth a lot more). So, if you took the notional value of all the debt and divided by the capital, as you would to say a bank if you wanted to calculate the debt-to-equity ratio, this would produce a very large number. In essence, you would have a few companies worth tens of billions insuring trillions of debt (just for reference, even a tiny regional conventional bank would be worth tens of billions). But I believe this is all misleading and the actual risk is much lower.

I will note that there is a material risk here but I also think there is a lot of speculation, rumours, and misunderstanding of what these insurers do.

Ambac Rebuttal of Morgan Stanley Analyst Remarks

Ambac also released a rebuttal of Morgan Stanely's analyst comments from late last week. Well, at least management is fighting back.

Potential Disaster from a Monoline Insurer Collapse

Reuters just touched on the impact of a monoline insurer collapsing:

If anyone is thinking of taking a position in one of these monoline insurers, it is absolutely critical that they invest in something that is not going to get downgraded. If your company loses its rating, it is going to be a disaster. The AAA rating is the #1 competitive advantage of companies like Ambac. If they lose that, they won't be able to insure many of the municipal bonds since most of those are A or AA rated (insurance is supposed to raise the rating of the underlying bond to that of the insurer's capability).

Even if a rating downgrade impacts one of Ambac's competitors, it can result in another round of sell-off on the stock market. If you thought there was uncertainty now, wait until some debt insurer gets downgraded. I think the possibility of Ambac or MBIA getting downgraded is slim right now.

The reason the market is very panicky is because the notional amount of bonds insured is very large. Furthermore, any loss the high ratings will cause a chain reaction and force those who actually own the CDOs, MBSes, etc to take further losses. What Merril Lynch and others wrote off will be a joke compared to what all the mutual funds, hedge funds, etc would write off if muncipal bonds dropped from, say, AAA to A.

For those looking at the sector, the above comment sort of indicates the risk level in each of these firms. MBIA, for example, is safer than Ambac. That's why Ambac's stock price of ABK is down much more than MBIA. I haven't compared the two deeply but a quick glance shows that ABK has far more CDO exposure than MBIA. CDOs are what David Dreman calls "toxic waste".

The author of the article finishes off by citing some of his concerns:

If you are thinking of taking a position in these monolines, one should consider the cited potential issues. Furthermore, being someone who is pessimistic and expecting a weakening US economy, one other thing I would watch out for is weakening credit card debt. No one has brought that up yet but given that many Americans and Canadians are living outside their means, things can deteriorate on that front in the future.

Update: For those that may or may not be familiar, some funds, such as Pershing Square have been bearish on bond insurers for a while. Here is a presentation that they made early this year. If one were to consider taking a position in bond insurers, they need to convince themselves that the arguments in the presentation are not correct or the downside won't materialize.

CDS Report: Credit derivatives markets tighten but fear remains

European credit derivatives markets reversed the strong widening trend of the past three days on Tuesday, but volumes were thin as traders remained cautious about further US subprime mortgage pain to come from the banking sector.

The iTraxx Crossover index, a widely watched measure of risk appetite, opened about 5 basis points tighter at about 350bp, before tightening by another 5bp to about 345bp in morning trade. This means it now costs €345,000 annually to insure €10m of Crossover debt against default over five years.

Analysts said that volumes were down to levels last seen at the height of the liquidity squeeze in the inter-bank lending market, when traders were most nervous about the potential for big losses at the major banks.

“Things are fragile to say the least,” Suki Mann, head of credit strategy at Societe Generale, said in a note to clients. “We’re back to pre-September risk-aversion mode where the ability and willingness to transact has waned considerably. In other words, real illiquidity.”

However, the cost of protection for banking industry debt saw better performance than the broader market on Tuesday, with both the senior and subordinated indices of financial companies seeing stronger tightening than the main iTraxx Europe, which tracks investment grade debt. The cost of insuring financial bonds against default has been soaring as banks such as Citigroup and Merrill have been forced to take much larger-than-expected writedowns on losses related to the US subprime mortgage market and related securities.

The iTraxx Europe tightened to about 44.25bp, against 46bp at Monday’s close.

This entry was posted by Robert Cookson on Tuesday, November 6th, 2007 at 12:17 and is filed under Uncategorised. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.

American International Group (AIG)		AIG left the business in 2005
MBIA (MBI)	A monoline; the world's biggest bond insurer;	CIFG and FGIC have the highest probability of capital erosion because of the falling value of CDOs, Fitch said. Ambac has a ``moderate probability'' and MBIA is at ``low'' risk
Ambac Financial Group Inc.(ABK)	A monoline; the world's second largest bond insurer	CIFG and FGIC have the highest probability of capital erosion because of the falling value of CDOs, Fitch said. Ambac has a ``moderate probability'' and MBIA is at ``low'' risk
Financial Guaranty Insurance Co. FGIC (Whatamess) “Financial Guaranty Insurance Company (the “Company”) is a wholly owned subsidiary of FGIC Corporation (“FGIC Corp.”). “ FGIC Corp is “the Company’s sole stockholder ”	owners include Blackstone Group LP http://www.fgic.com/ http://www.fgic.com/investorrelations/factsheet/investorfactsheet.pdf	CIFG and FGIC have the highest probability of capital erosion because of the falling value of CDOs, Fitch said. Ambac has a ``moderate probability'' and MBIA is at ``low'' risk
ACA Capital Holdings Inc. (ACA)	A holding company. HQ NYC	a small player with big exposure to CDOs. One client is Bear Stearns (BSCC). Bear remains the company's largest shareholder, with some 27% of its stock. ACA Chairman David E. King is a senior managing director at Bear and an executive vice-president of Bear's private equity group.
Security Capital Assurance Ltd.(SCA)	two segments, Financial Guarantee Insurance and Financial Guarantee Reinsurance	Hamilton, Bermuda-based financial insurer and reinsurer
MGIC Investment Corp (MTG)	Mortgage insurance	the largest U.S. mortgage insurer; PMI Group Inc is the second-largest.
XL Capital Ltd. (XL:NYSE)	A monoline. five segments: Insurance, Reinsurance, Life Operations, Financial lines, and SCA	http://investing.businessweek.com/research/stocks/snapshot/snapshot_article.asp?symbol=XL
Radian Group Inc. (RDN:NYSE)	three segments: Mortgage Insurance, Financial Guaranty, and Financial Services	http://investing.businessweek.com/research/stocks/snapshot/snapshot_article.asp?symbol=RDN
CIFG Assurance North America, Inc.; CIFG Europe; CIFG Guaranty; CIFG Holding (Whatamess)	Some kind of multinational glop. CIFG NA was granted a New York license in May 2002. http://www.cifg.com/fin_info/index.shtml Investor Presentation - US	CIFG and FGIC have the highest probability of capital erosion because of the falling value of CDOs, Fitch said. Ambac has a ``moderate probability'' and MBIA is at ``low'' risk