By Christine Richard and Cecile Gutscher
Nov. 15 (Bloomberg) -- The crisis of confidence in bondinsurers that bestow top credit ratings on debt sold by borrowersfrom the New York Yankees to Citigroup Inc. may cost investors asmuch as $200 billion.
The AAA ratings of MBIA Inc., Ambac Financial Group Inc. andtheir five smaller competitors are being reviewed by Moody'sInvestors Service and Fitch Ratings. Without guarantees, $2.4trillion of bonds may fall in value and some issuers would getshut out of the capital markets.
``We shudder to think of the ramifications,'' said GregPeters, head of credit strategy at New York-based Morgan Stanley,the second-biggest U.S. securities firm by market value. ``Youhave politicians, taxpayers, municipalities, states. It justopens up a Pandora's box. That is a huge destabilizing force.''
For more than 20 years, the safety of insurance has easedthe way for elementary schools, Wall Street banks and thousandsof municipalities to sell debt with unquestioned credit quality.Now, mounting downgrades on insured bonds backed by assets suchas mortgages are raising doubts about the stability of theguarantors. Armonk, New York-based MBIA, the world's largest, hasa 28 percent probability of default, and Ambac's is 40 percent,prices of derivatives show.
MBIA fell $1.44, or 3.6 percent, to $38.37 in New York StockExchange Composite trading as of 12:10 p.m., and have dropped 47percent year to date. Ambac's shares fell $1.33, or 4.4 percent,to $29.09, and have lost 67 percent year to date.
Forced Sales
Moody's and Fitch, both based in New York, are examining theinsurers on concern that a slide in the credit quality of some ofthe 80,000 securities they guarantee has eroded their capital somuch that they no longer deserve AAA ratings.
The ratings companies said New York-based Ambac, FGIC Corp.in New York, and CIFG Guaranty of Hamilton, Bermuda, have a highor moderate chance of being told to add capital or forfeit theirtop status. Fitch and Moody's said MBIA has a low risk of adowngrade.
Borrowers would see their costs increase if they lose toprankings. Municipalities ranked A pay $190,000 more a year ininterest on $100 million of debt than those with AAA bonds,according to index data compiled by New York-based LehmanBrothers Holdings Inc.
Lower Ratings
Lower ratings would force some investors to sell securities.About 110 municipal bond mutual funds are required to hold mostof their assets in AAA debt, according to data compiled byBloomberg.
As many as half of all municipalities have an underlyingcredit strength equivalent to AAA, according to Lehman Brothersstrategist Peter DeGroot. If yields on half of all insured muniswere to rise by 19 basis points, reflecting the differencebetween AAA insured yields and A rated yields, the loss in valuewould be $9 billion.
When home sales soared this decade, insurers increased theirguarantees of securities created from mortgages, includingsubprime loans to people with poor credit and home-equity loans.
They now guarantee almost $100 billion of collateralizeddebt obligations backed by subprime-mortgage securities as ofJune 30, according to an Aug. 2 report by Fitch. CDOs are createdby packaging debt or derivatives into new securities with varyingratings.
Writedowns
Banks and investors in CDOs may be forced to write down thedebt by more than $30 billion if the debt became uninsured, basedon the values that New York-based Citigroup and Merrill Lynch &Co. assigned to their holdings in the past month. Merrill wrotedown 29 percent of its CDOs and other securities linked tosubprime mortgages and Citigroup cut 21 percent.
Insurers are required by accounting rules to reflect thecurrent market value of the guarantees on the bonds they insurethrough derivatives contracts.
Then there is the $1 trillion market for insured securitiesbacked by assets such as home-equity and consumer loans. Concernsabout the underlying quality of the assets and the viability ofthe guarantors have caused investors to price some securitiesrelative to the credit-default swaps of the insurers, accordingto David Land, a mortgage-bond fund manager at Advantus CapitalManagement. Advantus, based in St. Paul, Minnesota, overseesabout $18 billion.
Insured securities backed by home equity-lines of credithave fallen by 15 percent, based on the rise in credit-defaultswap rates this year on Ambac's insurance company. If the entireinsured market were to drop that far, it would reduce the valueof the securities by $150 billion.
`20 Hurricane Katrinas'
``The insurers can protect you from one unusual,idiosyncratic event, like a Hurricane Katrina,'' said DanielCastro, chief credit officer of structured finance at GSC Groupin New York, which oversees more than $24 billion of debt. ``Whatif you had 20 Hurricane Katrinas and everything is wiped out?That's what you have right now.''
Ambac, which pioneered municipal-bond insurance in 1971, hasbeen rated AAA since 1979. MBIA got the top rating when it wascreated in 1974 as the Municipal Bond Insurance Association. Whenbacking debt, the financial guarantors, also known as monolines,agree to make principal and interest payments if an issuer can't,allowing the debt to get the highest rankings.
Ambac, the second-biggest in the industry, guarantees $546billion of securities. MBIA stands behind about $652 billion ofmunicipal and structured finance bonds, while FGIC has insured$314 billion of debt, including $600 million of bonds for the NewYork Yankees, according to the companies' Web sites.
`Never Questioned'
MBIA, Ambac, FGIC and their competitors have paid claims onless than 0.01 percent of the total debt from all municipal bondsthey've insured, company statements show. MBIA shares rose anaverage of 13 percent a year from 2000 through 2006 and Ambacgained 15 percent. The Standard & Poor's 500 Index advanced 1.1percent a year in the same period.
``Investors in guaranteed debt have never questioned the AAAguarantee from monolines,'' said Toby Nangle, who helps oversee$37 billion at Baring Asset Management in London and avoids debtguaranteed by monolines. Given the rise in the perception ofrisk, they ``may start to wonder if the emperor has no clothes,''he said.
Ambac has tumbled 66 percent on the New York Stock Exchangesince June 1. MBIA dropped 40 percent. New York-based ACA CapitalHoldings Inc., an A rated insurer that S&P said it may cut, isdown 89 percent. FGIC isn't publicly traded.
Swaps Triple
Credit-default swaps on MBIA more than tripled to 410 basispoints since Oct. 15, according to CMA Datavision in New York.The price suggests that investors see a 28 percent chance MBIAwill default, according to JPMorgan Chase & Co. valuation models.Contracts on Ambac have climbed to 620 basis points, CMA datashow. They imply a 40 percent chance of default.
Credit-default swaps are a type of derivative that allowsinvestors to speculate on a company's ability to repay debt.Derivatives are financial instruments derived from stocks, bonds,loans, currencies and commodities, or linked to specific eventslike changes in the weather or interest rates. A basis point on acontract protecting $10 million of debt from default for fiveyears is equivalent to $1,000 a year.
What has investors so concerned is the declining value ofinsured CDOs and mortgage securities. Bond insurers reportedcombined losses of $2.9 billion last quarter after writing downthe value of some of the CDOs and other securities they guaranteeamid the worst housing market since 1991.
Pervasive Problems
``What concerns us is the pervasiveness of the potentialproblems,'' Morgan Stanley's Peters said in an interview thisweek. ``The bond insurers touch so many aspects of the financialsystem.''
The writedowns are so-called mark-to-market losses,reflecting the reduced value of the securities. Those losses maynever be realized as the securities mature, Ambac Chief ExecutiveOfficer Robert Genader said on a conference call Nov. 7, arrangedto allay investor ``misconceptions'' about the company'sbusiness.
MBIA believes it has sufficient capital, spokeswoman LizJames said in an e-mail. ``As future developments in the economyare uncertain, we may consider taking steps to further bolsterthe company's capital position,'' she said.
Ambac spokesman Peter Poillon and FGIC spokesman Brian Mooredidn't return calls. CIFG spokesman Michael Ballinger said thecompany, and its parent, Natixis SA of France, were committed tomaintaining AAA ratings.
Fitch, a unit of Paris-based Fimalac SA, and Moody's saidlast week that they would spend a month studying each insurer'scapital cushion, or the excess capital over what the ratingscompanies require to maintain their current rankings.
Padding Boost
Insurers could boost their padding by reinsuring thesecurities they guarantee, Fitch analyst Keith Buckley said on aconference call Nov. 8.
Banks may step in to back the companies because it would becheaper than taking more writedowns, Michael Barry and SethLevine, analysts at Charlotte, North Carolina-based Bank ofAmerica Corp., wrote in a report.
``The securities industry, no small force, has a keeninterest in the financial guarantors remaining healthy and ratedAAA,'' they wrote. ``Financial guarantors would not have to lookfar for help making sure the demand was met.''
The issues facing insurers go beyond ``misconceptions''referred to by Ambac's Genader, said Geraud Charpin, London-basedhead of credit strategy at Zurich-based UBS AG. The firm isEurope's largest bank by assets.
Government Intervention?
Losses may be so big that governments would step in toprevent losses from hurting municipal bondholders, many of themretirees, and states and municipalities, which may be preventedfrom selling debt, he said.
``A form of bailout would probably be worked out,'' Charpinsaid in a Nov. 6 note to investors. ``A politically engineeredsolution will insure an acceptable way out where the innocentpensioner does not lose out and states are able to continuefunding themselves and build more roads and schools.''
MBIA guaranteed $15.9 billion of CDOs backed by subprimemortgages and had excess capital of about $550 million, S&P saidin an Aug. 2 report. Ambac had a cushion of about $1.15 billionon $29.3 billion of CDOs backed by home loans to people with poorcredit, while FGIC had $350 million more than it needed for $10.3billion of securities. ACA's cushion was around $500 million for$15.7 billion of subprime-backed CDOs.
$3 Billion Hit
Had the insurers reduced the values of the bonds theyguaranteed by the same magnitude as the writedowns at Merrill andCitigroup, MBIA would have taken a $3 billion hit, instead of$342 million, William Ackman, president of hedge fund PershingSquare Capital Management, said at a conference in Stamford,Connecticut, last week. Ambac would have had a $6.1 billion loss,rather than the $743 million it reported, said Ackman, who hasshort positions on MBIA and Ambac that benefit from a drop in thecompanies' stocks and bonds.
``This has implications for global financial markets,'' saidAckman, who has pushed for changes at companies such asMcDonald's Corp., the world's biggest restaurant company, andWendy's International Inc. He first raised questions about thebond insurance industry in a 2002 research report titled ``IsMBIA Triple-A?''
To contact the reporter on this story:Christine Richard in New York at crichard5@bloomberg.net
Last Updated: November 15, 2007 12:36 EST
