http://www.princeofwallstreet.com/2008/02/03/bond…
Last week after all the speculation about how much the federal reserve would cut rates, the real market mover turned out to be speculation about the troubled bond insurers. On the 30th of January, when the Federal reserve cut interest rates by half a percentage point, the markets briefly rallied but then closed down after the credit downgrade of bond insurer FGIC. The big news on the Friday before the Monday global sell-off two weeks ago, which was overlooked by most of the financial press, was the downgrade of 420 bond issuances insured by Ambac after Ambac was downgraded. One of the larger gains in the market over the last two weeks came when MBIA said it was certain it would retain its AAA rating. On February 1st, a report by CNBC that eight banks were putting together a consortium to rescue bond insurers caused the market to rally again.
The fallout from the downgrade or failure of any bond insurer would be far reaching. In many ways the losses from major trouble among bond insurers would be massive at investment banks since credit instruments in all industries and across ratings levels would be affected. Widespread downgrades of bond insurers could lead to more across the board downgrades of thousands of credit instruments that were insured by the bond insurers. Furthermore, as instruments get downgraded from AAA many instructions participate in forced selling since they are unable to hold paper that is rated below AAA. This further exacerbates the downward pricing pressure on the credit markets. About $3.5tn of bonds have been insured and some estimate that the impact on banks of recent downgrades of insurers could be close to $10bn. In a worse case scenario it is easy to see how banks could take more write-offs and suffer declining values in their portfolios as forced selling because of downgrades grips the credit markets. In many ways, like the leveraged loan crisis this summer, it is difficult for market participants to truly gauge the size of the effect of continued downgrades related to struggling bond insurers.
How the bond insurers got into a distressed position is a simple story. Originally, bond insurers business was to put their names to municipal bonds. The municipals were not able to qualify for AAA rating by themselves but with a bond insurers backing the municipals were able to qualify for higher ratings and lower their cost of borrowing. Had bond insurers stayed in this low growth and low return business they would not be in trouble but they also would not have participated in the orgy of fees they received over the last few fees from insuring other credit instruments. The bond insurers are now in trouble because they have insured CDOs and are now mired in the subprime crisis. Insurers have been taking writedowns on their CDO portfolios and this has threatened their credit ratings. A downgrade from a AAA rating would likely end the insurer’s ability to book new business. That in turn reduces the options for municipalities looking for insurance.
Investments held by banks and insured by companies like Ambac or Security Capital or insurance contracts banks hold on the bond insurers themselves would all likely lose value if bond insurers ratings continue to fall. Given the exposure that many large credit investors and banks face as a result of insurers insuring bonds they hold in their portfolios it certainly makes sense for these two parties to band together to bolster the balance sheets of insurers. It seems like equity injections or new debt issuances (provided the debt could be placed with investors) would be cheaper way for these two groups to avoid further losses related to their credit portfolios’ exposure to bond insurers. Certainly the current troubles for bond insurers should be getting more coverage by the financial media because these troubles are having an enormous effect on market sentiment.
http://www.princeofwallstreet.com/2008/02/03/bond…
-The Prince
http://www.princeofwallstreet.com
