Bond Insurers, Subprime's Victims

♠ Posted by Emmanuel in at 8/21/2007 12:10:00 PM
Bond insurers, the so-called "monolines," have fallen under hard times. Obviously, what they do is insure bonds. In so doing, they function like credit rating agencies who have skin in the game. If these insured bonds default, then they become liable for both principal and interest to bondholders. Credit agencies have been accused of being unreliable, first during the Asian financial crisis when they made nary a warning sign about the impending crisis while giving favorable ratings to Southeast Asian countries and now during the subprime crisis when they made nary a warning sign about the impending crisis while giving favorable ratings to securities containing subprime loans.

While rating agencies might be subject to more scrutiny and lose some rating business at the most, the subprime mess can cause bond insurers a lot more trouble if the more dire prognostications of mass defaults come true. Unlike the credit rating agencies, the bond insurers will literally have to pay. The July 26 Economist offers this backgrounder:

As America's subprime-mortgage tempest spreads, Wall Street's latest parlour game is to bet on who will be next to get caught in the storm. A fair few have placed their chips on the so-called monoline insurers, an obscure but important bunch who guarantee the timely repayment of bond principal and interest when the issuer defaults.

The two largest monolines, MBIA and Ambac, both started out in the 1970s as insurers of municipal bonds. In recent years, much of their growth has come in structured products, such as asset-backed bonds and the now infamous collateralised debt obligations (CDOs). The total outstanding amount of paper insured by monolines reached $3.3 trillion last year.

AndrĂ© Cappon of CBM Group, a financial consultancy, describes monolines as “rating agencies that put their money where their mouth is.” Arguably the keenest of credit-market observers, they extend their gold-plated credit ratings to paper they deem worthy of their protection, in return for a premium.

The monolines' share prices have tumbled this year as the depth of the subprime crisis has sunk in (see chart). The cost of insuring against their own default has shot up, prompting talk of a “monoline meltdown”. This week Ambac's second-quarter profit missed forecasts due to a $57m write-down on credit derivatives.

The industry's tormentor-in-chief is William Ackman, who runs Pershing Square, a hedge fund. Mr Ackman has spent the last five years, no less, telling anyone who will listen that the monolines are doomed, with MBIA particularly vulnerable. He points to their massive leverage: outstanding guarantees amount to 150 times capital. He also questions MBIA's “aggressive” accounting techniques. Earlier this year the company paid $75m to settle allegations that it used reinsurance contracts to conceal losses.

Amid the market's jitters, other hedge funds are readily buying into this message. That may be all Mr Ackman, who holds a short (bearish) position in MBIA shares, wants. But most analysts think his analysis is based on a misunderstanding.

Monolines may be highly geared compared with traditional insurers. But, as Rob Haines of CreditSights points out, they are highly conservative in other ways. They model each transaction under a variety of high-stress situations and only accept those that show no losses in all scenarios. This may explain why they had little exposure to New Century, the biggest mortgage lender to go bust so far. Subprime makes up only 1-3% of their direct exposure.

To wipe out the monolines' capital cushion, it would take a loss twenty times bigger than the hit they took last year. Even in today's febrile markets that is hard to imagine, especially since the insurers are at the back of the queue when it comes to taking losses on CDOs. So, though losses may run into the hundreds of millions, they are unlikely to be big enough to deprive the biggest monolines of their cherished triple-A rating.

The monolines may lose business as investors turn their back on CDOs and other structured products. But MBIA's finance chief, Chuck Chaplin, thinks the general confusion over credit risk may even help them, as more debt issuers seek comfort in guarantees. It remains to be seen if that optimism is, like Mr Ackman's pessimism, somewhat overdone.

Today's Financial Times also offers an update on these monolines. It seems that many are still above water, though times are indeed testing for many investors are running away scared. As mentioned earlier, one of the problems of these bond insurers is that their capital base is remarkable small in comparison to the total amount of bonds they insure. In other words, the insurers themselves have little insurance :

The crisis in US subprime mortgage-related bonds and its spillover into broader structured credit markets has had a huge impact on one important but little-known group of companies: the bond insurers.

Among the worst hit has been Radian Group, which specifically insures mortgage-backed debt. It has seen its shares tumble by more than 60 per cent this year while the cost of protecting its debt against default in derivatives markets has spiked nine times higher.

Other bond insurers have also suffered because they have tiny capital bases compared with the volume of assets they insure.

Yet the rating agencies remain confident that these firms are stable and are weathering the problems in subprime markets. Some analysts, too, remain confident in their prospects.

Bond insurers lend their high credit ratings to securities issued by others in return for a fee.

Although the largest of these so-called “monoline” insurers, MBIA and Ambac, began as insurers of municipal bonds, much of the industry’s growth in recent years has come from providing guarantees to structured securities such as asset-backed bonds and collateralised debt obligations.

Now that such complex securities have run into trouble, the monolines are facing serious questions over their risk-management practices. If they were to prove unsound, that could pose a threat to the ratings of more than $3,300bn of securities that they insure, which includes much of the municipal bond market.

There are some signs that Radian and rival MGIC could already be facing difficulties.

Both companies have drawn on liquidity facilities from banks and last month they announced that their dual investment in Credit-Based Asset Servicing and Securitisation, which buys and services subprime securities, could be worthless.

Radian said last week that it had exposure to $47bn of collateralised debt obligations. Meanwhile, MGIC, whose shares are down 42 per cent this year, is trying to extricate itself from a merger with Radian agreed in February.

However, Rob Haines, analyst at CreditSights, the independent research firm, said the monolines are less exposed to the crisis than market prices are currently suggesting.

Subprime mortgages, he said, make up only a small portion – between one per cent and 4 per cent – of their direct exposure. Meanwhile, the monolines insure almost exclusively senior bonds that are protected by losses in more junior securities and they are not exposed to changes in market value, only actual defaults.

“The markets are treating Radian like the walking dead,” says Mr Haines. “While Radian’s credit risk profile has certainly deteriorated far faster than we ever anticipated, we think it is premature to place a high probability of near-term bankruptcy.”

For its part, Standard & Poor’s, the rating agency, said in a recent report that the deterioration in the subprime mortgage market did not threaten the ratings of the monolines.

“We come to this view as a result of the insurers’ underwriting standards . . . their sound risk-management practices . . . and their conservative capital management strategies,” it said. The agency added that the monolines could see “adverse development without jeopardising their capital adequacy”.

However, inadequate capital reserves are regularly cited by those betting against the industry as the chink in the monolines’ armour.

Ambac, for example, has guaranteed $26bn of CDOs with subprime exposure and a further $9bn of subprime mortgage bonds against a capital base of just $1.15bn at the end of last year.

At MBIA, the company’s outstanding guarantees amount to 150 times capital.

Jim Chanos, hedge fund manager and noted short seller, said MBIA is one of his largest short positions because his firm always like to bet against “financial alchemy stories”.

Mr Chanos believes MBIA keeps insufficient reserves against future credit losses and that, in doing so, “MBIA turns a very risky insurance scheme into a gold-plated credit rating for questionable debt issuance”.

Another long-standing and vociferous critic of the industry is Bill Ackman, head of Pershing Square, the activist hedge fund.

“People think of the bond insurers as safe because they started out by guaranteeing general obligation municipal bonds [that] rarely default,” he said. “Over time, they have morphed into financial institutions that take structured and corporate credit risk as they have moved up the risk spectrum.”