The Reckoning

Last autumn, Gary Vaughan-Smith of SilverStreet Capital predicted that the monoline insurers would be the next big ripple from the sub-prime implosion. “This is a major event still to come,” he said. “When one or more of  these credit insurers goes bust it will hit the insured bonds, and one doesn’t know where that will end up.”

At that point few investors neither knew or cared what a monoline did, nor why their name was so misleading. This was to change in the coming months, as the ratings agencies looked to their models and began to grow concerned. “Towards the end of 2007 Fitch looked again at its monoline model and the capital these businesses required to retain their Triple A ratings,” said Greg Carter, managing director of insurance at Fitch Ratings, speaking at Fitch’s credit day last month. “We thought some companies were short and the business is dependent on the Triple A rating – that’s what people are buying.”

Indeed, that’s what people were buying. Whether anyone wants to take that rating at face value any more is doubtful. Whilst Moody’s has focused on encouraging the hapless monolines to raise capital to retain their Triple A ratings, Fitch has changed tack in recent weeks, with dire warnings about the losses coming down the line. As Pershing Square’s Bill Ackman said in his frumious letter to the US regulators: “It is hard to fill a bucket with a hole in the bottom.”

The numbers are big: the volume of bonds underwritten by Ambac and MBIA – two of the biggest US monolines – is said to be around US$2.4 trillion, and Ackman puts the losses for the universe of ABS CDOs issued between 2005 and 2007 at about US$231 billion. Ambac and MBIA are said to be in the frame for about US$11.6 billion each.

MBIA has managed to raise US$1.5 billion of new capital through surplus notes and a direct equity investment from Warburg Pincus, with an additional US$500 million equity investment through a rights offering backstopped by Warburg Pincus. However, Fitch believes these additions to capital may not be sufficient to maintain MBIA’s Triple A rating. It has already downgraded Ambac to AA, proving it means business.

Other insurers that Fitch is scrutinising include CIFG, FGIC and SCA. The latter is the parent company of XL Capital Assurance – which Fitch has previously identified as having material sub-prime exposure within its insured portfolios. With the results of Moody’s and S&P’s reviews pending, credit managers and banks are nervously considering their portfolios.

“If all the monolines went bust today and you saw all those bonds move down in price suddenly then it would have an enormous impact on banks and leveraged structures,” says Vaughan-Smith. “It’s not going to happen immediately, and the market is gradually discounting this, but it’s an incredibly disruptive effect, and it is not a predictable effect.”

This is one of the biggest problems for portfolio managers, insurers, pension funds and banks trying to work out exactly what kind of trouble they are in. “You think you’ve got a bond which is secured on very predictable earnings, but in fact you have a credit risk if the insurer goes bust,” he explains. “You may still get paid out, but the credit rating on your bond goes down.”

A lot of the bonds that have been insured have ended up in leveraged structures, such as Collateralised Bond Obligations (CBOs). “That asset pool has to have a certain credit rating and be managed in a certain way,” he adds. “And the people who are managing it will have been told that if a bond is downgraded to AA as a result of a monoline downgrade, they have to sell it or trim it.” Naturally, forced sales are bad news for anyone else still holding these bonds.

Fortunately, the weeks of uncertainty should soon be over, just as the banks head into reporting season. “One way or another it will come to a head,” says Vaughan-Smith. “It’s moving very quickly now in the markets and will be resolved quite quickly – probably in a negative way. It will be a bad period.”

If you want to read more about the embattled monolines and their arcane business, please visit:

http://www.thomsonimnews.com/story.asp?sectioncode=7&storycode=35614  

If you would prefer to hear something more cheerful about the credit markets, please visit:

http://www.thomsonimnews.com/story.asp?sectioncode=7&storycode=35541