What does a AAA mean anyway?

S&P has affirmed MBIA's insurance sub's rating at AAA, and has removed it from negative watch. MBIA does remain on negative outlook. In credit ratings parlance, no longer being on watch means a downgrade is not imminent. The negative outlook reflects the simple fact that MBIA may well fail to regain a AAA-level reputation, regardless of the AAA rating. If they fail to regain their reputation, their business will not ultimately recover. But for financial institutions with exposure to MBIA, chief among which was Merrill Lynch, this is unequivocally good news.

S&P wasn't done doling out the good news. They also affirmed Ambac's AAA rating, although Ambac remains on negative watch. Normally negative watch indicates that a downgrade is imminent. In this case, however, S&P indicated that Ambac was about $400 million short of the capital level needed for a stable AAA rating. Therefore if Ambac is able to complete the capital infusion plan reportedly in the works, which will supposedly raise $3 billion, they should be able to retain their rating. Several reports indicated that the only thing holding up the negotiations between Ambac and the banks is a sign-off by the ratings agencies, and I'd say today's report from S&P tells us that at least one agency would indeed sign-off.

The market continues to be highly skeptical of these ratings. CDS on both MBIA and Ambac's AAA-rated insurance subs are still well over 300, roughly in line with BBB+ rated Washington Mutual, wider than A rated Bear Stearns.

Now we can quibble about S&P's methodology of estimating "stressed losses" on mortgage-related securities. For 2007 vintage tranched RMBS rated A or lower, S&P assumed at least a 84%+ loss rates on Alt-A and closed-end second mortgages, and home equity lines of credit. On first-lien sub-prime loans the loss rates are slightly better, no doubt owing to somewhat better recovery. The 2006 vintage loss estimates are similar, with some product worse and other product better.

On ABS CDOs, S&P assumed loss rates of around 60% on higher-rated collateral and 80% on lower-rated collateral for the '06 and '07 vintages. Given that the monolines generally only insured the most senior tranches of ABS CDOs, that probably puts the eventual monoline losses on these products in the 40% area.

So like I said, we can quibble about whether or not that represents a "stressed" scenario or not. The reality is, it doesn't matter what we think. If S&P says that Ambac and MBIA have enough capital to be called AAA, then they are AAA. Banks will now use AAA ratings when calculating their capital ratios. Money market funds can keep holding insured paper.

It especially doesn't matter what we think because neither Ambac nor MBIA is in any real danger of running out of cash in the near term. Ambac and MBIA reported over $18 and $35 billion in marketable securities respectively as of 4Q 2007. Plenty to pay any losses they are likely to incur over the next several quarters. So if the monolines aren't going to actually run out of cash, if they aren't actually going to go bankrupt, who is to say they aren't AAA?

And that's what bothers me. When you come down to it, the debate over whether the monolines should or should not be rated AAA is entirely subjective. We all agree that a AAA-rated bond should have a remote chance of taking losses, but how remote is remote? We all agree that a AAA-rated insurer should be able to withstand a 6-sigma event, but what constitutes a 6-sigma event? There is no single answer to these questions. Its subjective.

That would be OK, except that credit ratings are so ingrained in our financial system. Everything from banking and insurance regulations, mutual funds, money markets, pension funds, debt service reserve accounts, etc. all depend on a ratings system to guide them. Try sometime sitting down and reading the SEC 2A-7 rule, which governs money market investments. The rules all but encourage managers to buy whatever they want as long as the instrument has the right rating and right maturity. And yet if 2007 taught us anything, its that credit ratings are just opinions. No matter how sophisticated the modeling and financial analysis, those opinions can be just plain wrong.

On Monday, the Dow rallied nearly 200 points, and credit spreads almost universally tightened. Why? Because a AAA rating for MBIA and Ambac means that banks won't have to pledge more capital against downgraded ABS. This gives them more capital to lend into the economy. No matter what you think of S&P's analysis, that's the reality. If that reality bothers you, perhaps your derision should not be aimed at S&P or MBIA, but at the banking regulations that are so heavily reliant on ratings.