Wednesday, June 04, 2008

Monolines: Let me see you with my own eyes

That snapping sound you hear is the last ray of hope for MBIA and Ambac shareholders. Moody's put both on negative watch today, which tells you a downgrade is inevitable.

On Ambac they say...

Moody's stated that the ratings review was prompted, in part, by concerns about the deterioration in ABK's financial flexibility since the company's $1.5 billion capital raise in March 2008, as evidenced by the substantial decline in the firm's market capitalization and high current spreads on its debt securities, making it increasingly difficult to economically address potential shortfalls in the company's capital position should markets continue to worsen. Additionally, there is meaningful uncertainty surrounding Ambac's ability to regain market acceptance and underwriting traction within its target markets.

On MBIA...
Moody's said that recent mortgage performance data, and MBIA's own reported first quarter results, are indicative of continued deterioration within the guarantor's insured portfolio. As part of its review, Moody's will evaluate the effect that mortgage-related stress, particularly with respect to MBIA's second lien mortgage and ABS CDO exposures, could have on the firm's risk-adjusted capital adequacy position. Moody's said that it will also review other areas of the portfolio that may be susceptible to economic slowdown.

The logical question is, why now? I mean, the marketplace widely discounted either company's ability to remain AAA for several months.

Perhaps the answer lies in their share prices. On MBIA: "...the significant decline in MBIA's stock price since February is making it increasingly challenging for MBIA to economically address capital shortfalls by raising new equity..."

And Ambac: "...the substantial decline in the firm's market capitalization and high current spreads on its debt securities, making it increasingly difficult to economically address potential shortfalls in the company's capital position should markets continue to worsen..."

Moody's also mentioned regaining investor confidence, which "concerned" the ratings agency. Its way beyond concerning. There is no hope of either company ever regaining the confidence of investors so long as there is significant RMBS and CDO exposure.

No further evidence of this is needed beyond the CDS market. Credit default swaps on Ambac's insurance subsidiary is currently bid at 23 points up front and 500bps/year. MBIA is 19.75 points up front. That means that in order to be protected against Ambac defaulting on any of their insurance obligations, the cost is 23% of the amount protected. On 4/30, Ambac was 730bps/year (nothing up front) and MBIA was 710bps.

Now for the so what?

Currently the municipal market puts no value on Ambac or MBIA insurance. Really since at least January. The only value put to Assured Guaranty or FSA insurance is for liquidity, not as a credit replacement. So I don't think this changes much for the muni market. If there is an actual downgrade there may be some forced selling, but from what I've heard, most of those who would be forced sellers have done so already. Because, you know, every one saw this coming.

The impact on financial institutions holding ABS/CDO paper is a little less clear. Before the advent of the TSLF and TAF, the markets were very much attuned to the goings on with MBIA and Ambac. Now that capital is a little easier to come by, it seems as though the markets are less worried about the monoline insurers. Today is a perfect example. The Dow moved from about 12,480 just before the news to 12,402 just after the news. Now 78 points is a decent move in about 45 mins. But compare that to February 22, the day there were mere rumors of an Ambac bailout. The Dow went from 12,155 (down over 130 points on the day) to close at 12,381.

Given that all CDS contracts are supposed to be marked to market, and that ABS/CDO insurance was always done in the form of a CDS, financial institutions should have been valuing those CDS with the counter-party in mind. I guess we'll see how true that is. Looking at the CDS on their insurance arms, the insurance should be considered near worthless.

Of course, not entirely worthless. If regulators deem either (or both) MBIA and Ambac insolvent, they'll go into run-off. Most of the run-off circumstances I'm aware of have been voluntary. As in a company just doesn't want to be in the auto-insurance business or whatever so they put it into run-off. I'm not sure anyone really knows how the run-off of a bond insurer will play out. Currently both MBIA and Ambac have substantial cash and investments, and could likely last in run-off for several years. Maybe even in perpetuity. If any readers have access to research on how the run-off would work, please e-mail me (accruedint at

Meanwhile, MBIA Chief Jay Brown says they might start a new insurer with some of the capital MBIA raised back in February. I can't comment on how this might work legally, but if he could pull it off, it might just work. MBIA isn't such a pariah that they couldn't come back into the market if they managed to shed the non-muni exposure. I dunno what odds to give this, but at least its possible to generate some value to shareholders with such a plan. Ambac seems to be content to stick its fingers in its ears and sing the Star Spangled Banner as oppose to think of anything beneficial to its shareholders.

The bottom line is that we're finally getting to the reality of the monoline situation. They aren't going to be able to generate any new business in their current form. Finally the ratings agencies are acknowledging this. The mask has come off.

(By the way, the relevant lines are... "But you'll die" and "Nothing can stop that now.")


Anonymous said...

I agree with a lot of points. There shouldn't be anyone surprised by a downgrade.

The firms weren't doing a lot of new business, so the downgrades don't hurt them as much as their counterparties (if you use counterparty in the broad sense to include owners of insured bonds).

A significant impact will be on the rating agencies themselves since they will have to rerate huge numbers of bonds that previously relied on the insurers rating.

Don't forget that the AAA was always on the insurance subs. They use 'statutory' insurance accounting rather than GAAP, so they are likely not close to insolvent. They would just stop accepting new business and when their surplus (capital) was deemed sufficiently impaired, the State insurance departments would get involved.

As far as insolvencies, there have been some big ones -- Reliance and Kemper to name a couple.

The Jay Brown idea of using holding company capital to start a new insurer is interesting. Also, the reason the good company/bad company solution didn't work is that the insurance subs didn't have the capital to do it and remain AAA. If they are no longer AAA, then that option might come back into play.

cap vandal said...

As far as the credit default swaps on the insurance subs, exactly what is the reference issue and the trigger? As you noted, they could pay for a long time before running out of cash. Also, I am not aware that they have debt at the insurance sub level, except for some surplus notes, which aren't exactly debt.

Anonymous said...

hi, off topic but how many times did you watch Episode VI before it all sinks in ? :-)


Accrued Interest said...

Zig: They haven't been able to do any new business at all, at least in the primary market. I've read some claiming that MBIA and Ambac could morph into a reinsurer with a A or AA rating. Again, I'm no expert on the insurance business so I can't comment.

Moody's and S&P will not be re-rating anything. By this I mean, if they didn't have an underlying rating before, they won't now. Unless the issuer pays for it, that is.

Cap: I believe any insured bond is deliverable against the insurance sub CDS. So most likely people would deliver some really crappy ABS paper, as that would be cheapest to deliver.

Now it seems to me that those buying protection on the insurance sub are taking an awful risk. I've looked at Ambac's balance sheet and their insured exposure, and it sure looks like they have a decent chance of lasting in run-off for a very long time. So to get paid 20+ points up front sounds pretty attractive. I wouldn't actually do the trade unless I could really get up to speed on the legality of run-off, but it really makes you wonder.

Fred: I've been watching Star Wars for a long time... a long time...

Anonymous said...

Ziggurat, wrong - the AAA used to be on both the insurer and the holding companies. Most now have divergent ratings now but almost all were AAA / AAA for both.

As for the insurance of an insolvent insurer being worthless - WRONG! If ABK CDS is 700 over, and you can buy a wrapped bond at 700 over, buy the bonds. If the insurer is insolvent, that doesn't mean you get $0 if the wrapped bond defaults. You get (70% / 80% / 90% / 99%) of your bond paid back because the insurance assets are distributed to the claimants (as the senior creditors).

Accrued Interest said...

Anon: Calm down. I believe Zig was saying that MBIA Inc. was not rated AAA. They were rated Aa2 or lower since 1992 by Moody's. Same with Ambac.

Anonymous said...

Hi AI, sorry for a naive question: but I am not sure I understand what type of CDS has an upfront payement of 23%? and what about the 500bps a year? They are paid quarterly on top of 23% upfront? Thanks, peter.

Accrued Interest said...

A lot of high-yield CDS trade in points-up-front instead of a straight spread. If you want to protect $1 million of exposure, and the CDS is 20 points up front, then you pay...

$200,000 to the seller up front
$12,500/quarter ($50,000/year) until mty or default event.

My understanding is that since the HY market typically trades in dollar price (and not spread) trading CDS in this manner fits the cash market better. So like 5-year GM bonds trade in the 70's dollar price, it makes more sense to trade the CDS with points up front.

Anonymous said...

Sorry if this is not in sync with on going discussion but just wanted to acknowledge that there are many silent admirers of this blog (my whole office) being one of them.
Please accept thanks from our behalf.

Accrued Interest said...

Thanks Andy.

For whatever reason, I usually get critical comments and positive e-mails. There's a phychology experiment in there somewhere.

PNL4LYFE said...

Couple of interesting things I've heard over the last few days:

1) According to many people with fairly deep knowledge on the subject, it's not totally clear how a default at the insurance sub will work for CDS holders. I believe AI is right that any wrapped bond is deliverable into the CDS. I've heard there are some wrapped bonds trading in the 50s which makes buying those bonds and buying CDS in the 20s a no brainer. But the fact that the apparent arb is so wide shows that many people aren't confident of how it will work.

2) MBI's recently issued 14% surplus notes require regulatory approval to pay the coupon. The first one is due to be paid on 7/15 and the request has been submitted to Dinallo, but not yet approved.

@AI regarding pts up front: I think the main reason is that protection sellers want to protect themselves against a jump to default in the first year or two of the contract. If you sold protection at 1400bp (roughly equivalent to 25 pts up front) but default happened within the first 6-12 months, you collect very little premium. Dealers usually switch from bp running to 500+pts at around 900bp which is around 15 pts up front.

But as you said, it's much easier to trade in pts up front because everyone has the same coupon. Only the upfront cash changes so it's much easier to unwind or assign old trades.

Accrued Interest said...

Thanks PNL.

FYI, S&P just cut Ambac and MBIA. Wouldn't want Moody's to get all the glory!

Anonymous said...

Why am I not surprised at all?

Anonymous said...

Can someon tell me on CDS trades if accrued interest is included on the fee when points upfront are in play