Thursday, July 24, 2008

And now young monoline... you will die

Sometimes life is unfair. Take, for example, Moody's Investor Service's ever changing criteria for a Aaa rating. On Monday, Moody's put both Assured Guaranty and FSA's Aaa rating on negative watch. This despite Assured Guaranty having excess capital, defined as 1.3 times Moody's assumed losses given a "stress" scenario, and FSA falling short by only $140 million. FSA, it should be noted, just secured a $5 billion line of credit with parent Dexia.

In both cases, Moody's cited declining use of bond insurance in general: "Bond insurance volumes in the municipal segment have also declined significantly, with insurance penetration rates dropping by a third or more." It seems Moody's has concerns that the decline of muni insurance in general is a negative for FSA and Assured Guaranty's long-term business models. Which is interesting since both FSA and Assured Guaranty have both increased their market share considerably. In Assured's case, they are writing substantially more business now than last year, and for FSA its at least close.

It still looks to me like FSA and Assured Guaranty have plenty of capital, especially given their lack of ABS CDO exposure. But it isn't my opinion that matters. So what should municipal investors do with their FSA and Assured Guaranty paper? And would a downgrade of either lead to an investment opportunity?

First, consider what "negative watch" means. In most cases, negative watch turns into a downgrade, unless some intervening event occurs. For FSA, its possible that Dexia contributes capital to bring FSA above Moody's target levels. But given that Assured is already above those levels, its not certain that a capital infusion would make any difference. So investors should assume that FSA and Assured Guaranty will be downgraded. I would also assume that S&P will eventually follow suit.

Within an existing portfolio, look at each credit in your municipal portfolio. Are there any that you own strictly because of the insurance? If so, you are probably best to get out now. Get the underlying rating of all your positions. If you are with a financial professional who cannot readily provide the underlyings... well, that should tell you something.

As far as looking for opportunities, they will be there for investors with long investment horizons. But be aware of liquidity. Institutional investors are going to be better sellers of insured bonds for some time to come. Scrutiny from the public (in the case of publicly reported portfolio) or from a board (in the case of insurance companies) will cause portfolio managers to shun bonds where a downgrade is expected. If you bid on a FSA insured bond today, the odds are fair that you are the only bidder. And what does that tell you about your ability to sell the bond yourself? If you are going to bid on a FSA insured bond, make sure you bid a price at which you are comfortable holding for the long-term.

Of course, if you do decide to look at a FSA insured bond, you need to look at the underlying rating. Until recently, the market didn't price A underlying bonds much differently than those with a AA underlying ratings. That's going to change in a big way. Investors will demand significantly more yield for an A-rated risk, even before FSA or Assured gets downgraded officially. Keep this in mind when bidding on bonds. Among non-insured bonds, the gap between A and AA is about 50bps, which is about 4% in price on a 10-year bond.

I had previously said I thought that municipal insurance would remain viable, despite the problems with FGIC, Ambac, and MBIA. I think the fact that a large percentage of new issues in 2008 have carried insurance bears that out. However, if Moody's (and S&P) cannot establish consistent guidelines for maintaining a top rating, then it will be impossible for insurers to plan for capital adequacy. Having the Aaa rating is crucial to that business, yet its unknown what the criteria will be from week to week. That's an impossible business to capitalize intelligently.

Ironically it won't be a lack of demand that kills muni insurance, but a lack of supply.


PNL4LYFE said...

Not precisely on topic, but I heard something interesting this morning. Collective state budget deficits have tripled this year to $60bn. What could that mean for underlying ratings? Could this potentially offset some of the upgrades resulting from the change in methodolody for muni credits?

Tony Towers said...

I expect FSA to soon draw on its line of credit with Dexia. FSA is Dexia's most important line of business. They will draw, in my opinion, at least $500 million, far more than incremental excess capital reserve requirements under a stress scenario.

Gringcorp said...

Nice headline. I was't that sure that Berkshire's monoline was going to grab market share, since it didn't seem to be hiring many people. But BH has an advantage, in that the agencies will be warier about downgrading its monoline, in my cynical opinion.

Your next post could be titled "Help Me Obi Warren Buffett Kenobi, you're my only hope."

Accrued Interest said...

PNL: Working on a piece about property tax collections. I'm not real worried about states, but if it weren't for this Gloabl Scale BS, I'd expect more downgrades than upgrades certainly. Generally speaking, states have a whole bunch of revenue sources, and they've dealt with decreases in sales taxes or income taxes many times in the past.

But falling property taxes has been much more rare. So I'm most worried about local governments. I'm specifically using LA as a test case.

As we speak, every deal that was going to come with FSA is coming uninsured.

GS751 said...

the best part of this post was the title.

Jenny and Shawn said...

TDG, you're overreacting. Moody's has lost all credibility already and is just running scared, trying to show they were "being fair and thorough" on all monolines as they brace for lawsuits from all quarters.

Read their press release. As you note, AGO is still over $100 million ABOVE the threshold of 1.3x losses in a "stress" scenario that Moody's has been using. So what's the catalyst for the negative watch?

This is just Moody's moving the goalposts on Aaa criteria without notifying the company. No insurance company has ever (as far as I know) or should ever have its credit quality judged on its ability to write new business. Why should we care if Allstate writes a single new policy? Their underwriting, loss reserves and investment portfolio quality should be the key metrics. Wouldn't an insurance company that *had to* write new business to maintain its credit quality be called a Ponzi scheme?

Furthermore, if an overall decline in muni insurance in general is a negative, then why does BHAC debut with a Aaa, as an entrant into a declining market? This is like Moody's assigning a Aaa rating to a buggy-whip maker who enters the industry in 1920, just because they have no history in it. (Heck, with this criteria, let's start the Accrued Interest Assurance Company -- since we have no legacy business and no portfolio to "stress test," we can debut at Aaa, too!)

Or if the ability to write new business was so important, then why weren't the bigger writers like MBIA and Ambac awarded quadruple-A ratings since they had more new issuance and greater market share?

Is it any wonder that Berkshire owns a big stake in Moody's?

What a joke.

Disclosure: long FSA and AGO insured muni bonds, all with investment grade underlying ratings independent of insurance

Anonymous said...

Local governments (mostly public schools) in Illinois that rely on property taxes levy an amount of total dollars. This won't change with falling property values. There will be political pressure to curb spending, but defaults on existing bonds would seem posible only in a total economic collapse.

Accrued Interest said...

RBN: I basically agree. But if you live in a mark to market world, like I do, you have to be thinking about what bonds are likely to perform better than others. I'd rather own a university or sewer system than a school district right now. I mean, I'm not scrambling to sell my school districts, but I'm cautious on them.

Jenny & Shawn: Again, I mostly agree with you that AGO should be able to perform on all their obligations. But my opinion doesn't matter. Neither does yours.

Gringcorp said...

I'm glad, Jenny and Shawn, I'm not the only one to notice the BH/Moody's connection. Buffett's position as the kind of patron saint of American capitalism, despite the untold messes his insurance businesses seem to tread in, is a mystery to me.

Tony Towers said...

You said that the majority of bond offerings were insured this year. Have you been able to determine if there was a decline in the second quarter. What was the percent of the bond offerings that were wrapped in the first quarter versus the second quarter?

Accrued Interest said...


No I said that FSA and AGO insured the majority of bonds that did come with insurance. In fact, it was probably like 95% starting in February or so.

I don't have the stats on the 2Q vs 1Q handy, but its definately falling. And now nothing is coming insured.

Dave Wright said...

What would you do?

I've had an FSA insured muni from Pitt County, NC yielding 5.5% since the Fall of 2000. The CUSIP is 724500DU4 . I think it is a School Facilities bond.

After reading the post, I had my broker get the underlying rating. He told me this morning that it's:
Moody's: A1
S&P: A+

This is a strict income stream for me, so I'm not overly concerned it it were to drop a few percent in value as long as it keeps paying the coupon.

Should I be concerned about the underlying rating, or are these OK?


Accrued Interest said...


Did your broker tell you anything ELSE about that bond that might be pertinent? Like that its pre-refunded?

Your bond is backed by an escrow account funded by U.S. Treasuries. Zero credit risk no matter what.

Dave Wright said...


I'm guessing that I should have been able to tell that from the "PRF10" notation. Alas, I am still a lowly Padawan with much to learn.

And no, the broker didn't mention that. I've found that most of them don't really understand the bonds any better than I do and have to ask the bond desk for most questions.

Thanks for the reply. This site is helping me learn a lot.


P.S. I won't reraise the issue about US Treasury credit risk that was the subject of a post a few weeks ago. Did you hear that the Fed deficit for this FY was revised up by 20% today?

Accrued Interest said...


Its a shame... but most brokers are like that. Bonds don't get a lot of attention. P.S. That's why the muni insurance business thrived.

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