My Two Cents - "The Story no one is talking about"

06/06/2008

Yesterday, Standard and Poor’s downgraded monoline bond insurers AMBAC and MBIA from AAA to AA. While on the surface, this may seem rather insignificant, what we’re talking about here are essentially insurance companies for municipal and mortgage-backed bonds, among other things. These two downgrades have serious implications. But let’s first take a look at the anatomy of bond insurance.

Municipalities rarely have the lump sums of money on hand to pay for large infrastructure projects like roads, water and sewer facilities, bridges, and schools. So they sell bonds which allow them to collect the money needed to pay for the project then stretch the payments out into the future. These bonds are often sold publicly and may be held by a variety of investors. There are mutual funds, closed-end funds, and exchange traded funds that focus on municipal bonds as a large part of their portfolio. Most bonds are rated and insured. The rating attests to the creditworthiness of the bond issuer, in this example, the municipality. Bond insurance provides bondholders with an assurance that should the issuer default, the bondholder will get their money back. Bond insurance adds to the intrinsic value of the bond since default risk is either greatly reduced or eliminated.

A second type of bond which has become rather notorious of late is the structured finance bond. Mortgage-backed securities are a very common type of structured finance bond. In the case of the mortgage-backed security, the payments to bondholders come from monthly mortgage payments made by homeowners. See a possible problem here? Many of these bonds are also insured to lessen or eliminate default risk. The mortgage-backed securities are then rated based on statistical models which portray the likely default rate based on various economic scenarios. Ironically, many of these bonds were rated AAA; the highest rating given.

For reference, the following is a summary of S&P’s rating nomenclature (from Wikipedia):

Investment Grade
AAA: the best quality borrowers, reliable and stable (many of them governments)
AA: quality borrowers, a bit higher risk than AAA
A: economic situation can affect finance
BBB: medium class borrowers, which are satisfactory at the moment
Non-Investment Grade (also known as junk bonds)
BB: more prone to changes in the economy
B: financial situation varies noticeably
CCC: currently vulnerable and dependent on favorable economic conditions to meet its commitments
CC: highly vulnerable, very speculative bonds
C: highly vulnerable, perhaps in bankruptcy or in arrears but still continuing to pay out on obligations
CI: past due on interest
R: under regulatory supervision due to its financial situation
SD: has selectively defaulted on some obligations
D: has defaulted on obligations and S&P believes that it will generally default on most or all obligations
NR: not rated

These ratings are assigned after an analysis of the specific financial situation of the entity being rated. Cash flows, debt, and economic conditions are just a few of the factors used in assigning the rating.

Why are ratings important?

Ratings help investors in that they are supposed to provide guidance on the likelihood of a particular entity defaulting on its debt obligations. For example, the US Government has been given a AAA (highest) credit rating by S&P. Ostensibly, the US government cannot default unless it actually chooses to, but that is the topic of another discussion. The AAA rating portrays the highest degree of stability and conversely the lowest degree of risk. Investors expect to be paid to take risk. One would therefore anticipate the yield on a BBB rated bond to be higher than that of an AAA rated bond and so forth. Accurate ratings are a necessary component of pricing risk.

Since AMBAC and MBIA insure bonds, the bonds are also priced with the benefits of that insurance in mind. It is obvious why a bond with no insurance would be worth less than a bond with insurance. But what about the quality of the insurance? What happens if it becomes more likely that the insurer cannot meet its obligations? Until recently, this has not been an issue. However, the misallocations of capital over the past decade or so have placed an increased burden on virtually every component of the financial system and the veracity of bond insurers has been brought into question.

AMBAC for example guarantees more than a half trillion dollars of debt, focused mainly in public (municipal) debt or structured financial products such as mortgage-backed securities. While it is unlikely that the entire $524 Billion parcel they guarantee would default, AMBAC must be able to pay up on whatever portion does indeed default. With credit conditions as stressed as they have been and foreclosures rewriting the record books before the last entry’s ink is dry, the prospect of these companies having to make significant payouts has become more and more likely. This as their ability to make such payouts has become more and more uncertain.

AMBAC and MBIA have been on the credit watch list for some time now. That in and of itself is not news. The constant threat of downgrade was a daily news item three months ago before the Bear Stearns bailout. What IS news, however, is that the downgrade has actually taken place. This means that all of the bonds that are insured by either MBIA or AMBAC will need to have their value reassessed. Remember, bond insurance adds intrinsic value to the bond. So it would follow that shaky bond insurance isn’t as valuable as bulletproof insurance. In the case of AMBAC, $524 Billion worth of bonds will need to be revalued. Over at MBIA, the numbers get even bigger with approximately $673 Billion worth of bonds insured.

I would make the case that the ratings for both of these companies, should in fact, be much lower. Simply put, both of these companies need favorable economic conditions in order to continue meeting their obligations. They need minimum defaults. They need the housing market to bottom and for people to pay their mortgages. Rising unemployment (now officially at 5.5%; unofficially much higher) does not help. Continued record home foreclosures and falling prices do not help. High food and energy prices eating discretionary income do not help. Tight credit markets do not help in that it hinders the ability of both companies to gain favorable financing terms. Jefferson County Alabama and Vallejo, California are both teetering on the brink of bankruptcy. As tax revenues continue to fall due to defaults and foreclosures there are bound to be more municipalities calling ‘Uncle’. Their bonds insurers will need to pay up. These macroeconomic conditions will only place more strain on the balance sheets of the bond insurers. To make matters worse, lower credit ratings also make it more difficult and expensive for these companies to acquire additional capital with which to meet their obligations.

Implications for Investors

Put simply, any investor who holds bonds in their portfolio insured by either of these companies must examine those holdings in a different light. They are not worth as much as they were yesterday and must be valued accordingly. Given the fact that the ratings agencies have been so far behind the curve in applying ratings that reflect economic reality, this situation is likely much worse than it would appear on the surface. Absent an intervention (discussed below), AMBAC and MBIA are now almost totally dependent on economic factors that are totally out of their control. In reality, this has been the case for some time, but the recent downgrades affirm it.

Counterpoint

On the other hand, this may not prove to be a big deal at all. On March 15th, the Federal Reserve affirmed its role as the lender of last resort. It asserted itself as the ultimate protector of the banking system. If push comes to shove, the Fed or the government may decide to guarantee the more than $1 Trillion in bonds guaranteed by these two companies. Bond insurance might effectively become nationalized. Again though, the cost of this course of action must be analyzed. The US government is insolvent when you adhere to Generally Accepted Accounting Principles. The Fed’s finances look at least as bad as AMBAC’s right now as it has taken billions of dollars in worthless mortgage bonds onto its own balance sheet to protect its member banks. Where is the money for yet another bailout going to come from? Sadly, the answer lies with overseas investors and in a higher cost of living for Americans.

We will discuss this situation at length on this week’s episode of ‘Beat the Street’, live Sunday night at 8:30PM on Blog Talk Radio. Visit www.blogtalkradio.com/my2cents for more information, call-in numbers or to listen live!

Graham Mehl is a pseudonym. He is not an ‘insider’. He is required to use a pseudonym by the policies of his firm when releasing written work for public consumption. Although not an insider, he is astonishingly bright, having received an MBA with highest honors from the Wharton Business School at the University of Pennsylvania. He has also worked as an analyst for hedge funds and one G7 level central bank.

Andy Sutton is a research and freelance Economist. He received international honors for his work in economics at the graduate level and currently teaches high school business. Among his current research work is identifying the line in the sand where economies crumble due to extraneous debt through the use of economic modelling. His focus is also educating young people about the science of Economics using an evidence-based approach.