End of the Line for Monolines

 Skrevet av Garrett Johnson - Publisert 19.01.2008 kl. 04:38 (Oppdatert 19.01.2008 kl. 20:38)

Pol/Econ Financeemail email email email email email email divider translate email email email

Just a few days ago Merrill Lynch stunned Wall Street by reporting a net quarterly loss of nearly $10 Billion. It was the worst quarter in company history. This much was well reported.

What didn't get nearly the attention was the largest reason for Merrill's loss. This involves a little known company called ACA Capital and a financial model on the verge of collapse.

Merrill reported a quarterly net loss of almost $10 billion on Thursday. Part of the hit came from $3.1 billion in credit valuation adjustments related to the firm's hedges with bond insurers, which are also known as monoline insurers.

Most of the $3.1 billion loss came from Merrill's hedges with ACA Capital, a smaller bond insurer that's struggling to survive.

The rating of ACA's bond insurance unit was slashed to CCC from A by Standard & Poor's in December because mortgage-related losses could exceed its $650 million capital cushion by more than $2 billion, the agency said.

Bond insurers agree to pay principal and interest when due in a timely manner in the event of a default. ACA has provided such guarantees on billions of securities, including more than $26 billion of collateralized debt obligations (CDOs), complex vehicles that are partly exposed to subprime mortgages.

If a bond insurer gets downgraded, in theory all the securities it has guaranteed have to be downgraded too.
Financial institutions that trade in mortgage-backed securities very often buy insurance, in the same way you buy insurance for your car, to protect themselves in the event of a default by the mortgage borrowers.

The problem is that a tidal wave of mortgage defaults are sweeping the nation, creating so many losses that small bond insurers like ACA are getting swamped. As it stands, ACA is expected to go under any day now.

Of course this means that when the bond insurer goes bankrupt all the bonds that it had insured are no longer protected, hence they are riskier. In the world of bonds, price and risk are directly and inversely proportional. Merrill's bonds go down in value the closer ACA gets to bankruptcy. Thus the huge losses.

Monolines Death Watch

So a little bond insurer went under. So what does this have to do with the price of rice in China? The problem is that this isn't limited to just ACA. The large bond insurers are approaching bankruptcy as well.
Credit-default swaps tied to MBIA's bonds soared 10 percentage points to 26 percent upfront and 5 percent a year, according to CMA Datavision in New York. That means it would cost $2.6 million initially and $500,000 a year to protect $10 million in MBIA bonds from default for five years.

The price implies that traders are pricing in a 71 percent chance that MBIA will default in the next five years, according to a JPMorgan Chase & Co. valuation model. Contracts on Ambac, the second-biggest insurer, rose 12 percentage points to 27 percent upfront and 5 percent a year, prices from CMA Datavision in London show.

Ambac's implied chance of default is 73 percent, according to the JPMorgan data.
Ambac and MBIA are not small companies. The seven bond insurers are responsible for $2.4 Trillion in structured debt. Ambac alone insures $556 Billion of debt.

And speaking of Ambac, they got downgraded from AAA to AA after the market closed today. The rating agencies are also looking at cutting the ratings of MBIA next week. But like Enron, the rating agencies are way behind the market which has traded their debt as junk for months now implying "a rating of 'Caa1,' seven levels below investment grade and 14 notches below its actual rating."
``The likelihood is quite high the others will follow,'' said John Tierney, credit market strategist at Deutsche Bank AG in New York. ``Barring some significant development on new capital, it's just a matter of time before S&P and Moody's act on MBIA and Ambac.''
{ad align='right' size='250'}These downgrades mean a lot more losses are in the works for financial institutions. If all the bond insurers were to be downgraded, that would mean $200 Billion in losses for whoever holds debt that is insured by the monolines. If the monolines all go bankrupt then the losses would be much more.

To put that into perspective, total losses from the entire subprime credit cruch since August that have rocked the financial world and garnered headlines so far have only amounted to a little over $100 Billion.

That's right. The damage from the credit crunch that has worried so many people could triple in the coming weeks.

And for these struggling bond insurers, bad news can lead to more bad news. An entire financial model is on the verge of collapsing.

How it hits home

The next question you should be asking is, what sort of debt do monolines insure?
The industry guaranteed $100 billion of collateralized debt obligations linked to subprime mortgages, $22 billion of non-prime auto loans and $1.2 trillion of municipal debt.
Most local and state governments have rules that require that their municipal bonds be insured. Ambac and MBIA alone insure $700 Billion in muni bonds.
The downgrade likely means Ambac will not underwrite any more business, said John Flahive, director of fixed income for BNY Mellon Wealth Management.
With MBIA's downgrade just days away, the two main sources of muni bond insurance are about to stop new business. For local and state governments that require the bonds be insured that means no new schools will be built. No sewer systems upgraded. No bridges repaired.

And it gets even worse.
Several types of municipal issuers will be most vulnerable if they can no longer secure insurance. These are borrowers like small private schools and hospitals that are not backed by a regular tax base or revenue stream. Typically, these entities have had to secure insurance to gain credibility with the public and sell their debt.
At the very least, local and state governments will have to pay higher interest on the debt they issue. Coming at a time when the economy is entering a recession, this could put an additional strain on the budgets.

At the worst, they won't be able to sell their debt at all.

Pol/Econ Financeemail email email email email email email divider translate email email email