The circus: ACA,Ambac and MBIA
As noted in my previous few postings, the fallout in the US financial markets might be far from over. I may have started hunting for bargains both in Singapore and Abroad but I am always checking whats ahead on the horizon.
John Mauldin explains best about the problem facing the largest bond reinsurers:
Here’s a quick primer on how they work. Let’s say you are a small municipality and want to borrow $10,000,000 for a bond offering to build a road or a water treatment plant. If you went to the market with your credit rating, it would be a low rating and the cost of the money would be high. But if you get one of the seven monoline insurers to guarantee your bond, then you get whatever their credit rating is. The fees for such insurance are lower than the savings you get on the bond, so everyone wins.
But over the years, most of the monocline insurers went from boring municipal bonds and jumped into the mortgage-backed security markets, selling credit default swaps that significantly juiced up their earnings. But it also added a lot of risk that they clearly, in hindsight, did not understand.
The extent of the fall out depends on alot of factors. To the markets, if this coincides close to the recent writeoffs with the subprime mortgages, we can look for the S&P 500 to go into a deep deep fall.
ACA has already seen its rating go from A to CCC, which is basically junk. This puts it out of business, as no one will pay to be rated as junk. ACA now has only $425 million in capital to cover the $69 billion in mortgage and corporate bonds they insure. Interestingly, they added $20 billion of that between April and September of last year. Talk about doubling down on a losing trade. Merrill wrote down almost $2 billion in bonds that were insured by ACA. They will not be alone.
Should they have seen it coming? Probably. However, when the market is less risky and volatility is low, these reinsurers are forgoing serious free premium. Only insane, yet sensible investors and managers would do that.
When Warren Buffett bought Gen Re, the large re-insurer, five years ago, he presciently made the decision to reduce their exposure to credit default swaps. It took them four years to reduce the number of contracts from 23,218 to just 197 at the end of 2006.
"We lost over $400 million on contracts that were supposedly ’safe and properly priced’ and we did it in a leisurely way in a benign market," says Mr. Buffett. "If we had to unwind it today in one month, who knows what would have happened?" (The Wall Street Journal)
This is something that i didn’t ponder about, yet maybe i should: How does a re-rating becomes a writeoff?
If you are a bank or regulated entity, and you have mortgage-backed securities that have been written by a AAA monocline company, you can carry that debt on your books as AAA. But as the companies get downgraded, you have to write down the potential loss. Quoting from a recent note from Michael Lewitt:
"MBIA’s total exposure to bonds backed by mortgages and CDOs was disclosed to be $30.6 billion, including $8.14 billion of holdings of CDO-squareds (CDOs that own other CDOs, or mortgages piled on top of mortgages, or, to quote Jeff Goldblum’s character in Jurassic Park again, ‘a big pile of s&*^’). MBIA was being priced as a weak CCC-rated credit when it issued its bonds last week; it is now being priced for a bankruptcy. MBIA’s stock, which traded just under $68 per share last October, dropped another $3.50 this morning to under $10.00 per share.
So who are the big winners and losers, like the S&L crisis last time, many of these banks and re-insurers might vanish from this financial world. Watch for the sovereign funds like Temasek to swoop in for large long term names in the financial markets. My opinion is that they might not make as much of a good choice as that of Warren Buffett.
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I found your site on technorati and read a few of your other posts. Keep up the good work. I just added your RSS feed to my Google News Reader. Looking forward to reading more from you.
Allen Taylor