Monoline concerns could rock capital markets

"By 1998, Dinallo's predecessor at the NY insurance superintendent's office agreed to allow monolines to sell credit-default swaps (CDSs) on asset-backed securities such as mortgages. The basic premise was that separate shell companies would be established, through which CDSs could be issued to banks for mortgage securities."


Monoline concerns could rock capital markets

By James Quinn
Last Updated: 1:19am GMT 04/02/2008
Source

The concerns over the monoline bond insurers could rock the capital markets still further, says James Quinn

As leading bankers crowded around the conference table in his Wall Street office 10 days ago, Eric Dinallo uttered three words that caused the assembled faces to recoil in horror.

Fifteen billion dollars. That amount, the New York Insurance superintendent claimed, would rescue the world's leading bond insurers, and so help to put the financial markets back on track.

For several present - having spent the past four months righting their own balance sheets - the prospect of propping up another set of ailing institutions was too much to bear.

The summit ended with no firm resolution and since then as Dinallo and others have worked on rescue packages to save the bond insurers, global markets have been rocked by concerns that the sector is doomed.

That few people outside Wall Street and the City of London had heard of bond insurers until the last few weeks is of little surprise.

In spite of the fact that their fortunes hold the key to the smooth running of the financial markets - and therefore the wider economy - companies such as MBIA, the world's largest bond insurer, have flown beneath the corporate radar.

The companies in the sector, which guarantee $2.5 trillion of public and corporate bonds between them, are also known as monolines, because they insure a single line of business - bonds.

Monolines were initially established to guarantee bonds from municipalities, such as local and state authorities or private finance initiatives, to help them raise money in the debt markets. The model was simple. By having a guarantee from a bond insurer with an AAA credit rating, the cost of borrowing was less than it would normally be and the number of investors willing to buy such bonds was greater.

For the monolines, guaranteeing such bonds was largely risk-free, with average default rates running at a fraction of 1 per cent. As a result, monolines leveraged their assets to build their books, and it was not being uncommon for a monoline to have insured risks 100 to 150 times the size of its capital base. Until recently, Ambac, for example, had capital of $5.7bn and guarantees of $550bn.

That changed, however, in the late 1990s, as companies in the sector were increasingly faced with reducing margins and an increase in local authorities issuing bonds without a guarantee.

By 1998, Dinallo's predecessor at the NY insurance superintendent's office agreed to allow monolines to sell credit-default swaps (CDSs) on asset-backed securities such as mortgages. The basic premise was that separate shell companies would be established, through which CDSs could be issued to banks for mortgage securities.

The move into structured finance went well. MBIA saw premiums rise from $235m in 1998 to $998m last year, boasting of an increase of 140 per cent in its structured finance book last year alone.

But then along came the US sub-prime mortgage crisis, and the music stopped for the monolines.

As the mortgages within bonds from the banks defaulted - sub-prime mortgages written in 2006 are already defaulting at a rate of 20 per cent - so the monolines had to step in and cover the payments.

On Thursday, MBIA highlighted the true extent of these problems, revealing $3.5bn of writedowns and other charges in three months alone, leading to a quarterly loss of $2.3bn.

And that is likely to be just the tip of the iceberg. "The answer is no one knows," says Donald Light, insurance analyst at US research house Celent, when asked what the potential downside loss is. " I don't think we will know to perhaps the third or fourth quarter of 2008."

Myer agrees: "Remember, an insurance company only has to pay out if something goes wrong with the under­lying risk. At the moment, no one quite knows what the probability is - and therefore they don't quite know what the outcome is."

Credit ratings agencies have begun downgrading the monolines, taking away their prized AAA ratings, which means a monoline can no longer write new business, and the bonds it guarantees no longer hold a AAA rating either.

To date, the only monoline to receive downgrades from two agencies - usually required for such a move to impact on a company - is FGIC, cut by both Fitch and S&P.

Ambac, the second largest monoline, has been cut to AA by Fitch, with the other monolines on a variety of different potential warnings.

Myer says the damage may already have been done. "The financial system works on confidence. To the extent that there is a threat of a downgrade to the monolines, people question the confidence they have placed in them as soon as the threat appears."

The extent to which each monoline can meet potential claim payments as they fall due is company-specific, but in the case of the traditional municipal bonds this should not be a problem due to the largely low default rate.

Investors may seek to sell off such municipal bonds in the event of a downgrade, but given the stagnation in the credit markets, fears of a rapid sell-off are understood to be somewhat overblown. However when it comes to the question of meeting claims from structured finance bonds, the situation is very different and unquantifiable.

MBIA stressed during its marathon four-hour results conference call on Thursday that it would be able to meet claim payments as they fall due, only for S&P to put it on notice just hours later that it faces a possible ratings downgrade.

Bill Ackman, the founder of hedge fund Pershing Square, argues that Ambac and MBIA face combined losses of more than $23bn from risky bonds, and has sent details of the potential losses to Dinallo.

Banking analyst Meredith Whitney of Oppenheimer & Co argues that investment banks face further writedowns of between $40bn and $70bn due to exposure to assets guaranteed by monolines.

Whatever the eventual exposure, the impact could have a significant effect on capital markets, rocking banks' balance sheets further, and, says fixed income expert Robert Kessler, slowing the economy further. "I don't think people have to worry about the monoline situation per se, but the backlash from it. We have conservative leaders at our biggest banks, and they're going to take us into a period of slow growth because they have no vested interest in being aggressive," he says.

But worry about the state of the monolines themselves is spurring on Dinallo and his plans for an industry bail-out, but is also behind the thinking of investors such as private equity house Warburg Pincus, which is backing MBIA up to $1bn, and to billionaire investor Wilbur Ross who is understood to be considering investing in Ambac.

Both can see the clear revenue streams municipal monolines have to offer, and the low ratings such companies have as a result of share price collapses over the past three months. Ross believes a shake-out will take place in the coming weeks, with few insurers emerging unscathed: "There's a lot of pain that will have to be borne by a lot of people. If you throw municipal bonds into disorder, you're going to have a world-class problem."

Warren Buffett has already established a new monoline focusing only on municipal bonds and which will not get circumvented into bonds linked to structured finance where all the problems have taken place. For those who rely on the current monolines, Buffett could be the way forward.

What his new monolines will not solve is the way the markets absorb the losses and writedowns lying ahead for bond insurers.