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Another shady realm of finance goes begging for a massive bail-out.
Economist Staff, The Economist
January 25, 2008
This has been a crisis of risk in unexpected places. Think of collateralised-debt obligations (CDOs), structured investment vehicles (SIVs), and now a £4.9 billion ($7.1 billion) loss due to fraud at Société Générale. One particular nastiness has been festering in an obscure industry which, until recently, enjoyed pristine credit ratings: the "monoline" bond insurers. Their plummeting fortunes helped to spark the stock-market sell-off that prompted the Federal Reserve to act this week ahead of its scheduled meeting.
So perturbing was their plight that the prospect of a rescue caused a far bigger stock-market rally than the Fed's biggest rate cut in a quarter of a century the day before. There may be no better example of how a dull province of finance, when snared by complex risks it barely understands, can become terrifyingly unboring.
Though themselves no giants, monolines have guaranteed a whopping $2.4 trillion of outstanding debt. The two largest, MBIA and Ambac, cut their teeth "wrapping" municipal bonds, in effect, renting their AAA rating to the securities for a fee. For a long time this business, though staid, was nicely profitable.
But, as competition grew, the monolines — with two honourable exceptions, FSA and Assured Guaranty — were seduced by the higher returns of structured finance, especially the stuff involving subprime mortgages. As mortgage delinquencies rose, so did paper losses. Ambac and MBIA wrote assets down by a combined $8.5 billion in the past quarter.
The monolines' thin capital cushions, adequate when they wrote only safe municipal business, now look worryingly threadbare. Moody's and Standard & Poor's—the very rating agencies the monolines relied so heavily upon when piling into the mortgage business—are threatening downgrades unless they raise more equity. Ambac's failure to do so last week prompted Fitch, another rating agency, to cut its debt by two notches, to AA.
This has spooked investors for several reasons. First, heavily downgraded insurers would lose their raison d'être and thus face the prospect of selling up or going into "run-off": closing to new business and gradually winding down.
Worse, from a systemic point of view, when a monoline is downgraded all of the paper it has insured must be downgraded too. Hence, after its move against Ambac, Fitch went on to cut no fewer than 137,500 bonds (including one issued by Arsenal football club).
This is more than academic: holders of downgraded bonds have to mark them down under "fair value" accounting rules. Some, such as pension funds, may hold only the highest-grade securities, raising the prospect of forced sales. And, with fewer top-notch insurers to turn to, bond issuers' costs would rise. The loss of the AAA badge would cost investors and borrowers up to $200 billion, reckons Bloomberg, a financial-information firm.
Banks that were active in asset-backed markets have multiple reasons to worry. Many not only used monolines to wrap their products but also bought protection from them through credit-default swaps (CDS). One insurer, ACA, has already had problems paying out, prompting Merrill Lynch to write down its exposure to the firm by $1.9 billion. Meredith Whitney of Oppenheimer has calculated that banks may have to write off $10.1 billion of the paper they insured with ACA.
Because the CDS market is barely regulated, it is impossible to know how much of this monoline "counterparty risk" banks are exposed to. In many ways, ACA was an outlier: with a rating that never rose above single-A, it targeted inferior bond issuers (whom its boss once described as "the cream of the crap"). But downgrades could leave others struggling to pay out on policies too.
Monolines have a tiny percentage of the CDS business, according to the Bank for International Settlements. But the market is so vast that this still amounts to $95 billion of protection, most of it sold to banks. If Merrill Lynch is a guide, fully half of Wall Street's subprime and CDO hedges were booked with monolines, says Brad Hintz of Sanford Bernstein. As the risk of MBIA and Ambac defaulting has grown, he adds, so has the cost of holding once valuable hedges with them.
A lifeline for the monolines
No wonder, then, that a group of banks is giving ear to a request from New York' s insurance regulator, Eric Dinallo, who oversees some of the big monolines, to discuss a possible rescue. In preliminary talks held on January 23rd, Mr Dinallo reportedly asked the banks to stump up as much as $15 billion to help MBIA and Ambac preserve their ratings.
The regulator, who apparently has the blessing of federal officials, is talking to other potential investors too, said to include Wilbur Ross, a vulture investor, and Warren Buffett's Berkshire Hathaway, which recently set up its own bond insurer and has not ruled out buying part of a troubled rival. These veterans believe the business has a future, despite its woes. That is because they understand that, on the municipal side at least, the market has always demanded a much higher spread than the actual cost of risk, points out CBM Group's André Cappon. Clever guarantors can exploit this gap.
It remains unclear how any bail-out would be structured. One possibility is to create the equivalent of "bad banks", ringfencing the monolines' tarnished CDO operations to allow their municipal businesses to continue unencumbered, or be sold. This would also assuage fears that mishaps in securitisation might bring down the public-finance markets, says Janet Tavakoli, a consultant. Another idea would be to create a so-called "excess-of-loss pool" that would allow the monolines to reinsure their nastiest tail risks.
Banks have reasons to pause before taking part. They have seen a Treasury-backed bail-out of SIVs wither for lack of interest, and they are not exactly flush with capital. But it may be a bet worth taking, however gingerly. Even if $15 billion were needed, that is thought to be a lot less than their (undisclosed) total exposure to the monolines. A painful contribution now looks preferable to another agonising round of write-downs later this year.