Risk Management

Should Monolines Blame Mark-to-market?

Despite downgrading two big bond insurers, Moody's says accounting rules that measure losses by market value aren't directly responsible for dimini...
Alan RappeportJuly 9, 2008

Losses that companies record for credit default swaps, using mark-to-market accounting, may not be a true indicator of credit deterioration, a new report by Moody’s Investors Services says.

MBIA and Ambac, two big bond insurers, recently have had their credit ratings downgraded by Moody’s, Standard & Poor’s and Fitch in the wake of the credit crisis, and both have faced heavy losses this year. Both had wide exposure to the CDS market, which tends to act as insurance against underlying credit instruments defaulting. But the mark-to-market charges that guarantors such as MBIA and Ambac are wrestling with may not by themselves actually affect their ability to pay claims, says Wallace Enman, a Moody’s vice president and author of the report.

“The magnitude of these charges has raised reasonable questions among some investors about the nature and degree of exposures at financial guarantors, as well as some confusion about how to interpret this information in the context of a guarantor’s financial strength,” according to the report.

Moody’s notes that guarantors have seen their financial statements damaged by the collapsed CDS market because they have to assign values based on current diminished market prices. However these are non-cash charges and, moreover, the losses will eventually be reversed when the CDS contracts expire.

MBIA contended in its March primer on mark-to-market accounting that market fluctuations do not matter to the fundamentals of its business because its CDS contracts are held to maturity. Aside from the $200 million in losses from defaults that it anticipates, MBIA expects the $3.7 billion market to eventually turn itself around.

Yet Enman acknowledges that the mark-to-market losses are more than just “noise.” They reduce firms’ financial flexibility and scare off investors, making it harder to raise capital. “Significant mark-to-market losses may dampen investor appetite for a guarantor’s debt or equity securities, inhibiting its ability to raise capital in a stress-loss scenario,” Enman says.

Insurers could face a cash crunch, according to Enman, if those that they insure cannot meet their debt obligations and are forced to terminate their CDS contracts and pay out the balance that is due. In those cases, which are considered extreme, an insurer might have problems paying claims.

S&P, another ratings agency, noted the impact of mark-to-market accounting on insurers last October. Like Moody’s, it argued that volatility in the market did not reflect the economic fundamentals of the insurers and that they should not directly impact their ratings. To account for this it incorporated different models that excluded mark-to-market and instead focused on metrics such as operating earnings.

In spite of such acknowledgments from the rating agencies, Moody’s, S&P and Fitch — all feeling more conservative of late — downgraded MBIA’s AAA rating last month, citing “diminished new business prospects and financial flexibility.” Ambac also saw downgrades, due to its shrinking market capitalization. At the time, MBIA claimed to be “disappointed” and “baffled” by the analysis.

“We have stated from the beginning that we believe MBIA Insurance Corp. has substantially more claims-paying resources and liquidity than it will need to satisfy fully all policyholder obligations on a timely basis,” Edward Chaplin, MBIA’s chief financial officer, said in a statement last month. “Now that the landscape has changed, we will re-evaluate our business strategies.”

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