The credit markets must be getting tired of watching the unthinkable happen. But when Fitch Ratings finally downgraded monoline insurer Ambac on January 18 it sent shock waves through the market that were reminiscent of the worst of the sub-prime crisis last summer. "The monolines now represent the biggest threat to the credit market – this will be sub-prime all over again," warns an investment banker.
The downgrade of a monoline has always been seen as an Armageddon prospect in the credit market – and one that many participants believed would never happen (see Monolines: Beyond protection, Euromoney, December 2007). The impact of Ambac’s downgrade on MBIA is plain to see (see chart) and confidence in their guarantees has evaporated fast.
|
MBIA equity and CDS levels |
 |
|
Ambac equity and CDS levels |
 |
|
Source: SG |
The sense of confusion and disarray in the monoline sector has been stoked by the rating agencies, which have repeatedly revised their loss assumptions and capital requirements for the insurers. Standard & Poor’s announced a further review of the entire sector in early January following changes to its methodology on US RMBS and CDOs. The result of this was that MBIA was required to put up an additional $340 million of capital and Ambac’s capital requirement rose from $1.85 billion to $2.255 billion. MBIA has a $2.5 billion capital plan in place (a combination of Warburg Pincus investment and reinsurance) but Ambac’s capital cushion was woefully short at about $1.6 billion.
Fitch made it clear that if Ambac was unable to raise an additional $1 billion, it would be downgraded. The original indications were that the downgrade would be to double-A plus, but when it came it was to double-A and stayed on negative watch. "We are really surprised by the downgrade," admits a structured financed banker. "We did not expect it at all."
Although Ambac is not the first monoline to be downgraded (ACA’s rating was slashed to triple-C), its size and market share mean that the impact will be significant. The brunt of this will be felt in the US municipal bond market. Roughly 50% of the $180 billion muni market is wrapped. If MBIA also gets downgraded, the rating agency action on those two names will destroy the triple-A rating on $1.2 trillion of debt. The biggest worry for the structured finance market is the impact that worthless monoline wraps will have on bank write-offs from the ABS CDO sector. Monolines have been widely used to hedge bank exposure to the structured finance market, with the guarantor acting as a CDS counterparty in a negative basis trade. If these contracts become redundant, the scale of write-offs that many banks will have to take could balloon. Merrill Lynch recently announced an additional $2.6 billion in write-downs arising from monoline wrapped transactions.
Generalized nervousness
Although the Ambac downgrade is a blow, the big risk is that nervousness will now affect the entire sector – regardless of each firm’s capital position. "We were surprised that Ambac and MBIA CDS have traded so closely, given the difference in their position," say Jean-David Cirotteau and Chris Greener at SG CIB credit research in London. "MBIA had announced firm plans to add around $2.5 billion of risk exposure whereas Ambac had little more than good intentions." They add that the market is left with the sense that it is impossible to quantify the amount of capital that rating agencies require to move on from the sub-prime problem. "Market sentiment reflects little confidence that rating agencies have correctly identified the risks to the financial guarantor industry," they claim.
Ambac’s downgrade was triggered by $3.5 billion of write-downs on guaranteed securities and its inability to raise a $1 billion capital injection but the implications of the decision will be many multiples of that. According to Bloomberg, if Ambac, MBIA and FGIC all lost their triple-A ratings, losses in the municipal and structured finance markets might hit $200 billion. It seems incomprehensible that the market will sit back and allow these firms to lose their triple-A status given the extent to which the banks have relied on the monolines to hedge their exposure to the structured finance market. Surely some form of bank-orchestrated rescue would be in those same banks’ best interests, rather than a full disintegration of the monoline sector being allowed to run its course? "Bank and broker balance sheets may be highly stretched, but an effort to organize a bail-in, where all players (ideally both US and European) inject equity capital either into the major remaining monolines or into a single monoline reinsurer could dramatically change the outlook for monoline ratings," says Christian Stracke at CreditSights.
However, Hank Calenti, director of financial institutions at Royal Bank of Canada Europe, reckons the chances of this are slim. "We do not anticipate a coordinated bailout of the distressed monolines," he said on January 21, before news of a potential regulated plan. "There are low barriers to entry into the market and stronger rivals are now benefiting from their more conservative positioning."
Certainly FSA and Assured Guaranty, which largely avoided writing business in the ABS CDO market in recent years, have fared well compared with their contemporaries. And Warren Buffett’s recently formed Berkshire Hathaway Assurance Corp will be well positioned to take business from the incumbents. But this market is interlinked, and it will be difficult for even the strongest players to remain immune to contagion. FSA’s owner, Dexia, has announced that the firm has reinsured $3.4 billion of Ambac-wrapped bonds and has $512 million of Ambac exposure in its portfolio. It has also purchased $1.3 million of reinsurance from Ambac. "While there is likely to be some impairment in value, we do not feel the magnitude is likely to be material in the context of FSA’s ratings," says Ron Thompson, head of securitization and real estate research at RBS.