The $2.5 trillion bond insurance problem

[pepe]

LONDON, Nov 6 (Reuters) - Bond insurance, a key safety net of the financial system, is looking vulnerable, raising the possibility of another round of forced sales, writedowns and contagion.

Fitch Ratings said on Tuesday that it may cut the AAA ratings of bond insurers after an upcoming review of their exposure to complex collateralized debt obligations.

This matters a lot, because the bond insurance companies, such as Ambac and Financial Guaranty Insurance Company, have insured a collective $2.5 trillion of bonds and structured financings.

If the ratings of one or more of the bond insurers are cut, the rating on the bonds they insure, many of which are municipal bonds, will fall too. This may force some investors who can only hold very secure debt to sell, depressing prices which would already be under pressure due to the lower value of an insurance policy from a lower rated company.

It could also touch off another round of writedowns by banks, insurance companies and others who hold instruments insured by these companies.
It could hit the staid municipal bond market especially hard, as about $1.6 trillion of the bond insurance in force is municipal. The rest is asset-backed debt of various types, including subprime.

None of this, including the review, will make it easier for the insurers to raise capital to shore themselves up.

In the unlikely event of a default, things could get really dire.

"What if the bond insurers default? You could think it does not matter because they are small companies," Credit Suisse analyst Guillaume Tiberghien wrote in a note to clients.

"The problem is that overnight the $2.5 trillion of insured bonds would reverse back to the ratings of the issuer... Imagine the impact on the economy of a downgrade of $2.5 trillion of assets.

"The current LBO and CDO write-downs experienced by the banks during the third quarter would appear very small in comparison."

While Tiberghien cautions that what he lays out is a very gloomy scenario, fear of it is probably a large factor behind the recent market sell-offs.


SAFE AS HOUSES?

So, how did the insurers get themselves into this situation and how worried should we be?

Fitch said it was carrying out a review after a series of downgrades of CDOs tied to subprime mortgages by itself, Standard & Poor's and Moody's, saying they had been "broader and deeper" than previously anticipated.

Fitch said it would take four to six weeks to review the situation and if needed give any companies facing a downgrade a month to raise capital or take other steps.

Given that the rest of the world has taken a bit of notice of how badly subprime and some CDOs are performing, that wouldn't be easy.
Fitch said that CIFG Guaranty, owned by French bank Natixis,and Financial Guaranty Insurance Co, the bond insurer whose owners include private equity firm Blackstone Group, had a "high probability" of facing erosion of their capital cushions. AMBAC and Security Capital Assurance faced a "moderate probability" and MBIA Insurance had a "low probability."

Standard & Poor's is carrying out a similar review.

Markets, for their part, have voted with their feet on the insurers.

Credit derivative traders have recently valued Ambac and MBIA as deep junk. The cost of insuring AMBAC against default has soared from 185 basis points a month ago to 620 basis points last week, while its shares are down about 60 percent since the beginning of October. Security Capital shares have fallen by more than 75 percent from their 2007 peak.
Ambac on Tuesday posted a rebuttal on its website to a critical Morgan Stanley report, saying it was confident in the quality of its internal credit rating process.

To be sure, Ambac and others have been vigorous in defending their creditworthiness.

But two points make me very cautious, if the Fitch review passes without issue.

First, a spreading of contagion into municipal debt is likely to bring up another round of unforeseen and unmeasurable consequences, few of them good.

Second, the housing, subprime and prime, that is causing the problem in the first place is worth less day by day, is falling farther and faster than credit committees could reasonably have expected, and will continue to fall for quite some time.

Reuters

[Caldric]

I am sure Brian and Shooter are going to have fun wrapping around this one. I just don't have the mind to understand these global economics. I get lost, perhaps that is because they make it so weird a normal person can't relate. (no offense shooter brian haha)

[Shooterman]

Originally Posted by Caldric

I am sure Brian and Shooter are going to have fun wrapping around this one. I just don't have the mind to understand these global economics. I get lost, perhaps that is because they make it so weird a normal person can't relate. (no offense shooter brian haha)

No offense taken, Caldric. I'll just say this; Top and I go back a long way, even farther than I do with some of you from the old Ironside forum, and there is usually very little we do not agree on.

I certainly don't always understand how the machinations of the financial community works.

I do know this appears to be just another example of the economy in freefall. What affects the biggest investors eventually affects all of us, especially those of us on limited incomes.

As an aside, when I read this yesterday, and considering the little podunk town I live in, ( population about 120000 ) just passed a 389 million dollar school bond issue to refurbish and build new schools, among other things, I'm sure, and it passed with about 1/10th of the people voting both sides of the issue, the best I can hope for is the silly buggers won't be able to sell the bonds without insurance on them, effectively killing the issue.

This same school district has the 2nd highest paid superintendent in the state of Texas, BTW, and so much dead wood at the top as to make one's head swim.

[BrianK]

Notice that main stream media isn't picking up on the various parts & pieces of what is happening.

I'm not sure if it's because the democrats are putting legislation together concerning taxes or if the reality of the economy hitting the skids as it did in 1929.

I tend to think about this as the perfect storm with significantly more factors. Trade imbalance, lagging education, health issues, dollar decline, increasing personal debt, lower work force, higher draw on social programs, wages to sustain the economy much higher that emerging countries, suburban living as opposed to urban, dependent on oil.

Toss in the goal of the radical islamics to ruin our economy as a way to dominate and we are on a path that doesn't look good. Of course the bond problem is in there too and a part of the bigger picture.

IMO we've been programmed to depend on Gov. to solve our problems. In order to get re-elected over & over I think many politicians have created the problems we are facing.

[Caldric]

I heard an interview of Lou Dobbs this morning, who just released a new book "Independents Day". I also sent him CNN also and he was raving haha was good stuff he told Republicans and Democrats to go to hell hahaha. My sentiments also.

But anyway in the interview he made a good point about how Corporate America in the last 20 years has dislocated its self from the great American Democracy. That since the beginning they have been a part of it but have now sold out national concern for global profit.

He said things like corporate investment in our own country and its significant weight in politics has been sold out to the Chamber of Commerce and its desires instead of being part of our nation. He was saying the CEO's of the past were some of our greatest leaders but now they are not even in the same world as the rest of us and no one even knows them. Well I would agree with him but we all know too well the CEO and leaders of ENRON and add your favorite we all know the crooks.

[pepe]

"Yesterday's excesses" now haunting Paulson, who helped create them.

New York: Treasury Secretary Henry Paulson says that the United States is examining the subprime mortgage crisis to ensure that "yesterday's excesses" are not repeated. He could be talking about himself and his former firm, Goldman Sachs.

Paulson does not mention that Goldman still has on the market an estimated $13 billion of almost $37 billion in bonds backed by subprime loans or second mortgages that it created while he was its chief executive. Those bonds have an average delinquency rate of almost 22 percent, higher than the average of other subprime bonds from the period, according to data compiled by Bloomberg.

Goldman, the most profitable investment bank, was one of 14 primary dealers of U.S. Treasury notes that contributed to a three-year binge as $1 trillion worth of subprime mortgages were packaged and sold to investors. The value of its remaining subprime bonds trails the $33 billion at Lehman Brothers, out of $106.8 billion created during the time Paulson was at Goldman, and $28.8 billion at Morgan Stanley, out of $82.5 billion.

"He should admit to having been involved in creating the problem that we have now," said the U.S. Representative Brad Miller, a North Carolina Democrat, who introduced a bill last month to make firms packaging subprime mortgages liable for bad loans in some circumstances.

The subprime crisis developed earlier this year when falling home prices triggered defaults by homeowners who would not have normally qualified for a mortgage. Starting in March, Paulson said that the damage was "largely contained" and was no risk to the larger economy. When other credit markets began to be affected, he and others began pushing for solutions.

"I can't help but notice that when middle-class homeowners were losing their homes to foreclosure, he was pretty nonchalant about it," Miller said of Paulson. "But when Wall Street CEOs start seeing trouble in their absurdly complicated financial instruments built on the mortgages of middle-class homeowners, he feels their pain."

Paulson declined to comment, said spokeswoman Michele Davis. Michael DuVally, a Goldman spokesman in New York, declined to say how much subprime mortgages contributed to profits at the investment bank, or to Paulson's compensation during his tenure from May 1999 through June 2006.

Goldman paid Paulson $38.5 million for 2005, and he received an $18.7 million bonus for the first half of last year.

While competitors reported losses from their subprime portfolios in recent months, Goldman said in September that it profited from the market's decline by using derivatives to bet that mortgage securities would keep falling.

Paulson's involvement in the subprime crisis "points out that there needs to be complete accountability up and down the system," said Allen Fishbein, the director of credit and housing policy at the Consumer Federation of America in Washington. "Goldman wasn't alone. All the brokerages did this."

Goldman ranks 10th among 118 issuers based on the amount of subprime loans still on the market. Bonds with a face value of $484.6 billion remain from those created in the years Paulson ran Goldman.

The market leader, Countrywide Financial, has $40.7 billion in subprime bonds still on the market, or 8.4 percent of the total. GMAC's Residential Capital has $34.4 billion. Lehman leads Wall Street firms, with $33.1 billion.

Countrywide, the biggest U.S. home lender; ResCap, the home-lending arm of the General Motors finance subsidiary; and Goldman were among those competing to create pools of mortgages consisting mostly of subprime loans.

Goldman has more subprime debt outstanding than Credit Suisse, which has almost $10 billion; Citigroup, with $6.8 billion; or JPMorgan Chase, with $7.8 billion.

The data on subprime bonds, compiled by Bloomberg from reports by debt servicing companies, do not include all of the mortgage bond offerings managed by any of the firms. That is because all of them handle offerings by bond issuers outside of Wall Street, including New Century Financial, a subprime lender based in Irvine, California, that is now in bankruptcy.

The proposal Miller introduced in the House of Representatives is backed by Representative Barney Frank, the Massachusetts Democrat who is chairman of the Financial Services Committee. One provision would make firms that package and sell subprime mortgages liable for damages if loans violated minimum standards, including ensuring a borrower's reasonable ability to repay.

Paulson criticized the liability idea in a speech last month at Georgetown University in Washington.

"We need to ensure yesterday's excesses are not repeated tomorrow," he said. Penalizing Wall Street for packaging mortgage loans "is not the answer to the problem," he said. To which I say, BS!

IHT