Credit Crisis Tentacles: Bond Insurers

A: Such an important topic to discuss and one that we talked about months ago. Proof the credit crisis has tentacles, ratings agency Moody's threatened to downgrade the credit rating of Ambac, a bond insurer. Stretching this news out, Merrill plans to write off $2.6 Billion of default protection from Ambac & others, because that very protection of the toxic CDO's held, are now worthless. This is one of the events we discussed months ago that posed a possibility of haunting us as the credit cycle continues to play out.

First the news. According to Yahoo Finance article "Moody's Sinks Bond Insurance Stocks":

Bond insurance stocks plunged Thursday after a ratings company said Ambac Financial Group Inc.'s plan to raise cash may not be enough to save its crucial credit rating. Moody's Investors Service said Wednesday night it is considering cutting Ambac's "AAA" financial-strength rating, which would squelch the insurer's prospects for winning new business.

"A rating agency downgrade would be the death knell for Ambac," Friedman Billings Ramsey analyst Steve Stelmach wrote in a client note. "Merely the threat of a downgrade complicates the company's capital-raising plans even further."

Ambac and MBIA are under pressure to prove their capital cushions are sufficient to cover claims.

Bloomberg has the release on Merrill's write down of $2.6B as they realize the protection they thought they had for their toxic securities is worthless:

Merrill Lynch & Co., the biggest underwriter of collateralized debt obligations, said it will write off $2.6 billion in default protection from bond insurers including ACA Capital Holdings Inc. because it's worthless. Merrill Lynch's writedowns demonstrate how a downgrade of bond insurer credit ratings can spread throughout financial markets. Losing the AAA stamp would cripple the bond insurers and throw doubt on the ratings of $2.4 trillion of securities.

The bond insurers guaranteed almost $100 billion of CDOs backed by subprime-mortgage securities as of June 30, according to an Aug. 2 report by Fitch Ratings. Most of those guarantees are in the form of derivative contracts. Unlike insurance, those contracts are required to be valued at market rates.

Back in late October, the bond insurers started getting whacked, raising this concern. Then in November, I discussed it in more detail when ACA Capital's stock was halted for news pending.

First Bond Insurer Close To Insolvent

If ACA loses its credit rating, they will most likely become insolvent. This is big news folks, because there are many other bond insurers (PMI, ABK, MTG, RDN, to name a few) in deep trouble and if these insurers go, then the ratings agencies will get serious heat, and those trying to receive claims will be left with nothing to get; and we know there are tons of brokerages, banks, and other institutions holding billions of dollars of untradable assets whose losses are yet to be revealed. This will have a crippling effect, the severity of which is the only unknown. You will also start to see heat on the ratings' agencies: MOODY's & FITCH. As the heat is put on, more companies will be put on negative watch and future downgrades of credit ratings are all but guaranteed.

Well, the heat was put on and the downgrades are likely to come. The impact of bond insurers going under is massive and will be another shock to the financial system. The reaction will be felt:

a) further writedowns at brokerages/banks of protection they thought they had on toxic securities
b) muni bond meltdown

Jeff discussed the potential impact on the muni bond market as a tentacle to the credit beast on November 19th:

Municipal Money Market Funds. Friday's Wall Street Journal discussed problems with bond insurers and the impact on municipal bonds as well. Municipalities and public institutions like hospitals use bonds to finance themselves and over the years, even those with lower credit ratings have been able to access capital markets easily by using bond insurers to help them attain investment grade status. These same bond insurers also insured CDOs and sub prime CMBSes and as a result of the sub-prime credit debacle stocks of the insurers like Ambac have gotten creamed this year. People are worried about how much of a hit they will take on the insurance they have written. As a result, municipal bonds backed by these same insurers are getting roughed up, raising the cost of new bond issuance by municipalities. You see this credit crunch keeps branching out and side swiping otherwise innocent bystanders.

Conclusion: Someone has to save these bond insurers! Their corporate bonds are trading like junk predicting major trouble, and Merrill already decided to write off their insurance protection as a loss. It will get much uglier if more bond insurers go under, so the thing to look out for now is how they may be saved.

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