There Will Be Bonds

Acting as an anvil around the stock markets’ neck are the damaged bond insurers, MBIA, Ambac Financial Group and Financial Guaranty Insurance.

They’ve added extra chop to an already volatile market hurt by the subprime mess. The bond market is severely damaged, but it can and will get up off the mat, once housing finds its bottom, and as soon as the bond insurers get a grip.

But new analysis shows that the bond insurers’ problems are worse than you can imagine. The joke about the insurers is that they pick up nickels in front of steamrollers. With their razor-thin capital bases, it’s more like freight trains.

This is an issue we’ve talked about at length on Money for Breakfast. It’s a problem I’ve already flagged to you in earlier blogs, (“Reality Check on the Buffett Bounce,” “In the Weeds” and “The Leave No Consumer Behind Act”).

OK here’s the back story.

The bond insurers are scrambling to calm the markets by saying they’ve got enough funds on hand to back their book of business. They guarantee the yields on a total of $2.4 trillion in municipal, corporate and mortgage debt, selling these bonds their triple-A credit rating — a claim that only 16 companies can make, a claim not even white-shoe corporations like IBM can boast.

Bond insurers are a key linchpin that prevents the financial markets from caving in. They save banks, investors and taxpayers money by keeping borrowing costs low. States and cities build infrastructure by borrowing money more cheaply when they get their yields on their debt insured. If a bond does default, the insurers take over paying out the principal and interest, payments that dribble out over the remaining lifespan of the bond.

But when the bond insurers branched out to insure untested, devilishly complex asset-backed securities in 1998, that’s when their businesses started to unravel. To get even more fees, they started to insure complex debt instruments that bundle bonds backed by sub prime mortgages and other loans, credit default swaps, even other CDOs.

Now record losses, credit rating downgrades, threats from regulators of a breakup of their businesses, all of these problems have stocks in the country’s bond insurers trading 80%-89% off their 52-week highs.

MBIA and Ambac both took a torpedo in the boiler room recently, as one analyst put it, posting record losses of more than $5 billion combined. The hit amounted to most all of the losses both have incurred since their inception. Concerns grew that the companies may not have enough capital to sustain their ratings, casting doubt on the $1.4 trillion of municipal and structured finance debt they insure. MBIA and Ambac alone make up about 50% of the bond-insurance market, according to Moody's.

MBIA executives have long maintained that they have more than enough capital to meet losses. With a new injection from Warburg Pincus, its capital reserves amount to a $17bn cushion to pay out on any defaulted bonds.

You would think that’s $17 billion in cash, cash and equivalents and credit lines to support MBIA’s $679 billion book of business. Not so fast. The cushion shrinks dramatically on closer look, according to new analysis from CreditSights, a New York research firm.

MBIA has chucked into that $17bn pot some $7.3bn in what it calls “contingency reserves,” “surplus to policyholders,” and “third party capital support.” These are essentially credit lines, fixed income assets and capital it can raise by issuing preferred stock.

It’s included, too, $3.76 billion in unearned premiums, meaning, premiums it hasn’t earned yet because the bonds are still outstanding. And it’s included $2.6 billion in “future” premiums that it estimates it may get from bonds it will insure. That’s money that’s not even in the door yet.

Similarly, Ambac says it has $14.5 billion in claims paying reserves to support a $524 billion book of business. In that sum are $7.2 billion in credit lines, fixed income assets and capital it can raise by issuing preferred stock. Ambac has included, too, $3.32 billion in unearned premiums, meaning, premiums it hasn’t earned yet, plus another $3.1 billion in “future” premiums that have yet to arrive in the mail.

Scary.

The credit markets remain frozen. In the broader market, investment houses are bracing for big write-downs in the range of $40bn to $70bn in the event the bond insurers are sharply downgraded, since their holdings of insured securities would also nosedive in value.

It’s a chilling possibility, given that new estimates from UBS Securities says that the financial system losses from securities backed by mortgages and other debt, a big slug of which the bond insurers guaranteed, would total $600bn. That outstrips the $400bn that many analysts estimated up until recently.

The estimates of losses are all over the place. S&P estimates the amount of subprime-related CDOs hedged by bond insurers at about $125bn. Royal Bank of Scotland esimates that the bond insurers have guaranteed $305bn of these collateralized debt obligations at U.S. banks, and $88bn overseas.

For MBIA alone, it says it has sub prime exposure of $16.7bn, including $4.7bn of direct exposure that Moody's has already noted. William Ackman of Pershing Capital, who has been short the bond insurers, has analysis that shows $11.6bn of losses each for MBIA and Ambac on guarantees of mortgage-backed debt and other securities. Moody's estimated MBIA's stress-case losses, based on its assumptions about defaults, would be about $13.7bn.

So now the bond insurers are scrambling to raise capital to plug their balance sheets and thus avoid a downgrade that would kill their business, which is entirely based on selling their triple-A rating. Over the past few weeks, Fitch Ratings downgraded Ambac and FGIC from triple-A to double-A. Standard & Poor's also cut FGIC to double-A. S&P and Moody’s Investors Service may soon make similar moves. Moody’s and S&P for now appear to have backed off downgrading MBIA, but they are still watching the situation.

Already, the bond insurers are talking about splitting away their safer muni bond business. Muni bond insurance makes up 65% of MBIA’s business, its riskier structured finance business which includes guaranteeing Frankenstein securities, 35%, including about $83bn of complex debt securities called CDOs most at risk of default (the figures include the sub prime exposure noted above, analysts note). MBIA says it’s going to take five years to split these businesses.

The world's largest bond insurer said it is eliminating its quarterly dividend in a move expected to save the company $174 million a year. The company also said it will stop ensuring new derivative credit contracts, and suspended the writing of new structured finance business for the next six months.

The bond market can only hope that this is enough.