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Pressure on bond insurers to save their credit ratings

By Saskia Scholtes in New York

Published: November 26 2007 21:10 | Last updated: November 26 2007 21:10

Specialist bond insurers are facing mounting pressure to improve their financial standing and avoid losing their top credit ratings because of the subprime mortgage crisis.

But while much investor attention has been focused on risks at the two biggest companies in the industry, MBIA and Ambac, analysts say the bond insurers most at risk are the smaller, less established players such as ACA, FGIC and Security Capital Assurance.

Shares in ACA are down more than 90 per cent this year on investor concerns that the insurer will lose its rating. The cost of protecting some of the other, smaller bond insurers against default in the derivatives market has leapt to levels far beyond what their top-notch credit ratings should imply.

The cost of insuring FGIC against default was more than 700 basis points yesterday, according to Markit, about in line with the cost of protecting General Motors, which is rated high yield.

The crisis last week forced the first co-ordinated bail out of one such small bond insurer, when two leading French banks pledged $1.5bn to prop up the credit ratings of CIFG. Caisse d’Epargne and Banque Populaire will buy the bond insurer from Natixis, the French investment bank that itself is controlled by the two mutuals, and then inject the $1.5bn to enable it to maintain its imperilled AAA credit rating.

Part of the problem, say analysts, is that the financial guarantee industry has faced growing pressure on profit margins from a combination of new entrants to the business and a lack of perceived risk after years of strong capital markets.

This encouraged many of the financial guarantors to insure a greater volume of collateralised debt obligations: complex debt securities backed by mortgage bonds or other types of debt, which have been hit hard by the market turmoil.

While many larger guarantors did begin to retreat from the CDO market by late 2005, some newer participants continued to take on exposure, partly because they lacked the flexibility to pull back from writing new business.

“The CDO market was seen as a panacea for the earnings pressure facing the guarantors,” said Rob Haines, analyst at CreditSights, a research company.

“Not only was the CDO market a source of growth but it offered much more attractive margins than the increasingly commoditised municipal market or plain vanilla structured transactions.”

Fitch Ratings and Moody’s are both reviewing their rating methods for the so-called monoline industry after mortgage-related bonds and CDOs they insure suffered ratings downgrades and sharp drops in market value. The reviews could threaten the bond insurers with downgrades below the AAA ratings that are crucial to their business model.

For a fee, monoline insurers lend their high credit ratings to less creditworthy borrowers to help them gain access to investor capital at cheaper levels. If the issuer defaults, the insurer agrees to make the interest payments over the lifetime of the bond and to repay the debt at maturity.

Based on preliminary reviews, both Moody’s and Fitch said CIFG was highly likely to fall below their capital adequacy requirements due to relatively high exposure to CDOs backed by mortgages. Fitch affirmed CIFG’s AAA ranking after the French banks took control, while Moody’s said the rescue “greatly reduces the risk” that CIFG’s capital will fall below the amount needed for the top rating.

The CIFG bail-out may help to set the tone for other bond insurers as they seek to avert a downgrade, but unlike CIFG, most monolines do not have a big banking parent to fund a bail-out.

Downgrades of the bond insurers could have serious consequences for investors who own the $2,400bn of bonds the insurers guarantee, which will in turn suffer downgrades and further drops in market value.

The consequences could be particularly acute in the case of ACA, because, unlike other insurers, ACA has to post collateral against its derivatives trades if it gets downgraded. This is in part because ACA, rated A, is one of the only bond insurers that operates with a rating below AAA. S&P began reviewing ACA’s rating for downgrade this month after the company posted a $1.04bn third-quarter loss.

The problem is that, as ACA says in a recent regulatory filing, it would not have the ability to post such collateral given the current market losses on its derivatives trades.

If ACA cannot post the collateral required, the hedge that banks and others have in place will no longer be effective, warn analysts at Lehman Brothers, potentially increasing the risk of CDO exposure and further potential writedowns on bank balance sheets.

Additional reporting by Stacy-Marie Ishmael

Copyright The Financial Times Limited 2007