Next Phase of the Crisis: The Great Ratings Debacle

[boatguy]

Important article

http://www.howestreet.com/articles/index.php?article_id=5068

The Collapse of the Great Ratings Scam

Right now, tens of thousands of ratings are issued for virtually every major bond, loan and debt in America. They're the brains and nervous system of our nation's entire credit markets. And the credit markets, in turn, are larger than all of our stock markets combined.

So when the integrity of these ratings is compromised, credit market pandemonium could be the result.

And, unfortunately, that's precisely the situation we're facing today. But it didn't happen overnight. It's the consequence of ...

Four Long-Standing Deceptions by the
Nation's Most Prominent Rating Agencies

We're talking about Fitch, Moody's and S&P. And their deceptions, when fully exposed, could emerge as the next major threat to the economy: "

[boatguy]

Washington Post has it now.

It's Not 1929, but It's the Biggest Mess Since - washingtonpost.com:

http://www.washingtonpost.com/wp-dyn/content/article/2007/12/04/AR2007120402186.html?nav=hcmodule

From the article:

"With these tranches, mortgage debt could be divided among classes of investors. The riskiest tranches -- those with the lowest credit ratings -- were sold to hedge funds and junk bond funds whose investors wanted the higher yields that went with the higher risk. The safest ones, offering lower yields and Treasury-like AAA ratings, were snapped up by risk-averse pension funds and money market funds. The least sought-after tranches were those in the middle, the "mezzanine" tranches, which offered middling yields for supposedly moderate risks.

Stick with me now, because this is where it gets interesting. For it is at this point that the banks got the bright idea of buying up a bunch of mezzanine tranches from various pools. Then, using fancy computer models, they convinced themselves and the rating agencies that by repeating the same "tranching" process, they could use these mezzanine-rated assets to create a new set of securities -- some of them junk, some mezzanine, but the bulk of them with the AAA ratings more investors desired."

[boatguy]

MBIA Tumbles on $8.1 Billion of CDOs, Fitch Warning

http://www.bloomberg.com/apps/news?pid=20601087&sid=ahJS.RmS5aMs&refer=worldwide

"More than $2 trillion of insured securities would lose their AAA ratings amid mass downgrades of bond guarantors"

"We are shocked management withheld this information for as long as it did,'' Ken Zerbe, an analyst with Morgan Stanley in New York, wrote in a report yesterday. MBIA simply did not disclose arguably the riskiest parts of its CDO portfolio to investors.''

[boatguy]

Buffett Swoops Into Bond Insurance

Bond issuers will flock to Buffet just to keep their AAA ratings even though it may cost more.

Bonded by Buffett

http://www.businessweek.com/bwdaily/dnflash/content/dec2007/db20071228_263014.htm?chan=rss_topStories_ssi_5

Struggling Players

Big players in the business, such as MBIA (MBI) and Ambac Financial Group (ABK), have been struggling amid anxieties about potential defaults on bonds and other debts they guarantee are supported by subprime mortgages. As a major part of their business, such outfits guarantee the bonds issued by government entities to finance public works such as schools and sewer systems. Even though their risks for government-bond defaults are small, their exposures in other areas are worrying investors and rating agencies and forcing them to seek hefty dollops of capital to preserve their high ratings.

[boatguy]

Why top mark is not always top notch

http://www.ft.com/cms/s/0/c5fbb68e-bfe7-11dc-8052-0000779fd2ac.html

The loss of the US government's top-notch triple-A credit rating, if it ever came to pass, would be a hugely symbolic blow to the status of the world's economic and political powerhouse.

Yet any debate about the merits of the US government's rating must reflect the fact that the triple-A stamp of approval has less and less meaning for investors. The credit crisis triggered by the growth in risky mortgage lending has dispelled the myth that a triple-A credit rating is a guarantee of security.

Instead, many of the complex debt structures used in recent years by banks and other financial institutions to disperse the risks associated with lending to people or companies, and which were rated triple-A, proved vulnerable to problems with the assets underpinning them. As a result, there have been hundreds of triple-A bonds, mostly complex structured instruments, downgraded in recent months.

"Triple-A [debt] has been the worst affected part of the market relative to its previously perceived credit quality," said Siobhan Pettit, analyst at Royal Bank of Scotland, in a recent report.

There are few companies with triple-A credit ratings. Yet there are many investors, such as pension funds or local governments, who want to invest their money as safely as possible. Some of these investors have lost money due to unexpectedly risky exposures.

In the government debt markets, the meaning of a top credit rating can be higher than in the corporate world. The US government's debt, for example, is owned by central banks, sovereign wealth funds and other important investors around the world. Some of these investors will place funds only in assets with a top credit rating.

"If you take away the cosmetic of a triple-A rating [for US government debt] you will discover it is not cosmetic at all," said Dan Fuss, fund manager at Loomis Sayles. "At the margin, buyers will go elsewhere."

Yet even the government debt markets are no strangers to different valuations of triple-A ratings: after the introduction of the euro in Europe, debt issued by Germany was regarded as safer than that of, for example, Italy, even though their ratings were the same.

This week, the diverging values to investors of triple-A companies was highlighted. Warren Buffett's Berkshire Hathaway, which has a big role in insurance, is one of the few US companies with a triple-A rating.

Mr Buffett has recently decided to enter the market for insuring bonds issued by municipalities. Bond insurers such as MBIA and Ambac who dominate the market have been hit by huge losses due to exposure to securities backed by risky mortgages - and are hanging on to their triple-A ratings. As a result, Mr Buffett was paid a higher premium by a New York municipal borrower to insure its debt than the borrower was willing to pay MBIA or Ambac.

The role rating agencies have played in failing to assess correctly the thousands of complex bonds they rated triple-A has come under scrutiny. Regulators and politicians have called for a change in the rules. This debate is likely to accelerate, especially if the credit crisis in the US deepens and further triple-A credit ratings bite the dust.

[boatguy]

Monoline Insurers Sink On Credit-Rating Reviews

http://online.wsj.com/article/SB120058159100297695.html?mod=googlenews_wsj

Pressure continues to build on U.S. bond insurers, as Moody's Investors Service and Standard & Poor's signaled fresh consideration of companies' all-important AAA ratings and markets soured further on the sector amid deepening losses.

The reports sent shares of the nation's two biggest bond insurers plunging for a second-straight day. Market leader MBIA Inc. was recently down 25% to $10.08, while Ambac Financial Group Inc. sank 44% to $7.25 after dropping 38% Wednesday, a decline which cost the company more than $800 million in market capitalization.

Moody's said late Wednesday that it had placed its ratings on Ambac on review for a downgrade, after the country's second-largest bond insurer significantly stepped up its expected losses from insuring complicated securities backed in some cases by subprime mortgages. Moody's also said it will be evaluating "in the near term" the extent to which its ratings of other firms in the industry will be affected by the sector-wide pressures that produced the losses at Ambac.

"In view of the uncertainty generated by Moody's surprising announcement, Ambac is assessing the impact of this action on the company's previously announced capital plan," Ambac said Thursday.

Less than a month after completing a review of the highest-rated U.S. bond insurers to assess whether they held enough capital to deserve their stellar ratings, ratings company Standard & Poor's also is beginning to re-evaluate the sector's ratings to take into account its new, more dire view of the U.S. housing market downturn. The review should be completed by the end of next week, a spokeswoman said.

"The market stresses contributing to Ambac's recent financial and organizational announcements are also evident at other financial guarantors, particularly those with significant mortgage and mortgage-related CDO exposures," Jack Dorer, a managing director at Moody's, said in a release.

Bond insurers have been rocked by concerns they could be hurt by guarantees they've written on complex debt securities that have plunged in value. Banks that have used those guarantees to hedge exposures have taken charges of at least $6 billion to reflect concerns bond insurers -- particularly junk-rated ACA Capital Holdings -- won't make good on their commitments. On Thursday, Merrill Lynch wrote down $3.1 billion in the value of its hedges.

Ambac said Wednesday it expects to report a loss of $5.4 billion on its portfolio of credit derivatives. In addition, Ambac conceded that it expects to see actual losses of $1.1 billion on some collateralized debt obligations linked to subprime mortgages, backing away from its long insistence that losses would be primarily on paper only.

To plug the hole, Ambac plans to sell at least $1 billion in securities and will cut its dividend by two-thirds. It also said Chairman and Chief Executive Bob Genader has resigned after 20 years at the company. The loss, and Mr. Genader's departure, troubled Moody's.

"This is a significant change in Ambac's view of the ultimate losses to be realized from these transactions," Moody's wrote. "This loss significantly reduces the company's capital cushion and heightens concern about potential further volatility within Ambac's mortgage and mortgage-related CDO portfolios."

Fitch Ratings put Ambac's AAA rating on watch for a downgrade last month, warning the company had four to six weeks to raise $1 billion. Without the capital, Fitch said Ambac would fall short of its requirements to hold AAA ratings.

The AAA rating is crucial for Ambac's business of insuring securities. Ambac has guaranteed principal and accumulated interest on $556 billion of debt, including mortgage bonds. Fitch has been more aggressive than other ratings agencies. Ambac said its current capital position meets or exceeds the AAA capital requirements of both Standard & Poor's and Moody's Investors service.

Fitch used similar language with MBIA, which last week raised another $1 billion in new capital and said it will slash its dividend by 62%.

MBIA Bonds Lose Value

MBIA's $1 billion in notes, sold Friday at 100 cents on the dollar with a 14% coupon fixed for five years, were trading Wednesday at 90 cents on the dollar, yielding 17%, according to Wayne Schmidt at AXA Investment Management. The hefty yield may not bode well for Ambac's capital raising efforts.

Fitch affirmed MBIA's AAA rating Wednesday and removed its ratings from negative-ratings watch. Fitch hasn't yet commented on Ambac's planned equity offering, but said Wednesday when it announced MBIA's rating that if the market migrates away from the use of bond insurance, MBIA and many of its competitors may have difficulty expanding their businesses in the future.

"Financial guarantors such as MBIA are facing heightened challenges and uncertainties with respect to ultimate subprime-related losses, their competitive positioning, as well as the critical demand and pricing for their products, including municipal bond insurance policies," Fitch said in its report.

The ratings agency also said Wednesday that it will continue to monitor the bond-insurance landscape in the coming months, and if negative fundamental trends appear to be enduring, the agency will reconsider its rating outlook on MBIA specifically or financial guarantors in general.

Still, the agency noted that "fundamental trend for bond insurance could stabilize during 2008, as companies look to streamline their portfolios and focus greater attention on less capital intensive and more stable asset classes at acceptable returns on capital."

Morgan Stanley analyst Ken Zerbe questioned whether Ambac would be able to accomplish its planned equity offering and questioned how much the company might try to raise. "First, the company has only guided toward raising "at least" $1 billion of equity and equity-linked securities," Zerbe said, adding that it is "unclear if the company will actually be able to raise the equity," due to investor hesitance.

At the heart of the crisis is concern about bond insurers' decision in recent years to stray from their core role guaranteeing municipal debt to providing guarantees on complicated debt securities amid a boom in structured finance. Many of those securities are underpinned by subprime mortgages that are plummeting in value.

Ambac guaranteed $38 billion of debt linked to subprime mortgages, or poor quality home loans, which have fueled the ongoing credit freeze. The company is also exposed to $45 billion of other mortgage investments.

Standard & Poor's, in a report released Tuesday, pointed to "the growing economic consensus that U.S. home-price declines will be larger than previously forecasted and that the slump in the U.S. housing market is expected to last far longer than previously anticipated."

S&P said as a result it has made "fundamental changes" to its assumptions for U.S. residential mortgage-backed securities that could affect bond insurer ratings.

[boatguy]

Insurer Of Bonds Loses Top Rating

http://www.washingtonpost.com/wp-dyn/content/article/2008/01/18/AR2008011803592.html

Without its flawless rating, Ambac may now find it nearly impossible to attract business, analysts said. Rombach and others questioned whether Ambac could even stay afloat. Some analysts said the move by Fitch would trigger downgrades by the other two major credit rating agencies, Moody's and Standard & Poor's, which have been reviewing the ratings of Ambac and its peers.

"The Fitch downgrade only exacerbates Ambac's difficulties in their ability to write business as well their ability to access capital or other capital-like instruments," said Dick Smith, managing director of global bond insurance ratings at Standard & Poor's. He said S&P was already focused on those issues as it conducts its review.

Moody's warned Thursday it was also reviewing the ratings of MBIA, the largest bond insurer, citing "growing concern about the potential volatility" in the performance of mortgage-related securities and "the corresponding implications for MBIA's risk-adjusted capital adequacy." Moody's decision came even after MBIA had carried out its own $1 billion debt issue.

[usedcasting]

Great thread boatguy. I understand the problems go much deeper than the sub-prime. Sub-prime is a smoke screen to cover up the much bigger problems in the financial markets. Thanks for the posts.

uc.

[boatguy]

Thanks UC.

Looks like tomorrow may be one for the record books

U.S. stock futures point to major decline on re-open

http://www.marketwatch.com/news/story/stock-futures-pointing-sharp-losses/story.aspx?guid=%7B9A894790%2D5D69%2D48C6%2D8303%2D18EE41CA5D1C%7D

LONDON (MarketWatch) -- If futures contracts traded on a day when U.S. stocks weren't even due to open are anything near accurate, then markets will be in for a major decline on Tuesday, with concerns about bond insurers and the health of financial institutions dragging markets lower.

March contracts on the Dow Jones Industrial Average traded 482 points lower to 11,624.

[422fwhp]

Good reading....I applaud you for the diligence.

I'm thankful I'm currently mostly cash with the exception of a few short positions.


Jody

[boatguy]

Thanks Jody, I'm 85% cash myself.

Banks May Need $143 Billion for Insurer Downgrades

http://www.bloomberg.com/apps/news?pid=20601087&sid=aXYHj_zLrIXA&refer=home

From the article:

" Banks will need at least $22 billion if bonds covered by insurers led by MBIA Inc. and Ambac Assurance Corp. are cut one level from AAA, and six times more    for downgrades by four steps to A, Paul Fenner-Leitao wrote in a report published today. Barclays' estimates are based on banks holding as much as 75 percent of the $820 billion of structured securities guaranteed by bond insurers.

``This is a huge amount, but the assumptions we use are also very aggressive,'' Fenner-Leitao in London said in a telephone interview. The estimate shows how bank capital could be diminished in the event of significant downgrades, he said.

The risk of a deeper capital shortfall may help explain why New York's Insurance Superintendent Eric Dinallo is trying to arrange a bank-led bailout of the bond insurers. Downgrades would cast doubt on the credit quality of $2.4 trillion of bonds the industry guarantees.  "

[boatguy]

Dinallo's Rescue Plan Focuses on Ambac

http://www.bloomberg.com/apps/news?pid=20601087&sid=aVDZmYRHBVsk&refer=home

"One of Dinallo's proposals to rescue the company would have banks and securities firms act as reinsurers of bonds and securities that Ambac guarantees, one of the people said. Ambac would pay an upfront fee in return for a promise that the banks would reimburse it if insurance-related losses exceeded an agreed-upon limit, the person said.

Another option would be for banks to provide the bond insurer with capital to help it pay claims. The banks discussing a possible Ambac rescue also include Royal Bank of Scotland Group Plc, Wachovia Corp., Barclays Plc, Societe Generale SA, BNP Paribas SA and Dresdner Bank AG, one of the people said."


"Federal regulators may object to letting banks prop up Ambac because the maneuver may artificially delay writedowns of debt holdings, said Joshua Rosner, managing director at New York-based research firm Graham Fisher & Co.

``Those losses might ultimately happen anyway,'' Rosner said in an interview last week."

[boatguy]

Ackermann Says Bond Insurers Threaten Debt `Tsunami'   

http://www.bloomberg.com/apps/news?pid=20601087&sid=aLl6BMPB_juQ&refer=home

"Deutsche Bank AG Chief Executive Officer Josef Ackermann said rating downgrades for bond insurers pose risks that could match the U.S. subprime market collapse.

"It could be a tsunami-like event comparable to subprime,''

It is bad practice to rely on the judgment of those whose misjudgments have caused the current crisis''  Ackman wrote in the letter dated Feb. 5.

European Central Bank President Jean-Claude Trichet rejected Ackermann's characterization of the potential fallout from bond insurer downgrades.

[boatguy]

Bond Insurer Seeks to Split Itself, Roiling Some Banks

http://online.wsj.com/article/SB120308290353671507.html?mod=hps_us_whats_news

By LIAM PLEVEN, KAREN RICHARDSON and CARRICK MOLLENKAMP
February 16, 2008; Page A1

The beginning of a messy endgame to the bond-insurance crisis may be underway, and the industry that emerges could look very different from the one that bet big on subprime mortgages.

On Friday, FGIC Corp., holding company for the nation's third-largest bond insurer, told the New York State Insurance Department that in effect it wants to split up the business. The idea would be to create a new company to insure safe municipal bonds and for the existing one to keep responsibility for riskier debt securities already insured, such as those tied to the housing market.

The move may help regulators protect investors who have municipal bonds insured by the firm. But it could also force banks who are large holders of the other securities to take significant losses. Some banks that have been talking with FGIC in recent weeks to bolster the firm were taken aback by the announcement and could yet try to block it, say Wall Street executives.

Either way, the move is a further sign that the industry could retreat from insuring some of the complex financial instruments that fueled the recent housing boom.

If the market settles down, that would be good news for local governments that have been dragged into the subprime-mortgage mess. They would like to see competition among financially solid bond insurers, so that the cost of insuring their municipal bonds remains low.
[Eliot Spitzer]

"Certain aspects of the business model almost certainly will not look the same at the end of the year," said New York State Insurance Superintendent Eric Dinallo, who has been consulting with the bond insurers about new regulations that will cover what risks they can assume.

Already, MBIA Inc., the largest bond insurer in the country, has been forced to raise more than $2.5 billion in capital in an attempt to preserve its triple-A credit rating. Ambac Financial Group Inc., the second-largest, has also been talking with banks about a possible rescue plan.

Additional pressure came from New York Gov. Eliot Spitzer, who told Congress on Thursday that bond insurers have three to five days to find a solution to their problems before regulators could step in. Lawyers for insurers and banks are expected to work through the U.S. holiday weekend.

Bond insurers have been around for decades, but little noticed by the public. They built their business by promising to repay interest and principal on bonds issued by municipalities if the municipalities defaulted. The insurance made the borrowing cheaper. Now, the insurers have become a linchpin of the financial system, backing more than $2 trillion worth of securities.

Riskier Business

The industry plunged deeper into riskier business lines in recent years, including insurance for securities backed by subprime mortgages. The downturn in the mortgage market has exposed them to potentially sizeable losses. That has, in turn, called into question whether they can maintain the triple-A ratings that are critical to their business, and has forced some to go looking for more money.

Holders of the debt securities -- ranging from banks to ordinary investors -- also have a lot at stake because the value of the securities hinges in part on the rating of the insurer. That's one reason regulators have been trying to rally banks to help rescue the insurers.

FGIC has already lost its top-notch triple-A rating from all three major ratings firms. Moody's Investors Service on Thursday cut FGIC's triple-A financial-strength rating by six notches to A3, with a warning that it could be cut to the lowest investment-grade level of Baa if FGIC's strategic and capital plans had "an unfavorable outcome."

Mr. Dinallo told Congress on Thursday that the department would consider letting bond insurers split themselves in two, effectively giving his imprimatur to the idea.

On Friday morning, FGIC's general counsel, Ed Turi, notified Mr. Dinallo's department of its intent "to begin the process" of creating a new bond insurance company in New York. That would require the department to issue a license. If it gets a license, the new insurer will support public bonds previously insured by FGIC and seek new municipal-bond business, the company said.

Mortgage insurer PMI Group Inc. owns a 42% stake in New York-based FGIC, while private-equity firms Blackstone Group Inc. and Cypress Group each hold 23%. FGIC insured about $315 billion in debt as of Sept. 30, including about $31 billion backed by mortgages.

FGIC's move caught at least some of the banks in the group that have been negotiating with it by surprise, according to a person familiar with the situation. Banks that own securities insured by FGIC face the risk of write-downs if FGIC is downgraded further, because the value of securities it insures could fall further.

Incentive for Infusion

FGIC's move could serve as an incentive to get the banks to step up to the plate on a cash infusion for the company. In the past, regulators have said dividing the insurers is a last resort and urged the banks to put in fresh capital.

Calyon, the investment-bank arm of Credit Argicole SA, is leading the bank group. A Calyon spokeswoman declined to comment.

The full bank group has had only tentative discussions with FGIC. One question that has dogged the group is whether the principal negotiating partner should be FGIC, its shareholders or regulators.

The banks learned of the split-up plan Friday by seeing it reported on CNBC, this person said, calling it a "bizarre situation."

All of the banks have hired legal counsel and are prepared to go to court. The person familiar with the situation said FGIC's move could result in "instant litigation." FGIC didn't respond to queries about the banks' reaction to Friday's announcement.

One plan the parties are discussing involves commuting, or effectively tearing up, the insurance contracts the banks entered into with FGIC, according to another person familiar with the matter. In exchange, FGIC would pay the banks some amount to offset the drop in value of those securities, or give them equity stakes in the new municipal-bond insurance company.

Some observers questioned whether the breakup plan would be fair to all FGIC policy holders. It would probably help municipal governments, because the entity insuring their debt would be healthier, while hurting those who mainly relied on FGIC to insure riskier securities. Also unclear is how the ratings services would treat the two insurers after a split.

"You're trying to unscramble the egg," said William Schwitter, chairman of the leveraged-finance practice at law firm Paul Hastings. "When you take a balance sheet that is supporting a variety of obligations and try to split it in two, it's difficult."

Mr. Schwitter, who isn't involved in the FGIC negotiations, noted that many investors who bought bonds supported by FGIC insurance probably had no idea the company could be split later.

However, if a breakup is endorsed by the New York Department of insurance, that could limit the legal liability.

One other wild card: If FGIC splits into two, it could throw into turmoil potentially billions of dollars of bets that banks, hedge funds and other investors have made on whether FGIC would default on its own debt. If FGIC is split, it isn't clear how those "credit default swaps" would be valued, since one half of the new company would have a higher risk of default than the other.

--Aaron Lucchetti contributed to this article.

[boatguy]

Citigroup Shareholders' Relief May Not Last as Capital Dwindles

http://www.bloomberg.com/apps/news?pid=20601087&sid=avUb49fO8dzY&refer=home

From the article:

Downgrades

Standard & Poor's said it is reviewing Citigroup's rating for a possible downgrade, noting that earnings may be further depressed by loss reserves on the bank's loan portfolio. Fitch Ratings lowered the company's rating one level to AA- from AA, with a negative outlook. Fitch cited deteriorating earnings in the consumer business and investment bank losses.

"Citigroup's so-called Tier 1 capital ratio -- a measure of its ability to withstand loan losses -- fell to 7.7 percent at the end of March, the New York-based bank said yesterday. Citigroup says it needs a 7.5 percent ratio to provide a margin of safety and preserve its credit ratings."

"We're in a recession, they have a huge consumer book, and there's huge double-digit-billion provisions that they're going to have to take in the next 18 months to two years,'' CreditSights Inc. analyst David Hendler said. ``They're undercapitalized for their risk.''