The monolines or credit wrappers were one of many businesses caught in the line of fire during the credit crisis. As losses ate into their capital, a loss of their coveted AAA credit ratings appeared imminent. Credit markets feared that given the volume insured by these businesses, a downgrade would unleash a nasty wave of selling.
This article upset the Australian managing director of MBIA, who said it was irresponsible and full of errors. I agreed to meet him to discuss and it turned out pretty much everything I wrote was spot on. The only point I had to concede was that I couldnt assume a monoline downgrade would lead to a 'dramatic widening of spreads'. It was evident from my visit that it was an uncertain time for his once thriving operation and he did not appear too confident of survival.
In my opinion the monolines were another absurdity of the pre-crisis world. And I have reason to dislike them. My employer to be ANZ would be forced to write a $100 million loss on 'credit intermediation' trades, whereby they entered into large swap agreements with US monoline ACA, who proved to be inadequately capitalised. ANZ booked a profit of A$1.5m on this and other similar trades (about A$20m overall) but now face massive losses. About 10% of an otherwise profitable markets division lost their jobs last year. Those directly responsible for conceiving and authorizing the trades still sit in the highest management positions and collect healthy bonuses.
***Wrapped and tangled (25 January 2008) ***
In another difficult week for global credit markets, all eyes have been on the fate on the monoline insurers.
Monoline insurers, or credit wrappers, rely on capital to attain a AAA rating from the rating agencies. Their business is to use their strong capital base and rating to guarantee bonds of lower rated borrrowers, earning a premium for their services.
The turmoil in credit markets has placed severe strain on the insurers who have suffered huge losses and write downs. Their capital has been drained, threatening their AAA rating and placing their futures in serious doubt.
Market consensus has been that since a AAA rating essential for their tbusiness, everything possible would be done to ensure they retain their rating. Also, with trillions of dollars of bonds insured by the monolines, a downgrade would trigger subsequent downgrades in insured bonds which could have widespread implications in global credit markets. Regulators were assumed to be keeping a close watch and ready to step in and save the monolines for the greater good of financial markets.
To date the monolines have been frantically raising capital to appease the rating agencies and retain their AAA rating. But despite the absolute importance of maintaining a AAA rating, it appears they may be overextended.
“The monolines will be feeling a bit miffed with the rating agencies who keep moving the goalposts, requiring them to raise more capital in anticipation of further write downs,” said a banker.
Another problem for the monolines are the interests of their own shareholders who have seen their stake in the business diluted as more capital is raised to maintain their credit standings.
The shareholders of Ambac, one of the larger insurers, have indicated that raising more capital is diluting their stakes in the business to the extent that any future growth of the business is not sufficient compensation for the diluting of existing premiums. The shareholders appear to be valuing the past more than the future and may be prepared to throw in the towel.
Regulators are aware that the monoline stakeholders interests may longer be aligned with that of the financial system and are stepping in. They are calling on the larger banks to inject capital into the monolines to ensure they maintain their AAA ratings.
Some in the market question the logic of a bail out which would require capital from the major banks.
“It’s a somewhat circular solution. Most of the losses and write downs resulting in downgrades of the insurers would be borne by the same banks who are being asked to support the monolines. The banks are requiring to put up more capital as their assets are downgraded and losing value and now they are being asked to put up further capital to save the monolines.”
Downgrades of the monolines will trigger subsequent downgrades of nearly all the bonds and securities they have guaranteed. The impact of downgrades are uncertain but there are likely to be a number of noteholders who either have to sell or chose to sell their holdings.
While all the monolines face severe challenges some are in a better position than others. Ambac and XL Capital have already seen negative rating action taken upon them. Others such as FSA, who is owned by the highly rated Dexia has better access to capital and less of a need to dilute equity. This is evident by Fitch Rating’s recent affirmation of FSA’s AAA rating
According to nabCapital research about A$20 billion of Australian bonds are insured by the monolines. MBIA has insured about 37 per cent of bonds, Ambac 26 per cent, FSA 18 per cent, XL Capital 12 per cent and FGIC 7 per cent. The majority of bonds are in the infrastructure and utilities sector.
Discussions with a number of banks who originate and distribute Australian credit wrapped paper revealed who might be holding these assets. There are essentially three types of investors that buy AAA rated credit wrapped bonds.
The first are fund managers that buy AAA rated credit wrapped bonds for rating diversity. They would not be forced to sell if bonds were downgraded but would, in many cases, prefer to sell the bonds. They would suffer from dramatic widening of spreads as bond would be priced according to underlying rating.
Some asset managers whose mandates require them to hold an average credit rating might be forced to sell, but may be able to transfer assets into less restrictive funds.
Banks also hold credit wrapped bonds. It would still be beneficial for them to hold these securities under Basel II regime but they would get hurt on mark to market valuations if bonds were downgraded
Conduits and SIVs have also been big buyers of credit wrapped bonds. These investors need to hold to hold AAA rated securities. Some would not have to sell if bonds were downgraded but many would.
Liquidity would be a major concern as the only demand would be from investors in a position to invest with a view on the underlying collateral.
According to some source estimates, about 40 per cent of insured bonds are held by banks and conduits, with about a quarter in the position where they would have to sell in the event of a downgrade.
It is also difficult to determine if the banks had bought these assets for their balance sheets or placed them into sponsored conduits.
The banks and sponsored conduits however, have in the past been understood to absorb large chunks of a credit wrapped deal and in many cases an entire deal.
In some instances, once the bank bought the credit wrapped bonds they would award a mandate to another monoline insurer to write a credit default swap contract at a spread lower than the yield of the bond. This would in theory ensure a risk free cash flow which the bank would book as a profit. Often if a monoline was not awarded a mandate to credit wrap an issue, they would be awarded a mandate to write the credit default swap and often the fees would exceed that of wrapping the bond.
This is known as a negative basis trade, executed by the bank. These trades could now unravel. If the assets are downgraded internal bank models will require for the price of the asset to be adjusted, the capital charge to be increased and the profit and loss to account for the fall in value. The small risk free gains would be wiped out.
Investors will have to place greater emphasis on the underlying assets of credit wrapped bonds.
“In assessing these securities we emphasise the underlying security and pay less attention to the monoline insurer. They are not trading at AAA levels so we cannot regard them as AAA. We do, however, acknowledge there that there is some additional credit enhancement,” said a fund manager.
“The market will be asking is the model broken. I think the answer is no, but until we know that for sure these assets will not be very saleable. The underlying assets and their sectors themselves are still attractive,” said an investment banker.
The actions of regulators later in the week however reaffirm the thesis that the monlines are too big to fall.
“The monolines will be recapitalised somehow, and life will go on. At the very least the AAA monoline wraps are essential for the US municipal market, so its too politically sensitive to let them go. In other words, no AAA wraps means municipalities in the US cant fund themselves for infrastructure and other needs and the US government will not allow that,” said an investment banker.
The fallout caused by the plight of the monolines has led many to question how insurance businesses should operate.
“Mortgage and monoline insurers have taken safe business models and moved into more speculative geared wrapping of deals, in order to grow their businesses. This had the potential to unravel rapidly. The perception of the safety of insurance has been dissipated greatly by these activities.” said a fund manager.
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