Problems with Mortgage Bond Insurers

Jake asked me about the problems with mortgage / bond insurers. Here is a good article that briefly explains the problems with the mortgage insurers and the implications for our economy. The big dooms-dayers like David Tice (manager of my BEARX fund) and Robert Prechter have actually outlined the scenario that has begun to unfold, on their website: http://www.prudentbear.com/ in a PPT posted there (see: “The Case for a Secular Bear Market”) that I reviewed in 2003 and shared with you in my annual newsletter that year. Those two have long been leaders in campaigning against the dangers of fiat currencies and the prospect for uncontrolled inflation and dollar devaluation in the United States. The scenario began somewhat like is currently unfolding, with the inability of the insurance companies to back up the banks’ lending hedges, precipitating a financial calamity. This is the reason I own quite a bit of BEARX as a hedge. I figure that Tice will construct that fund to benefit from the disaster scenario he foretold, IF IT HAPPENS.

And that is a very big if. Even Tice has always conceded that the government had the ability, by turning up the printing presses and calling on its trading partners, to forestall or stop his worst-case scenario. But he also warned that if the Fed slipped up and miscalculated, the downward spiral could get away from them and become impossible to stop. Is Bernanke, President Bush and Congress up to the task? That is a very important question. So, just in case, I have a hedge. Ultimately, if Tice is right and as he outlines, even the dollar will become worthless (as has happened in other economies which mismanaged themselves into hyperinflation by overprinting currency, like post WW1 Germany and 70s Argentina). If the worst case occurs, the only safe haven is gold, as the historical store of value. But gold miners and ETFs are no good according to Tice as they are transacted in fiat currencies. If events get bad enough, only physical gold is really safe, as the fund companies sponsoring gold bullion ETFs (like XAU or GLD) can go broke on a cash flow basis have the physical gold reserves in bankruptcy court. My youngest brother buys gold coins because he instinctively does not trust the government. Maybe he will turn out to be right.

I am not paranoid or pessimistic enough to think the worse will happen, so my position is more moderate as mentioned. I think the government will backstop the financial system by guaranteeing the loans / insurance as they did during the S&L crisis when the formed the Resolution Trust Corp to do the same with the S&Ls (and this was a less serious problem to our national economy than the current global banking crisis). But I am monitoring the situation, and if it gets bad enough (say, DOW below 10,000), I will probably use my reserve cash to start buying enough gold bullion to survive an ultimate financial meltdown. But I won’t go all the way and build an underground bunker with food for 3 months, like my brother has.

Here is the article:

Bond-insurer woes may trigger more write-downs, turmoil By Alistair Barr Jan 18, 2008 18:08:00 (ET)

SAN FRANCISCO (MarketWatch) -- Just when you thought it was over, trouble in the $2.3 trillion bond-insurance business could trigger another wave of big write-downs from banks and brokerage firms, experts said Friday.

Leading bond insurers Ambac Financial (ABK, Trade ) and MBIA Inc. (MBI, Trade ) look increasingly likely to lose their AAA ratings. While almost unthinkable just six months ago, such concerns are also causing turmoil in the $2.5 trillion municipal-bond market.

Bond insurers agree to pay principal and interest when due in a timely manner in the event of a default -- a $2.3 trillion business that offers a credit-rating boost to municipalities and other issuers that don't have AAA ratings. Without those top ratings, their business models may be imperiled.

A more worrying consideration is that when a bond insurer is downgraded, all the securities it has guaranteed are, in theory, downgraded as well.

If Ambac and MBIA lose their top ratings, billions of dollars of muni bonds will be downgraded, and the guarantees that have been sold on mortgage-related securities such as collateralized debt obligations, or CDOs, will lose value.

Bond insurers guarantee roughly $1.4 trillion worth of muni bonds and more than $600 billion of structured finance securities, such as mortgage-backed securities and CDOs, according to Standard & Poor's. Ambac alone has guaranteed about $67 billion of CDOs.

"The destruction of the bond insurers would likely bring write-downs at major banks and financial institutions that would put current write-downs to shame," Tamara Kravec, an analyst at Banc of America Securities, wrote in a note Friday.

Kravec cut her rating on Ambac and MBIA on Friday because she thinks that ratings downgrades are "highly probable" now.

Indeed, Fitch Ratings cut Ambac's AAA rating to AA on Friday, becoming the first major agency to take that step. Fitch downgraded 137,390 muni bond issues and 114 other securities guaranteed by Ambac soon after.

Merrill Lynch & Co. (MER, Trade ) took a $3.1 billion write-down on Thursday related to the firm's CDO hedges. Merrill had bought CDO guarantees from bond insurers including ACA Capital, a smaller player that's now struggling to survive. Most of the write-downs were related to ACA.

CIBC (CM, Trade ) and French banking giant Credit Agricole unveiled similar write-downs in December, related to guarantees they bought from ACA.
But ACA is much smaller than Ambac and MBIA. If the two larger bond insurers are downgraded, banks and brokers that have bought guarantees from them may have to write-down their exposures further.

Merrill has net CDO exposure of $4.8 billion. But that includes a lot of hedging, mainly through guarantees bought from bond insurers. Excluding those hedges, the brokerage firm still has a "whopping" $30.4 billion of CDOs on its balance sheet, Brad Hintz, an analyst at Bernstein Research, noted on Friday.

"We remain very uncomfortable with Merrill's CDO balance sheet exposure," the analyst wrote in a note to investors. "If the counterparties are downgraded, and they cannot post additional collateral, we would expect that Merrill Lynch would have to take a valuation reserve against that specific exposure."

Citigroup (C, Trade ) set aside $900 million during the fourth quarter to cover heightened credit risks related to counterparties it uses to hedge CDO risks.
The impact on the muni-bond market may be just as big, experts said Friday.
There are $2.5 trillion to $3 trillion of muni bonds. Roughly half of those are insured by bond, or "monoline," insurers like Ambac and MBIA.

So more than $1 trillion of muni bonds are now in danger of being downgraded. That could trigger losses for muni-bond investors.

"Assuming the "monoline" insurers lose their triple-A ratings, underlying insured muni bonds could be susceptible to downgrades and downward repricing, leading to losses for muni-bond mutual funds," Michael Kim, an analyst at Sandler O'Neill, told investors in a note Friday.

Shares of big muni-bond fund managers, including Franklin Resources (BEN, Trade ) and Eaton Vance (EV, Trade ) have already been hit by such concerns, Kim said.

Franklin stock has slumped 22% so far this year; Eaton Vance is off 27%.
Most muni bonds insured by Ambac and MBIA are now trading as if there isn't any insurance, Richard Larkin, a municipal-trading desk analyst at JB Hanauer & Co., commented Friday.

"The market has lost all faith in bond insurance and the ratings agencies," he said. "Prices are being discounted because people wonder whether there is any value to the insurance."

That's a big problem, because there are no official ratings for many of the underlying issuers of muni bonds, such as cities, school districts and utilities, he added.

When municipalities sold debt, they asked agencies like S&P and Moody's to evaluate the securities with bond insurance attached.

If the insurance on this debt becomes less valuable, muni bond investors have few ways of checking the new creditworthiness of the issuer, Larkin said.
That's creating an "information vacuum" because the rating agencies aren't going to re-evaluate muni bond issuers unless the municipalities request and pay for new analysis, he said.

"The lack of public underlying ratings on insured debt is a big problem, and if more bond insurers are downgraded, the rating agencies are not likely to fill the vacuum and publish underlying ratings unless they are paid additional fees to do so," Larkin explained.

"Trades are being made based on people's best guesses of the creditworthiness of issuers," he added. "And if these downgrades happen, that will be the environment going forward. Not a good one."