Jan 30 2008
Bond Insurers — Downgrade in the Air!
Wall Street bond rating agencies are poised to downgrade two big bond insurers, Ambac Financial Group and MBIA, even though New York state insurance regulars would like to get a postponement until the state can develop a bailout package, CNBC has learned.Losing a Triple A rating could be devastating for the bond insurers, preventing them from drumming up new clients — and possibly forcing them out of business.
That’s from CNBC.com, who is reporting that those downgrades could come as early as today.
This is dicey business. As you may recall from a previously posted highly publicized outburst by Cramer a few weeks back, many on Wall Street believe the ratings to be sheer fiction. After all, in the case of MBIA, how does a AAA rated company end up having to borrow at 14% — a rate common for high yield junk debt — on its newly issued paper that’s since traded at higher rates (meaning the paper has subsequently lost its appeal even more!).
The problem is what these rating imply. Many bonds that otherwise would have had lower ratings rely on these monoline insurers to guarantee their payments, thus the insurers ratings are applied to the individual bonds. When those ratings go down - as we think is not a matter of if, but when, it’ll be passed on to existing bonds. That will lead us to valuation issues on existing portfolios containing those bonds, and the big question is how much has the market already pre-discounted them.
Already bonds that have these AAA ratings have been trading well below AAA prices, so that may not be so bad as many alarmist are suggesting. However, where the real problem likely will arise is what a dropped rating will imply to forced sale situations. Many investment policy charters at hedge funds, pension, and other large investment pools — the ones holding these bonds — forbid holding bonds below a certain rating. If ratings drop, they’ll be forced to offload them into the market to abide by their charters.
Of course, the actors will be looking out for their best interest in this situations. Already the ratings agencies have lost tremendous credibility through this. My guess is the last thing they’ll want is to also be blamed for swinging the ratings pendulum firmly to the side of reality too quickly. After all, their ill conceived ratings had much to do with the risk indifference permeating contemporary finance over the last five years. Expect ratings to be gradually walked down to prevent panic selling.
Likewise, many bond holders have had time to contemplate this scenario. Odds are they’ll weigh that the best thing for their investors is to not offload in a forced sell market, and rather they’ll wait and gradually offload — at least to the extent that official regulations allow.
If anyone hears of any government authority easing their requirement that government pensions or insurance companies, and so forth, can’t hold much if any junk rated bonds, let me know.
