I have touched on this topic last month, but more trouble is brewing with the potential further downgrade of leading bond insurance companies, which could cause another big wave of write-downs from banks and brokerage firms. Here’s what MarketWatch had to say:
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.
Merril Lynch 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.
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.”
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.
Why is this important now? With the financial markets having moved into bear territory, continued bad news regarding huge write-downs will not sit too well with Wall Street and will not provide the ammunition needed to affect a major trend reversal. Additionally, from my non-economist point of view, it seems that if huge amounts of money in the tens of billions of dollars are written off, this will further impair many institutions to function properly and therefore make fewer funds available for day to day business loans and mortgages (credit destruction).
I am not sure if this will turn into a Black Swan event, but I suggest that you play it as safe as possible with your portfolios. If you are unsure about what to do, if and when to invest at all, simply don’t! Keep your money safely in a U.S. Treasury money market account because, in these uncertain times, protection of your assets should be priority one.
Getting 3% interest looks mightily good if the markets head south another 20% or 30%, and you might finally have bragging rights at the next cocktail party.