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Saving The Whales

FYI | Jan 24 2008

This story features QBE INSURANCE GROUP LIMITED, and other companies. For more info SHARE ANALYSIS: QBE

By Greg Peel

Two of the most talked about stocks in the US this last week are Ambac and MBIA. Ambac shares show a 52-week range of US$96.10 to US$4.50. They closed last night at US$13.70 – up about 80%. MBIA shares show a 52-week range of US$76.02 to US$6.75. They closed last night at US$16.61 – up about 32%. These are companies steeped in US financial history. Last week they nearly disappeared out the back door. They are both “monoline” insurance companies.

So what’s a monoline insurance company?

The best way to begin is to explain what they are not. We are all familiar with with “multiline” insurance companies, which insure everything from our houses to our cars and businesses. Think a QBE ((QBE)) or Suncorp-Metway ((SUN)). Multilines benefit from a diversity of insurance policies and do not suffer from concentration in any one asset.

Monolines, on the other hand, specifically insure bonds. They may be public sector bonds or corporate bonds, and the insurer provides a guarantee on the repayment of principal and interest in the case of default. With such insurance in place, a bond issuer can improve the credit rating on the bond, perhaps raising it to AAA to thus attract widespread investment interest. Some large funds are restricted to investing only in AAA-rated paper.

Monoline insurance can also extend into structured finance (eg insuring bonds issued for the purpose of a private equity takeover) or derivative securities such as collateralised debt obligations (CDOs). Ah hah! Now we see where the problem is.

This whole credit crisis started with subprime mortgages which formed part of billions in CDOs issued in the US. The mortgages are defaulting, and as such a lot of CDOs are now as good as worthless. Companies such as Ambac and MBIA insured these instruments, which is one reason why the securities were afforded AAA ratings. With massive losses clearly staring such companies in the face, ratings agencies (which gave the CDOs AAA ratings in the first place) are now threatening to downgrade the ratings on the insurance companies themselves. If Ambac, for example, lost its AAA rating, then any security Ambac insured will also lose its AAA rating. This would mean a lot of funds holding those securities would be forced to sell as they are not allowed to hold anything less.

While it might sound like just another fallout from the CDO market – a market which has already seen massive write-downs from all major investment houses in the US and elsewhere – the real problem lies in the fact that all securities insured by Ambac would be downgraded were Ambac itself to be downgraded. And this includes in excess of a couple of trillion US dollars worth of municipal bonds. Municipal bonds are issued by the likes of what we’d call “local councils” in Australia, and represent a truly enormous proportion of the US (and global) fixed interest investment market.

See the bigger problem?

Over the past few months FNArena has been liberally referring to a favourite metaphor as coined by Charles Gave of GaveKal. It involves “dynamite fishing”. First little dead fish rise to the surface, and then some bigger dead fish. But eventually, up pops a whale. Once the whale surfaces, a shift in monetary policy can be expected.

In Britain, the whale was Northern Rock. The demise of this significant mortgage provider forced the Bank of England to guarantee all British bank deposits. While the US has seen some devastating collapses in institutions such as Citigroup, to date there has been no real whale – nothing big actually dead in the water. GaveKal wonders however, whether monoline insurers may well be that whale. The shift in monetary policy was the emergency 75 point rate cut from the Fed.

The point of a shift in monetary policy is that it is what should trigger the rebound, or at least stabilisation. Throughout the credit crisis the Fed has been roundly criticised for being “behind the curve”. That is, it has acted reactively and not proactively, constantly doing too little too late and being forced to do more. Will the market see this latest move as being sufficient?

Well unfortunately the US Fed futures market is still pricing in a 74% probability of another 50 point rate cut next as quickly as next week (the scheduled meeting). This might mean the real whale is yet to actually surface. Could it come from Europe? The ECB is yet to respond to anything.

But along with monetary action we have also seen fiscal action, and now likely regulatory action. The Bush Administration is negotiating with Congress for a US$150bn “bail-out” of the US consumer through tax relief. This is aimed at addressing recession fears. And then last night we learnt that banks and brokers had got together with the New York state insurance regulator with regards to the crisis in monoline insurers.. It’s early days, but no doubt some sort of rescue package will emerge. Wall Street bounced hard on this news last night. is that enough to signal stability?

”A kind of bailout supported by monetary authorities or governments is the only chance for the industry to survive,” said Jochen Felsenheimer, the Munich-based head of credit derivatives research at UniCredit, Italy’s biggest bank. ”This bailout seems to be highly likely given the important role of bond insurers in the current market environment.” (Bloomberg)

The New York insurance regulator is currently going about drafting new legislation that will change the nature of bond insurance activities in the future. However, we still have the present to deal with. Ratings agency Fitch has already stripped Ambac of its AAA rating, while both S&P and Moody’s have put both Ambac and MBIA under review. Another insurer – ACA Capital Holdings – has managed to negotiate a stay of execution – avoiding immediate delinquency proceedings from its state regulator to allow time to unwind US$60bn of credit default swaps it can’t pay, Bloomberg reports.

Ah yes – credit default swaps. Another supposedly “new” problem that FNArena was warning about as long ago as October. These are contracts which “swap out” the sort of default risk monolines are insuring against. In many cases, there are more default swaps in the market over certain bonds than there are bonds. In other words, another disastrous form of leverage.

At present, credit default swap transactions are indicating both Ambac and MBIA themselves have more than a 60% chance of defaulting. If default is the case, the New York Fed would be forced to step in. Another forced monetary response to save the whales.

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