Debt Rattle, February 4 2008

Ilargi: There’s so much attention in the media for the monolines, we could easily fill our Debt Rattles with just that, for days on end. Not only would that become boring and one-sided, there’s a second big topic, albeit still out of sight of the mainstream, that deserves our focus: the role of the Fed in the markets. Why does the Fed choose to act as it does?

Still, we open with Oppenheimer analyst Meredith Whitney, who as usual looks a bit conservative in her numbers, but doesn’t pull any punches on the failing mechanisms. Note that the article below is from Investment Week, not exactly known as a doom paper.

The chances are “akin to finding reinsurers for the 9th Ward after Hurricane Katrina.”

A possible collapse of teetering bond insurers could cost financial firms, including Merrill Lynch & Co. and Citigroup Inc., as much as $75 billion, according to a report from Oppenheimer & Co. analyst Meredith Whitney, according to Crain's New York Business.

The losses would come on top of over $100 billion in mortgage-related write-downs taken by financial firms over the last few months. The huge additional potential hit stems from guarantees for complex securities written by insurers including Manhattan-based Ambac Financial Group Inc. and Armonk, N.Y-based MBIA Inc.—the nation’s two largest bond insurers. Their survival is very much in doubt as they wrestle with enormous losses on insurance they wrote on mountains of mortgage-related securities.

The New York state Department of Insurance is discussing a bailout plan as ratings agencies are preparing to slash the insurers’ pristine credit ratings unless they can somehow raise billions in cash to cover their losses. Those credit downgrades could be especially devastating for Merrill Lynch, Citigroup, and UBS, predicts Ms. Whitney, since they hold the largest amounts of guaranteed securities and would be forced to mark down their value steeply.

Ms. Whitney pegged Merrill’s exposure to the bond insurers at $14.7 billion, Citi’s at $12.9 billion and UBS at $10.8 billion. Altogether, she estimates financial institutions have about $88 billion of exposure to the bond insurers. “When it becomes clear (as we think it will) that more charges are on the horizon,” Ms. Whitney wrote, “we believe the market will take another turn for the worse.” Further losses, in turn, could force Wall Street firms to tap overseas investors yet again for costly injections of cash. That would likely further depress the firms’ battered share prices and raise questions in Washington about foreign ownership of American banks.

A bond-insurer bailout could help avoid this pain but Ms. Whitney deems it unlikely that such a plan will emerge. It also looks unlikely that the insurers will find sufficient capital to protect their credit ratings. As for the odds of finding other parties willing to take on the troubled businesses of MBIA and Ambac, Ms. Whitney said the chances are “akin to finding reinsurers for the 9th Ward after Hurricane Katrina.”

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Ilargi: The Financial Times still suggests that Ambac and MBIA can be rescued for around $1 billion. Sean Egan of ratings agency Egan-Jones said on Friday that to rescue 7 bond insurers would take over $30 billion each.

While most commentators keep stating that a bail-out will be realized, someway or another, it's not that easy. The risks and the money involved are far too high for most "credible parties" to step into. There are no parties left who don't have to focus primarily on their own bottom line.

Private equity firms unlikely to rescue Ambac and MBIA

Leading private equity firms are unlikely to participate in any recapitalisation of Ambac and MBIA, increasing the pressure on banks to come up with a rescue package for the troubled US bond insurers. A number of firms, including Bain Capital, Carlyle Group, Kohlberg Kravis Roberts and TPG, have looked at investing in the cash-strapped groups, which guarantee the value of everything from municipal bonds to the most complicated mortgage securities. These investors have all concluded that the risks are too great, according to people familiar with their thinking.

This puts more pressure on the banks to provide rescue financing for Ambac and MBIA. Some large banks and securities firms could face large writedowns on mortgage securities, as well as derivatives, if the bond insurers lose their triple-A credit ratings. A group of eight banks is considering a plan to inject capital into Ambac, which needs at least $1bn (£510m). Several banks are also believed to be talking to MBIA, which needs at least $500m. It is likely that any solutions - a top priority for regulators - will be crafted for each bond insurer, rather than as a general bail-out.

The reluctance of big private equity firms to become involved comes after they looked closely at the two large monolines. They also studied the experience of Warburg Pincus, which committed $1bn to MBIA in early December at what seemed an attractive price, only to see MBIA's share go into freefall. Additionally, they noted that Blackstone, which has a minority stake in FGIC, had so far declined to put more money into that troubled bond insurer.

"If we worry that we can get shot from the shadows by something we can't see coming, it is not for us," says the managing director in charge of financial service investments for one of the leading private equity funds.

"The financial guarantors pass neither the shadow test nor the ability-to-understand test."

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Ambac Still Eyeing 'Credible' Parties for Capital

Ambac Financial Group Inc, a big bond insurer struck by the global credit crunch, is still talking about its capital position with "credible parties," a managing director at the company said on Sunday.

Ambac is the subject of a rescue plan by investment banks seeking ways to shore up insurers' capital which has been weakened by downgrades of mortgage-related securities, two people briefed on the talks told Reuters on Friday. Lower values on the securities have increased insurers' financial responsibility and threatened their top-notch "AAA" ratings needed to reassure investors of the quality of their support. "We are committed to a triple-A rating," Paul Burke, Ambac's head of fixed-income investor relations told Reuters at a meeting of the American Securitization Forum in Las Vegas. He said he was reiterating what the company said last month.

Ambac Chief Executive Officer Michael Callen on Jan. 22 said the company was looking at other ways to raise capital after he shelved a planned $1 billion offering of equity or convertible securities due to market conditions. Callen spoke after the company reported the $5.2 billion pre-tax write-down for the fourth quarter. Burke's address about the development of markets for securitizations around the world helped kick off the ASF meeting of about 6,000 Wall Street dealers and bond investors trying to preserve a huge part of the bond market thrown into a tailspin by soaring defaults on U.S. mortgages

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How Wall Street Killed the Economy

The “subprime mortgage” mania began in 2004 when lenders started giving out mortgages to almost anyone — with little or no proof of income — because of profits that could be made off fees, high interest rates and reselling the mortgages. To sell subprime loans, lenders gave low rates for the first two years. After this the mortgage rate would shoot up, sometimes doubling or even tripling monthly payments. Caught between stagnant wages and rapidly increasing house values, Americans turned their homes into cash machines this decade and withdrew trillions of dollars in equity. By last year, many subprime loans were resetting at higher rates and homeowners started to default. This cooled off the housing market fast. Jobs were lost in real estate, construction and home lending, and retail spending slowed, slowing the economy.

How does this link to the financial sector? Say you’re Bank of America. You have 1,000 mortgages lying around, so you “bundle” them and create “mortgage backed securities” (MBS) to sell to banks, hedge funds and foreign investors. You get your cash back, and a steady stream of fees for managing the mortgages. To sell MBSs, you go to a ratings agency like Moody’s Investor’s Service or Standard & Poor’s. You slice up the bundle like cuts of beef. The choicest MBSs get Aaa ratings, meaning they will almost certainly be paid back. The ratings go down — Aa, A, Baa, down to Ccc and then unrated — according to the likelihood they will be paid back.

As lenders were writing trillions of dollars in mortgages to sell, not to hold, they didn’t have an interest in seeing the loan repaid. Then, lenders took risky mortgage backed securities (rated Bbb, for instance) and repackaged them as highly attractive Aaa financial products. Some of these are called “collateralized debt obligations” or CDO. Ratings firms generated huge profits from giving these dodgy products the seal of approval. Moody’s earned nearly $850 million from structured finance products in 2006 alone. The final player is “monoline” insurance companies, which insure more than $1 trillion in municipal bonds. If a city wants to build new schools or roads or expand mass transit it sells bonds. To lower costs, a city buys insurance from monoline insurers, such as MBIA or Ambac. This makes the bond more desirable to the buyer because the insurer will pay out if the city defaults.

Just as lenders pushed risky subprime mortgages, monoline insurers started insuring mortgage backed securities. An example shows how this works. Suppose your company is Goldman Sachs. GM wants to borrow $100 million. You give it a loan at 5 percent interest, which means they pay $5 million a year in interest. To be sure your loan is safe you buy insurance from MBIA. Deciding GM is a good risk, MBIA sells you the policy at 1 percent. So while GM pays you $5 million a year, you pay MBIA $1 million a year to assume the risk. If GM defaults on the loan, MBIA will cover the loss. These insurance contracts are known as “credit default swaps.” Taking the example above, GM starts bleeding money and can’t service its debt. This causes the value of your loan to decline, but the value of your insurance contract, the credit default swap, rises because it’s more likely it will have to be paid out.

Here’s where things get nutty. An unregulated market, totaling a breathtaking $45 trillion, grew up as banks, hedge funds, brokers and insurers sold these swaps back and forth. It’s pure gambling, where buyers and sellers often do not hold the underlying debt. As hundreds of thousands of homeowners began defaulting on subprime loans, many MBSs started going bad, too. By last year, there was $1.3 trillion in CDOs worldwide and 56 percent of this was made up of mortgage backed securities.

The damage is spreading on Wall Street with large job cuts in finance and a credit crunch that’s making it harder for businesses and homeowners to borrow. This creates more problems. As foreclosures multiply and property values decline, many cities and states are facing huge tax shortfalls. On the cusp of recession, they have to borrow more money to fund operations. But as monoline insurers are downgraded, the cost of insuring municipal bonds goes up. In addition to the blow of a recession, Americans will see government services slashed and having to pay more for the services that remain.

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ICBC Deposes Citigroup as Chinese Banks Rule in New World Order

There's a new world order for banks, and the Chinese, for the first time, are the biggest, with a market capitalization that has made perennial No. 1 Citigroup Inc. a distant also-ran behind Industrial & Commercial Bank of China Ltd., China Construction Bank Corp. and Bank of China Ltd.

"The tables have been completely turned," said Daniel Yergin, the Washington, D.C.-based chairman of Cambridge Energy Research Associates Inc. during an interview at the World Economic Forum in Davos, Switzerland.

The reversal of fortunes is the clearest sign yet that shareholders are betting on banks in the emerging markets rather than the U.S. institutions that dominated the financial landscape for most of the past century. As recently as 2003, there were 13 American banks ranked in the top 20 and not a single Asian rival, data compiled by Bloomberg show. Now, there are four Asian and six U.S. institutions. The collapse of the subprime mortgage market wiped out almost $100 billion of value from the three biggest U.S. banks in the past six months.

It was just a year ago that Citigroup was the world's biggest bank by market value, and ICBC was beginning its fourth month as a publicly traded company. Today, Beijing-based ICBC is the largest financial-services firm and Citigroup has tumbled to seventh on growing concern that the 196-year-old company is no match for a bank based in the world's fastest-growing major economy that has more customers than the combined populations of France, Spain and the U.K. "As far as the financial industry is concerned, in August you went from one world to another almost overnight, especially in the U.S.," said Yergin, whose book "The Prize: The Epic Quest for Oil, Money & Power" won the Pulitzer Prize in 1992.

Citigroup, Zurich-based UBS AG and Royal Bank of Scotland Group Plc in Edinburgh, names that headed the list of largest companies five years ago, are today's laggards. The new champions are ICBC and Beijing-based China Construction Bank, as well as Bank of America Corp. in Charlotte, North Carolina, and London-based HSBC Holdings Plc, two companies criticized by shareholders for relying on consumer banking networks rather than securities units that propelled profits at competitors until the second half of last year.

Investors have piled into Chinese banks to participate in an economy that expanded 11.4 percent in 2007, the fastest in 13 years. ICBC, China Construction Bank and Bank of China, the country's three biggest, are valued at $608 billion, compared with $496 billion for Bank of America, JPMorgan Chase & Co. and Citigroup. ICBC is worth about 1.99 trillion yuan ($277 billion), $82 billion more than Bank of America, its closest rival.

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More Data on Housing, Spending This Week

The markets are angling for more rate cuts to stoke the economy, but what could tie the Fed's hands is inflation. High food, energy and healthcare costs are a reason consumers _ particularly homeowners with tough-to-pay mortgages _ are cutting back on discretionary spending. Those high prices may also be the only reason readings on personal spending are in positive territory.

The Commerce Department's index last week for personal consumption expenditures, a gauge of inflation, rose 0.2 percent in December from November levels. This week, the Labor Department reports on productivity and labor costs; the market is expecting labor costs to decline, and could be disappointed if they end up being higher. "The worst of all possible worlds is stagflation," said Janna Sampson, director of portfolio management at Oakbrook Investments. Stagflation happens when the economy weakens at the same time prices are rising. It's a problem that can't be solved with rate moves; rate cuts spur inflation but boost growth, while hikes control inflation but also dampen growth.

This week, economists surveyed by Thomson/IFR are preparing for more signs that the economy is still growing, but very slowly because of a weak consumer. They expect the Commerce Department's December factory orders index on Monday to tick up and the Institute for Supply Management's Tuesday report on January service sector growth to show a slight slowdown. They also expect the weekly ICSC-UBS chain store sales index on Tuesday to post a decline. Meanwhile, the National Association of Realtors will release on Thursday its index on pending sales of existing homes, and economists predict a modest increase. And that same day, retailers are releasing their sales results for January.

Investors will also be paying close attention to speeches from Fed officials for insight into their thoughts on the economy and inflation, and whether the central bank is leaning toward lowering rates again when it meets March 18. Atlanta Fed President Dennis Lockhart, Richmond Fed President Jeffrey Lacker, Fed Governor Randall Kroszner, Philadelphia Fed President Charles Plosser and San Francisco Fed President Janet Yellen are all making public appearances this week

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Ben Bernanke Declares War on the US Dollar!

The Fed says its rate cuts are in anticipation of sustained economic weakness. Interestingly enough, the emergency cut came without new economic data. I'd say they were using excessive force to pre-empt significant stock markets losses with that one. However, there's no doubt that the U.S. economy is facing severe challenges right now: A housing recession ... the subprime mortgage crisis ... tighter credit conditions ... severe blow-ups on corporate balance sheets ... and anemic GDP figures.

Some of the latest signs:

• The rate of homeownership declined substantially in the fourth quarter of 2007. Vacancies among homes for sale are surging while house prices and sales of new and existing homes continue to drop.
  
• The U.S. posted GDP growth of just 0.6% in the fourth quarter. That was a huge disappointment. And the International Monetary Fund now estimates 2008 global growth at 4.1%, down from 4.4% in 2007.
  
• Expectations for corporate earnings are looking grim. Year-over-year earnings for S&P 500 constituents are expected to drop 20.5% from the fourth quarter of 2007. Ouch!
  
• Balance sheets of financial institutions across the globe are still chock full of bad debt thanks to scores of complex derivatives.
  
• There are major questions about the future of the U.S.'s two largest bond insurers. One of them, MBIA, just announced its biggest ever quarterly loss!

And then yesterday we got another round of bad news: The U.S. is losing jobs FAST! Payrolls declined in January for the first time since 2003. The report also noted downward revisions to the final months of 2007 — strengthening the case for a U.S. recession. You simply can't pull any positives from that pile of wreckage. And so, in that sense, it's hard to blame the Fed for slashing rates.

After all, the Fed's policy can have noticeable influences on our economy. Pouring money into the system, as they're doing now, can get things moving again. But in this instance, who's there to soak up all this money? Levels of debt have already reached extremes. U.S. household debt now sits at a stunning 130% of disposable income. And what business wants to borrow when the climate is so shaky? Translation: The Fed could lose its ability to stimulate spending, rendering its rate cuts ineffective. Americans may actually get TIRED of borrowing!

At that point, real assets will have to take a hit instead.

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BLS Censors Birth/Death Employment Disclaimer

An intrepid reader from Germany (we're big overseas) writes in to us to note a significant change in the BLS's documentation of the "Birth-Death model". This is a computation the BLS makes to its CES employment statistic to account for supposed business births and deaths which wouldn't be expected to show up in the job creation count. However, the contribution of this factor since 2001 has increased, at times accounting for 40-80% of all jobs tallied as created
The BLS used to admit that this factor would tend to be way off during economic trend changes. But as source points out:

Accidentially I noticed yesterday, that the most interesting part of the information concerning the model has been cut out: Please compare the current content of the site (last updated on Feb 1st 08) to the attached printout I made in Dec 07. Missing is a part of the text containing sentences like "The most significant drawback to this or any model-based approach is that time series modelling [...] is likely to have some difficulty producing reliable estimates at economic turning points..."

We used to consider the BLS's disclaimers refreshingly honest -- for anyone who actually bothered to read them and go beyond the superficial "headline" employment statistics. For example, these guys even admitted they implemented a "substitution effect" computation -- a favorable downward-smoothing -- into the CPI, even though actual studies looking for the effect were inconclusive. But hey, maybe they've erased that disclosure too. That'll solve the inconsistency.

Apparently, too many people are finding out that the employment statistics are extremely suspect, especially when the economy's trajectory changes. There has been a lot of coverage of this in the blogosphere over the last few years. So right now the BLS must realize that the last thing it needs is to be admitting that its employment numbers become almost purely fictional when entering an economic downturn. Given how important a topic the economy has suddenly become, one might argue this is the most critical time to have accurate numbers! (A point lost on academic economists with their back-testing.)

We'd love to hear the BLS's explanation for why they removed this disclaimer. Have the methods changed so radically (completely unannounced) that this flaw is now eliminated, or is this just more informational subterfuge from the government?

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Ilargi: Last week, we saw Reuters waking up to the looming Option ARM storm, now Business Week feels a draft. This is much bigger than subprime, and don’t you forget it. People with more money and better credit went in over their heads as well with big homes and big mortgages. And there’s more of them, plus they were able to borrow more in absolute terms. And they did.

Getting Knocked Down by Prime ARMs

Prime ARMs went to borrowers with good credit because they were less likely to default, right? Wrong

We've been reading a lot lately about how subprime mortgages have submarined the economy. Lenders and banks have been taken to the woodshed for irresponsibly giving money to home buyers with poor credit just so they could bundle up the mortgages and resell them as toxic residential-mortgage bonds. But, while there's no denying the subprime problem, on closer look it's clear that even prime borrowers were taking on more debt than they could afford.

How bad is it? In Arizona, between the third quarters of 2006 and 2007, there was a 902% rise in foreclosures started against homeowners who had prime adjustable-rate mortgages, known as ARMs, according to the Mortgage Bankers Assn. ARMs, whether prime or subprime, are the real culprit in the housing crisis because they've allowed too many people to buy homes with almost no money down, with the hope that they could flip the properties or have rates drop before the loans reset.

The rise in prime ARM foreclosure starts isn't isolated to a few states. Nationally, foreclosure starts related to prime ARMs jumped 253% in the third quarter of 2007 when compared to a year earlier. "The fact is the pain of the changing real estate markets is affecting more than just subprime borrowers," says Keith Gumbinger, vice-president of HSH Associates, a New Jersey-based financial information publisher. "It's more important to think of it as perhaps an ARM problem and a rate reset problem, not just a subprime problem."[..]

Of course, nobody would be complaining about ARMs if home prices were still rising.
"There was so much competition for mortgages over the last couple years that the definition of prime became less and less stringent," says Addison Wiggin, publisher of Baltimore-based Agora Financial, which publishes investment advice for individuals. "Even in the prime market, you had people taking on larger loans than they historically were able to handle."

Borrowers with good credit are in a healthier position than subprime borrowers because lenders see them as less risky candidates for refinancing and are willing to put them into fixed loans. But not all prime borrowers can qualify for refinancing, particularly if they owe more on a mortgage than the house is worth or if they've lost their job and can't meet salary or other underwriting requirements. Refinance applications from borrowers have surged in recent weeks, according to the Mortgage Bankers Assn., which doesn't break out prime and subprime applications.

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Fed's Main Task: Save The Banks

Aggressive moves to cut interest rates by America's central bank are intended to stave off a financial meltdown.

In moving with unusual speed to cut interest rates, officials at the Federal Reserve are aiming to prevent a nationwide recession, but they're also doing something more targeted: throwing a lifeline directly to the beleaguered banking industry.

The Fed says that it isn't trying to bail out anyone. Rather, its move is grounded partly in concern that banking troubles could deepen, choking off credit to the whole economy at a precarious time. The pace of consumer spending stalled in December, according to government data released Thursday. America's businesses are also on edge, with slow job creation causing a rise in unemployment. In response, the central bank is moving to stimulate growth. But it is also trying to forestall a possible bank meltdown that would worsen the situation.

The interest-rate cuts could give financial firms some breathing room to absorb losses tied to home loans. "This is more about Wall Street than Main Street," says Ken Goldstein, an economist at the Conference Board, a business-sponsored research group in New York. "We've got the monetary strategy we've got because financial markets are nervous." The Fed pointed to this anxiety, and to the risk it poses, in announcing its latest moves. "Financial markets remain under considerable stress, and credit has tightened further for some businesses and households," the Federal Open Market Committee said in the statement accompanying the rate cut on Wednesday.

Citing "downside risks" to the economy, the statement again pointed to Wall Street, saying it "will continue to assess the effects of financial and other developments on economic prospects" in deciding future policy actions. The key point: Financial developments have an impact that extends beyond the geography of Manhattan or the paychecks of investment bankers – many of whom are going without million-dollar bonuses this year.

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Who cares for the dollar? Not the Fed, surely!

Why the US rate cut may kill the dollar
Central bankers, economists and analysts are an anxious lot. As stock markets across continents are inexorably linked to the US Fed, they realise that the move to cut interest rates has far reaching implications. They know for sure that to save the United States' financial sector as a whole from complete collapse, the Fed has taken a huge gamble, especially on the dollar.

This could, in turn, have a debilitating impact on the US financial sector, American economy and by extension on the global economy, as talked about in the previous part of this column. But as global markets debate the rate cut move, the US Fed -- the author of the move itself -- goes virtually un-scrutinised and unquestioned, in and outside the US. Crucially, the approach of the Fed to savings, investments, stock markets and the symbiotic link provided to all these is central to understanding its motives and what drives its decisions.

Interest rate cuts -- Who benefits?
Despite being dependent on other countries for funding its trade deficit, the US establishment has never been bothered about domestic savings. It is in this connection that Ben Bernanke, who was the head of George Bush's Council of Economic Advisers and subsequently became the Fed chief, had suggested in 2005 that the world suffers from excessive savings -- what he termed as 'savings glut,' implying lack of investment opportunities within developing countries. Further, he argued that people save less in developed countries, especially in the Anglo Saxon ones, because of the sophistication in their financial markets -- read investments in stock markets -- and that higher savings in other countries is because of the 'poor returns' and 'underdeveloped markets.'

And Bernanke is not alone in this matter. In fact, this is the thinking within the Fed. . . Bernanke's predecessor, Alan Greenspan, a celebrated economist and a Fed chief for over 18 years between 1987 and 2005 in his book The Age of Turbulence, goes a step further and theorises that the propensity of the people to save is a sign of underdevelopment. In contrast, he points out how developed countries, through their vast financial networks, enable a 'significant fraction of the consumers to spend beyond their current incomes.' In short, according to Greenspan, Bernanke and the Fed, savings is a sin, spending a virtue.

This paradigm was captured brilliantly by The Economist which in a paper published on April 7, 2005, points out: 'It may be a virtue, but in much of the rich world thrift has become unfashionable. Household saving rates in many OECD (Organisation for Economic Co-operation and Development) countries have fallen sharply in recent years. Anglo-Saxon countries -- America, Canada, Britain, Australia and New Zealand --have the lowest rates of household savings. Americans, on average, save less than 1 per cent of their after-tax income today, compared with 7 per cent in the beginning of the 1990s. In Australia and New Zealand, personal saving rates are negative as people borrow to consume more than they earn.'

All these are not as simple as it seems on superficial examination -- an issue related to the importance of savings in an economy. What is crucial to remember is that if the developing ones do not fund the developed ones, especially the Anglo-Saxon countries, for the requirement of their capital, these 'developed' countries could come to a grinding halt. This is one issue that Alan Greenspan failed to answer in his book

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For Munis, Don't Sweat Insurer Woes

The idea of insuring munis may seem odd. Most of the issuing governments and government entities aren't in danger of going out of business.

But there are literally thousands of such issuers, and some sell debt rarely. Buying insurance enables them to get the top, triple-A rating for their bonds and issue the securities at lower yields, which cuts their costs.
Insurance also makes it easier for investors to value bonds sold by lesser-known issuers. But for now, many think that value has fallen. Concerns stem from moves in recent years by Ambac Financial Group, MBIA and other, smaller insurers to expand into riskier parts of the bond market, such as subprime mortgage-related issues. Last year, the value of those bonds plummeted amid surging mortgage defaults.

Ratings firms have threatened to cut ratings of the insurers because of concerns about the financial impact of having to compensate bondholders for missed interest payments, or ultimately, for some borrowers' failure to return investors' money. If an insurer gets downgraded, so do the bonds it insures. Fitch Ratings, the first major ratings firm to act on such threats, in mid-January cut Ambac's claims-paying ability rating to double-A from triple-A. It since has downgraded several smaller insurers.

Last week, MBIA raised additional capital and executives said they were confident the firm would retain its triple-A rating. Meanwhile, a consortium of banks is working on a possible bailout of Ambac and New York insurance regulators are mulling rescue options. Among fears of further downgrades, investors have responded by marking insured bonds down to the price levels where they would trade if they were uninsured.

But professional bond managers believe such selling has pushed many bonds down to attractive levels.
Because the interest paid by munis usually is exempt from federal income tax, and sometimes also from state or local income tax, munis typically yield around 80% to 90% of the yields of Treasurys. But as prices of munis have fallen, their yields -- which move the opposite way -- have risen to about the same level as those of Treasurys. That makes munis a good deal for nearly everyone who pays taxes, and not just for those in the highest tax brackets.

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Monoline concerns could rock capital markets

Monolines were initially established to guarantee bonds from municipalities, such as local and state authorities or private finance initiatives, to help them raise money in the debt markets. The model was simple. By having a guarantee from a bond insurer with an AAA credit rating, the cost of borrowing was less than it would normally be and the number of investors willing to buy such bonds was greater.

For the monolines, guaranteeing such bonds was largely risk-free, with average default rates running at a fraction of 1 per cent. As a result, monolines leveraged their assets to build their books, and it was not being uncommon for a monoline to have insured risks 100 to 150 times the size of its capital base. Until recently, Ambac, for example, had capital of $5.7bn and guarantees of $550bn.

That changed, however, in the late 1990s, as companies in the sector were increasingly faced with reducing margins and an increase in local authorities issuing bonds without a guarantee. By 1998, Dinallo's predecessor at the NY insurance superintendent's office agreed to allow monolines to sell credit-default swaps (CDSs) on asset-backed securities such as mortgages. The basic premise was that separate shell companies would be established, through which CDSs could be issued to banks for mortgage securities.

The move into structured finance went well. MBIA saw premiums rise from $235m in 1998 to $998m last year, boasting of an increase of 140 per cent in its structured finance book last year alone. But then along came the US sub-prime mortgage crisis, and the music stopped for the monolines. As the mortgages within bonds from the banks defaulted - sub-prime mortgages written in 2006 are already defaulting at a rate of 20 per cent - so the monolines had to step in and cover the payments.

On Thursday, MBIA highlighted the true extent of these problems, revealing $3.5bn of writedowns and other charges in three months alone, leading to a quarterly loss of $2.3bn. And that is likely to be just the tip of the iceberg. "The answer is no one knows," says Donald Light, insurance analyst at US research house Celent, when asked what the potential downside loss is. " I don't think we will know to perhaps the third or fourth quarter of 2008." Myer agrees: "Remember, an insurance company only has to pay out if something goes wrong with the under?lying risk. At the moment, no one quite knows what the probability is - and therefore they don't quite know what the outcome is."

Credit ratings agencies have begun downgrading the monolines, taking away their prized AAA ratings, which means a monoline can no longer write new business, and the bonds it guarantees no longer hold a AAA rating either. To date, the only monoline to receive downgrades from two agencies - usually required for such a move to impact on a company - is FGIC, cut by both Fitch and S&P. Ambac, the second largest monoline, has been cut to AA by Fitch, with the other monolines on a variety of different potential warnings.

Myer says the damage may already have been done. "The financial system works on confidence. To the extent that there is a threat of a downgrade to the monolines, people question the confidence they have placed in them as soon as the threat appears."

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Ilargi: I don’t know about you, but I find it funny that the Toronto Star, a major newspaper, can’t seem to find out who was picked as “executor” for the Canadian ABCP morass, while The Automatic Earth reported on that yesterday: it’s BlackRock.

Debt restructuring hurts Coventree

Claims committee ruling puts it out of business

Coventree Inc. has become the first Canadian casualty of asset-backed commercial paper after disclosing that a decision on restructuring the investment trusts essentially put it out of business. The firm said yesterday that the Pan-Canadian Investors Committee, also known as the Montreal Accord and headed by Bay Street lawyer Purdy Crawford, opted against a proposal by Coventree to act as an administrator and asset manager of the troubled ABCP.

The decision will essentially end all of Coventree's business activity, the company said. Coventree said the committee, formed last August by a group of financial institutions to rescue $33 billion in stranded commercial paper, asked several firms to outline who should manage the ABCP after the restructuring process. The firm was the largest non-bank arranger of ABCP in Canada, holding nearly half of the investment trusts, valued at about $16 billion.

"Coventree's supported bidder was advised that ... the Investors Committee selected another proposal," the firm said in a release. The committee declined to say who was chosen for the role.

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