WSJ and FT on How Far Down is Down, Exactly? (Bond Insurer/Counterparty Risk Edition)

Despite a sharply negative opening, the Nikkei is up as of this hour, so there is some hope that the frazzled nerves of Thursday might calm in the US too.

The Financial Times and the Wall Street Journal both address one of the major causes of the mini-panic: a new focus on counterparty risk. The credit markets have been more cognizant of this issue (frankly, equity markets can be remarkably thick as far as bad news is concerned), but concerns ratcheted up when Merrill announced that $3.1 billion of its $16.7 writedown was due to the apparent worthlessness of hedges written by an obscure (to those not following credit guarantors) counterparty, ACA Financial Guaranty.

Now to be fair to the press, it is pretty hard to write about counterparty risk until blow-ups start. We’ve been worried about this issue since last August in the context of credit default swaps (and voiced more concerns in November) but we were uncharacteristically tempered due to a dearth of smoking guns. This is an OTC market, and if you aren’t a participant and dealers aren’t talking to you, it is hard to know how imminent problems are. While we could point to structural conditions that were troubling, and thus seemed to make the area ripe for trouble given stresses elsewhere in the credit markets, it was an open question as to when the other shoe would drop.

Now to the Journal and FT stories. As is often the case, there is a curious disconnect between the two. The Journal uses the crisis at ACA to frame the counterparty risk problem in the $45 trillion credit default swaps market, but manages to omit central developments:

At the center of these concerns is a vast, barely regulated market in which banks, hedge funds and others trade insurance against debt defaults….called credit-default swaps, in which one party, for a price, assumes the risk that a bond or loan will go bad….

Not everyone who buys one of these contracts has bonds to insure; because the value of an insurance contract rises or falls with perceptions of risk, some players buy them just to speculate….

If they default, everyone is supposed to settle up with each other…. Even if there isn’t a default, if the market value of the debt changes, parties in a swap may be required to make large payments to each other…

“You are essentially counting on the reliability of strangers” to pay up on their contracts, notes Warren Buffett, the Omaha billionaire. In some cases, he says, market players can’t determine whether their trading partners have the ability to pay in times of severe market stress.

The issue is raising broader concern among regulators and investors over what Wall Street calls “counterparty risk,” the danger that one party in a trade can’t pay its losses…Banking regulators have focused on counterparty risk amid the boom in credit derivatives, instruments whose value depends on the value of some other asset. But they’ve concentrated mainly on banks that service the instruments and on hedge funds that actively trade them — jawboning to try to ensure that trades are properly documented. Few envisioned a little-known bond insurer like ACA causing so much instability

The Journal, using a standard template, narrates the ACA story long-form. That’s fine up to a point, but what is bizarre is what the Journal fails to discuss. First, it focuses on a small player, ACA, and largely ignores the 800 pound gorillas in the room, MBIA and Ambac, which probably had more to do with the market upset than ACA. This is the only reference, the fourth paragraph from the end:

Investors, banks and regulators are also concerned about bigger bond insurers. Moody’s said this week it may cut the top ratings on MBIA and Ambac.

This is simply breathtaking, verging on negligent. There is no indication of the importance or size of MBIA and Ambac relative to the puny and lower rated ACA, the sharp deterioration in how both the stock and the creditworthiness of both companies are perceived, or of the fact that S&P is also reviewing both companies. The Journal also mentions regulatory issues:

This market poses challenges for would-be regulators. It isn’t clear, for instance, how securities laws on fraud and insider trading would apply to credit-default swaps, because it’s not clear in what way they are even securities; they are private contracts.

Of all the regulatory concerns, fraud and insider trading are low on the list. And the idea that the SEC and banking regulators had no reach is spurious. Had they taken a dislike to this market, they could have curtailed it by requiring imposing high regulatory capital be held, which would have rendered the business uneconomic. Similarly, there is a case to be made (and I am surprised no one has argued it) that this is an unregulated insurance market, but going down that avenue might have created massive turf wars between Federal banking and securities regulators versus state insurance authorities.

The biggest problem with the lack of jurisdiction is that it isn’t at all clear who if anybody has the authority to address any problems that occur. A downgrade of MBIA or Ambac will have vastly worse consequences than the bankruptcy of Countrywide would have. Yet there is widespread belief that the government played a hand in the staged purchase of Countrywide by Bank of America, possibly to forestall the losses to the Federal Home Loan Bank system. But no regulator (save perhaps New York’s superintendant of insurance, Eric Dinallo) seems to be on top of this situation.

Believe me, I’d be delighted to be wrong and read of a Perils of Pauline rescue by wealthy foreigners. But don’t count on it. The best we can reasonably hope for is that the likes of Berkshire Hathaway and AIG shore up part of the monoline’s portfolios, either by purchasing them or more likely via reinsurance.

Predictably, the Financial Times gives more relevant and focused coverage. And the quote at the end from Jamie Dimon will become a classic if the situation deteriorates (let’s hope not):

Fears that the credit crunch might be entering a traumatic new phase grew on Thursday as investors lost confidence in the insurers that guarantee payments on billions of dollars in bonds.

Shares in Ambac Financial and MBIA, the world’s biggest bond insurers, fell 52 per cent and 31 per cent, respectively, as Moody’s Investors’ Service raised the possibility that both might lose the triple-A credit rating on which they depend.

The sector was dealt another blow when Merrill Lynch said it was writing down $3.1bn in hedges with bond insurers, mostly with ACA Capital, a guarantor that has lost its investment-grade rating and needs to raise $1.7bn by on Friday to avoid insolvency.

The triple-A credit rating of the bigger bond insurers is crucial because any demotion could lead to downgrades of the $2,400bn of municipal and structured bonds they guarantee.

This could force banks to increase the amount of capital held against bonds and hedges with bond insurers – a worrying prospect at a time when lenders such as Citigroup and Merrill are scrambling to raise capital.

“Significant changes in counterparty strengths [of bond insurers] could lead to systemic issues,” said Eileen Fahey, managing director at Fitch Ratings.

The crisis of confidence in MBIA and Ambac has been building because of their exposure to securities backed by assets including subprime mortgages. Warren Buffett’s Berkshire Hathaway set up a new bond insurer last month after New York state’s insurance regulator pressed him to do so.

The pressure on the traditional bond insurers rose on Wednesday when Ambac said it planned to raise $1bn in equity. Just hours later, Moody’s said it was putting Ambac’s triple-A rating on review for a downgrade.

On Thursday, Moody’s said MBIA’s triple-A rating could also be cut, including ratings of $1bn worth of capital that it raised just last week.

Standard & Poor’s said on Thursday that losses for bond insurers could be 20 per cent higher than previous estimates, raising expectations that it, too, might consider lowering its triple-A credit ratings for Ambac and MBIA….

Jamie Dimon, chief executive of JPMorgan, said this week when asked about bond insurers: “What [worries me] is if one of these entities doesn’t make it . . . the secondary effect . . . I think could be pretty terrible.”