Bloomberg reports that Security Capital is the first top-rated bond insurer to be put on watch for a possible downgrade. Note that Fitch says that Security Capital needs an additional $2 billion in equity to retain its AAA. Given that industry leader MBIA just secured $1 billion from Warburg Pincus, and many were surprised at that move, the notion of a smaller insurer raising $2 billion would seem an insurmountable task.
Note that Bloomberg refers to XL which is a reinsurer that has 47% stake in Security Capital.
From Bloomberg:
Security Capital Assurance Ltd. may lose its AAA credit rating at Fitch Ratings, the first top-rated bond insurer put on notice since the industry came under scrutiny last month.
Security Capital plunged 22 percent in New York Stock Exchange composite trading after the top ranking of its XL Capital Assurance unit was placed on “rating watch negative” by Fitch today.
The company’s capital is at least $2 billion below what it needs to retain the AAA, Fitch said. SCA has four to six weeks to come up with “firm capital commitments” to meet the guidelines, or the rating will fall two levels to AA, Fitch said.
“It’s simply the amount of capital needed to support their AAA ratings,” Thomas Abruzzo, an analyst with Fitch Ratings in New York, said on a conference call with investors. “The actions we’re taking are clearly proactive. It’s not our intention to take actions today and take more actions down the road.”
Security Capital is among seven AAA rated bond insurers that have been probed by Moody’s Investors Service, Standard & Poor’s and Fitch Ratings for the past month after declines in the credit quality of the securities they guarantee. A loss of its top ranking would wipe out XL’s main business of using its AAA rating to guarantee $154.2 billion of debt….
Of the securities XL insures, 38 percent are municipal bonds, 46 percent are structured finance securities and 16 percent are international transactions….
Fitch focused its examination on $16.1 billion of CDOs backed by subprime mortgages. Most of those transactions were underwritten in 2006 and 2007, years that are showing the most credit deterioration, Fitch said today.
“The announcement on SCA reflects sharp downgrades on a number of structured finance CDOs insured by the company,” Abruzzo said.
All of the CDOs that SCA insured were rated AAA at the time the company agreed to back them, and some have fallen to below investment grade in recent weeks, Abruzzo said. Fitch went through every CDO guaranteed by Security Capital before placing the debt on a formal review, Abruzzo said.
“We had to literally go through deal by deal and quite frankly that takes time,” he said. “Our CDO analysts have been working around the clock to support the effort.”
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So one would assume that Fitch rated these problem CDOs as AAA at some point–does the insurer do its own diligence on those things, or does it accept the ratings agency’s seal of approval?
Even if the insurer did its own due diligence, chances are they would have ended up with the same erm “situation” . The question is what kind of models and assumptions did they base those ratings on?
My useless contention is that the models had false static data as a result of 9/11 which resulted in probably 85%+ refi’s of all American homes, after mortgage rates dropped to 40+ year lows; the refis changed all the loss curves, because there was no accurate picture or curve to base defaults on. IMHO, the deafault rates for all the models were based on models which used either Great Depression worst case defaults, or other home owner recessions, like new england 1990 era…which was a logical and fast assumption, however, that data was all based on previous models linked to actual 30 year mortgages from previous generation home owneres, which had different default data relationships.
By using outdated models, all the rating agencies came up with loss curves resulting in bogus values.
Its a hunch at why they all screwed up, its either model distortion or the other theory that they all were paid off and failed in fiduciary roles; take your pick!
Pop Goes The Weasel:
Deal Structure
Dexia is selling the credit risk related to the AAA ABS portfolio to external parties by means of two credit default swaps: a non-funded super senior credit default swap with an undisclosed party and a junior credit default swap with Dublin Oak Ltd, a special purpose company registered in Ireland.
Pretty close Doc – This is a small bit of how Mason and Rosner put it in their May 2007 paper Where Did the Risk Go? How Misapplied Bond Ratings Cause Mortgage Backed Securities and Collateralized Debt Obligation Market Disruptions:
Since the 1970s, largely due to issuer demand for ratings as a way to increase investor confidence, the rating agencies revenues have increasingly been generated by issuers of securities. 8 In the past few years, these revenues have been increasingly driven by ratings for relatively newer structured finance products. As a result rating definitions have undergone significant changes to their meaning as well as the manner in which they are employed. These changes and their implications to the integrity of the rating process are significant.
In an effort to meet market demands for investment grade assets with higher yields, the rating agencies created new models and approaches to rating these assets. Given the limited number of Nationally Recognized Statistical Rating Agencies (NRSROs) and requirements directing certain investors to purchase only “investment grade” rated assets, their move to rate newer asset classes strengthened their market power, 9 or in the words of one rating industry executive, their “partner monopoly”.
The concentration of rating agency power is not limited to the structured finance market and extends into traditional credit rating business. However, unlike other debt markets where the number of issuers allows for the broad diversification of operational and model risk, 11 there is a significant concentration in structured finance. For example, a recent report by the French securities regulator pointed out that “12 banks account for more than 70 percent of European deals, and three rating agencies cover the entire market (two of them accounting for 80 percent). According to 2005 figures for the French market, three legal firms account for more than 60 percent of the legal structuring work in the CDO market, and three others account for more than 50 percent of volume in the MBS market.” 12 This concentration could have the effect of amplifying rating model risks, the risks to legal structures, other legal risks, counterparty risks, and the risks of misapplications of accounting rules (particularly FAS-140). Moreover, traditional corporate bond ratings have long a long history of application and have been empirically tested through various economic cycles. Many structured products – notably CDOs – have not.
11. Bank for International Settlements, Committee on the Global Financial System, The Role of Ratings in Structured Finance: Issues and Implications 24 (Jan. 2005) (“Model risk is … not confined to structured finance. However, given the lack of historical default data and the analytical challenges in assessing credit risk exposures (e.g. treatment of correlation, recoveries and time variation), it is likely to be a more important issue in the credit risk than in the market risk world. This applies, in particular, for structured finance instruments, as in the case of correlation assumptions discussed above. As a result, model-based risk assessments can be a long way from ‘true’ values and, to the extent that investors rely on ratings for their structured finance investments, the model risk linked to the agencies’ rating methodologies will be among the principal risks these investors are exposed to.”)
…
Bank for International Settlements, Committee on the Global Financial System, Incentive Structures in Institutional Asset Management and their Implications for Financial Markets 7 (Mar. 2003) [hereinafter BIS Study]. (“Similarly, with consensus on “best practice” regarding the modelling of portfolio credit risk still lacking, “model risk” in instruments such as collateralised debt obligations (CDOs) is an issue for even the most sophisticated market participants. Use of structured finance instruments, together with the occurrence of worst case scenarios relating to mispriced or mismanaged exposures, might thus lead to situations in which extreme market events could have unanticipated systemic consequences. Given these issues and the fact that structured finance markets are still largely untested, continued growth in structured finance activity warrants ongoing central bank awareness.”).
The models evidently assumed rising house prices, moderate defaults, and a wave of refi-linked prepayments in years 2 and 3. The insurers were betting that the duration of the tranches would be incredibly short compared to stated maturities, so that their at-risk horizon would be mostly limited to the teaser period for ARMs. (I think many of the holders of senior tranches expected exactly the same: buy at a discount, early return of principal, so the coupon rate of 50-95bp over LIBOR looked good compared to 3 – 5 year yields.) Insurers also expected that rising prices would quell foreclosure loses after years two and three, while unpaid principal would dwindle to almost nothing.
Steve,
I’m not doing this thread justice (good comments, BTW) but happened to see you comment and wanted to confirm it.
Right when this subprime mess was in its early days, a hedgie I know (very very smart guy, been through multiple cycles, knows more than a thing or two about risk) blithely asserted that subprimes weren’t a big deal because anyone who could pay on time for two years could refinance into a prime loan. There were clearly a lot of otherwise smart people who were of that view once.
Hi Yves,
Oh yes. It’s fair to say that the mortgagors, structurers, insurers, and (most of the) tranche buyers all thought that they were doing 2 – 3 year credit. Smart money and dumb money were in agreement about that (with a few exceptions on the smart end), and a lot of very sharp guys have gotten blown up. I don’t know, but I suspect that few on the short side expected their bets to work out as well as they did.