New Bond Insurer Storyline: Downgrade Likely, But Not So Terrible

The bond insurer front was quiet, with the only major news item the release of a report by Morgan Stanley’s credit analyst that argues that bank losses from a bond insurer downgrade would be only $5 to $7 billion, and it therefore isn’t worth their while to stump up for a rescue.

At this point, the estimates for losses, both for the bond insurer and financial institutions, are disparate, and despite the problem coming into greater focus, the figures from different sources do not yet show any sign of converging. That alone is troubling and says a great deal about the opacity and general uselessness of insurance industry accounting.

Note that this contradicts a rumor I heard yesterday, that European banks (note that the banks in the rescue discussions are primarily foreign) believe they are very exposed in the event of a downgrade, to the point where there have been concerned calls from the ECB to try to get the Treasury Department involved in a bailout. That is certain to be a non-starter.

One reason that a rescue may not make sense to US banks is the ones with the biggest CDO exposures may have taken writedowns that are sufficiently large that they believe the hit they would suffer from a bond insurer downgrade is limited.

Note that the Reuters story on the Morgan Stanley conference call was not explicit, but it presumably contemplated a downgrade only to AA, not a deeper cut that some believe is more appropriate. The story also refers briefly to a Citigroup research note that also views a bailout is unlikely.

From Reuters:

Financial institutions are likely to take only around $5 billion to $7 billion in losses from their exposure to bond insurers, far below recent estimates of as much as $70 billion, Morgan Stanley said on Monday.

Morgan Stanley also said a bailout of the bond insurance industry is not in the economic interest of banks, though analysts at CreditSights said late on Sunday they now view a bailout as more likely.

Monoline bond insurers are under review by credit ratings agencies and may lose the “AAA” ratings vital to their business.

Rating agencies do not view the bond insurers’ capital as adequate due to expected losses from insuring securities linked to the subprime mortgage market where defaults have risen.

Some analysts have said they believe U.S. financial institutions exposed to the bond insurers are facing as much as $50 billion to $70 billion in losses, but Greg Peters, Morgan Stanley’s lead credit analyst, said he views exposures as significantly lower.

“That (number) seems too high to us to begin with, and that is a gross number,” he said on Monday on a conference call.

Morgan Stanley evaluated mortgage exposure in collateralized debt obligations (CDOs) insured by the bond insurance arms of Ambac Financial Group Inc (ABK.N: Quote, Profile, Research), FGIC, Security Capital Assurance (SCA.N: Quote, Profile, Research), and MBIA Inc (MBI.N: Quote, Profile, Research), and determined that exposures by U.S. banks is likely in the $20 billion to $25 billion range.

Once the capacity of the bond insurers to pay out claims is taken into account, and assuming that a bankruptcy does not force the insurance arms of the companies out of business, likely losses by banks are in the $5 billion to $7 billion range, Peters said….

In this scenario, the counterparty exposure of banks to the insurers is negligible, he added.

Peters views a rating downgrade of MBIA or Ambac as likely and argues that supporting ailing insurers is not in the economic interests of banks.

“We just don’t think the incentives exist, banks are clearly capital constrained, the exposure to the monolines is far from uniform, so one dealer might not want to help out their competitor when they have a very limited exposure,” Peters said…

“A LTCM-style kind of bailout is pretty remote,” Peters said on the call.

Unlike LTCM, which was hurt by a temporary liquidity phenomenon, “you’re actually asking banks and dealers to pony up cash to help plug a loss that’s far from temporary.”

Citigroup analysts agreed a bailout is unlikely. “The scale of their losses on CDOs of ABS both explains why a bailout has been so slow in coming, and makes one unlikely in future,” Citi analysts said in a note sent on Monday.

“While political intervention is always hard to judge, we therefore think downgrades probably will take place, albeit of uncertain magnitude,” they added.

CreditSights analyst Rob Haines, however, argued that comments made by U.S. regulators, including Treasury Secretary Henry Paulson, who said last week he was monitoring the situation, make a bailout increasingly likely.

“Based on numerous comments from various regulators, we believe that the economic argument for a bailout is likely to build momentum,” Haines said in a report published late on Sunday.

As new entrants enter the bond insurance business and some existing insurers hold onto their top ratings, the markets may not need insurers such as Ambac, Morgan Stanley’s Peters said.

Financial Security Assurance (FSA), Assured Guaranty Corp (AGO), whose “AAA” ratings are not under review, and the new market entrant created by Warren Buffett’s Berkshire Hathaway Inc (BRKa.N: Quote, Profile, Research) (BRKb.N: Quote, Profile, Research) will likely be sufficient to satisfy market needs for bond insurance, Peters added.

“We’re not convinced that you need to have existing monolines still up and running as you have other ways that you could actually wrap that risk.”