Trust has always been vital in financial markets. Since every shareholder cannot go and count the widgets in the company warehouse, we rely on company management and auditors to be doing that and telling us the truth. That is why the Ambac saga is so alarming.
Ambac is the second largest monoline insurance company, whose core business is not in widgets but in guarantees that municipal bond holders will be paid.
When they branched out from guaranteeing plain old state and city government bonds to insuring exotic collateralised debt obligations (CDOs) and even went into backing credit default swaps (CDSs), they took on far more risk than their capital and risk assessment skills could support.
The premium growth was nice until the music stopped, of course. Just like their larger competitor, MBIA, Ambac had to take large write-downs late in 2007.
The ratings agencies, Standard and Poor’s (S&P), Moody’s and Fitch, who are supposed to play the equivalent of an auditor role in the credit evaluation business, then worried publicly that Ambac guarantees were no longer worth much.
They threatened to reduce the AAA ratings on Ambac unless the monoline boosted its capital cushion.
Those warnings got a lot of attention because of the domino effect. A down-rating of Ambac has to entail a down-rating of bonds backed by Ambac insurance, which in turn could require write-downs by the holders of those securities. Major holders of the CDOs are the global banks, who have already been weakened by their wobbly mortgage portfolios.
In February, the word was that state insurance regulators, supported by Governor Eliot Spitzer of New York, were pressing Ambac and MBIA to split the policies they had written into good and bad books of business to be owned by separate companies, as well as to recapitalise.
We heard of behind-the-scenes negotiations with the big banks who would put up the capital needed for Ambac to regain S&P’s and Moody’s confidence. Ambac mentioned being close to securing $2-3 billion from the banks.
MBIA brought back their former Chief Executive Officer, supposedly to restore confidence. Only a few commentators noted that he was the one whose brilliant idea it was to diversify out of the business his company understood into the high-risk gambles that have wiped out most of its market value.
Suddenly, before any split into good and bad books of business and without any new capital from the banks who have an interest in avoiding the downgrade domino effect, S&P and Moody’s announced that they had changed their minds about cutting the two big monolines’ ratings.
They pronounced themselves satisfied with the amount of money MBIA had raised late last year.
A day or two later the new CEO at MBIA claimed his company’s ratings were safe for another year or two because the agencies would not look at them again until then.
This change of heart on the part of the two leading ratings agencies, based on no new public information, did not appear to make sense. Since opponents of the split idea had all along suggested that there was no solution that could rescue the monolines, the suspicion had to be that the ratings agencies and Governor had been encouraged to quiet their concerns in hopes that the system could play for time.
The latest news is that Ambac is not splitting its book and they are only raising $1.5 billion of fresh capital, not $2-3 billion as previously advertised.
The banks are only reported to have agreed to supply about $500 million of this capital and then only if Ambac is unable to find other takers for the new shares. Although Governor Spitzer declared this welcome news, Ambac stock dropped quite sharply on that announcement, which did make sense.
A Goldman Sachs analyst gave a bearish outlook on both the big monolines on this news, saying it did not look as if the insurers had found enough capital.
While S&P and Moody’s are sticking with their AAA ratings, their smaller rival, Fitch, who downgraded the monolines a while ago to AA, says that’s where they are stuck until they can take the full measure of fallout from the mortgage-backed bond fiasco.
How is that fiasco coming along? The cracks are widening in mortgage finance.
Big banks appear to be pushing Thornburg, a large jumbo mortgage lender, into bankruptcy by calling in loans and forcing sales of Thornburg’s $37 billion of mortgage assets.
A Carlyle Capital fund, invested in mortgage-backed paper, also reported failing to meet bank margin calls. Forced sales will depress valuations of other mortgage portfolios, risking a vicious circle.
Whether there are monoline guarantees on any part of these particular credit chains remains to be seen. At the grass roots, mortgages in trouble rose from 7.3 per cent last September to 7.9 per cent by year end, the highest on record.
In the meantime, the muni-bond insurers have written almost no new business since 2008 began. Little wonder at that: bond buyers can and do place no faith in the guarantee of an under-capitalised guarantor who looks decreasingly likely to be in business over the life of the bond.
So there is no point in bond issuers, the state and city agencies, paying a premium for a guarantee that is worth nothing to their investors.
The state of California, for instance, which is a state with a low credit rating, has been issuing fresh bonds without any bond-insurer guarantee.
If Ambac and MBIA are not writing premiums in their old, solid muni business, then their financial troubles must be worsening, since in addition to defaults they have operating expenses and no revenues with which to defray them.
All this casts doubt not just on Ambac and MBIA but on the ratings agencies themselves.
If both the bond buyer and the bond issuer are saying that AMBAC’s guarantee is worthless, how can it make sense for AMBAC to continue to carry a AAA rating?
S&P and Moody’s conferred far too favourable ratings on mortgage-backed bonds and stuck to them until defaults soared and it was obvious that they were mis-rated.
They appear to be doing the same thing again with the monolines. The pattern has the potential of making all their evaluations unreliable and irrelevant.
As the Economist rather pointedly asked, why didn’t Warren Buffett, whose holding company has a big stake in Moody’s, share any thoughts on the ratings business in his annual shareholder letter, in which he roundly criticised excessive risk-takers for the mess they have made.
Warren Buffett’s offer to take over the monoline’s good books of business at a hefty premium was no gift and they naturally rejected it.
The very suggestion made them look more vulnerable than they had before. Who knows what Buffett’s game was?
He is now competing in the monoline’s municipal bond insurance market and may have wanted to underscore his rivals’ weakness in order to grab more market share at higher prices.
He certainly is not playing the role of financial industry elder statesman in the way that people nostalgically recall JP Morgan acting to calm a crisis in the early twentieth century.
Buffett is the richest man in the world, has tremendous insight into finance and risk, and is known for blunt speaking.
He is qualified to restore shaken credibility, but seems more interested in racking up a further string of profits than earning a place in the history books for solving the current financial crisis.
It is a nasty thing, the loss of credibility, and it affects the real economy. The chaos in the municipal bond market, as investors realised that insurance on their bonds no longer offered much comfort, seems to be abating as smart investors see great yield opportunities.
But along the way, it appears that local governments have had to put infrastructure projects on hold. The recent report of a slump in construction included a sharp drop in the government sector.
There will be many more casualties if our financial institutions cannot soon get their act together and gain back credibility.
The one bright spot is that, somehow, some folks keep on shopping. Retail sales managed to grow by 1.9 per cent in February despite all the gloom and the credit constraints.
Where do they find the money?
Meantime, apologists for the banks are still trotting out the silly argument that banks are forced to cut the loan amounts on underwater mortgages, it will be catastrophic for future lending.
$1.5bn: The amount AMBAC is raising in fresh capital. The banks are reported to have agreed to supply about $500m of this if AMBAC is unable to find other takers for the new shares
7.9%: The amount mortgages rose to last September. This is the highest on record
1.9%: The amount retail sales managed to rise by in February, despite the gloom