Downgrade of bond insurers may prompt new credit panic

By Ambrose Evans-Pritchard
The Telegraph, London
Tuesday, November 6, 2007

http://www.telegraph.co.uk/money/main.jhtml?xml=/money/2007/11/06/bcnfit...

Fitch Ratings has threatened to downgrade a clutch of top US bond insurers in a move that could set off a fresh credit crisis and cause contagion across America's $2,400 billion (L1,150 billion) municipal bond market.

The agency warned of a "high probability" that insurers CIFG Guaranty and Financial Guaranty Insurance Co. would be placed on negative watch in coming weeks as a result of losses on sub-prime mortgages.

Ambac Assurance and Security Capital face a "moderate probability" of slipping below the minimum capital cushion for the coveted AAA rating.

The potential damage from any downgrade could stretch far beyond the companies themselves by lowering the credit ratings of the AAA bonds that they insure.

This could force pension funds, mutual funds, and institutions to liquidate holdings on a vast scale, causing the credit crisis to spread into areas that have remained unscathed until now.

The group of companies -- known as financial guarantors, or "monoliners" -- play a crucial role in wrapping and guaranteeing bonds, with a total of $2,000 billion of insured paper on their books.

Not all are in trouble. Fitch said MBIA Insurance should weather the storm, while Financial Security Assurance faces "minimal" risk.

The core business of these companies is to give their seal of approval to US municipal bonds by guaranteeing new issues, a role that leaves them holding the default risk. This is a safe corner of the market.

However, several have plunged into newfangled forms of structured credit in recent years to boost returns.

By guaranteeing debt with a leverage of 150 times their capital base, they are highly vulnerable to even modest falls in bond values.

There have been mounting concerns that they may be the next shoe to drop in the seemingly endless chain of credit market casualties.

Matt Fabian, managing director of Municipal Market Advisors, said any downgrades would be a "crushing blow" to the municipal bond market. "I have never seen a crisis of confidence in insurers like this before," he said.

Thomas Abruzzo, author of the Fitch report, said the sector had $90 billion of exposure to risky varieties of structured finance, chiefly mortgage securities packaged as collateralized debt obligations (CDOs).

"This is a highly leveraged industry so there is a significant risk in that a heavy percentage of these obligations could be downgraded several notches," he said.

While CDOs and structured finance make up just over 4 percent of total exposure for the monoliners, the damage may nevertheless be enough to poison the vast pool of "muni bonds" that they insure.

Mr Abruzzo said Fitch would reach a verdict over the next four to six weeks. Any company put on negative watch will then be given a month to avoid a downgrade below AAA, either by raising capital or executing a "risk mitigation" strategy.

Raising capital could now prove extremely difficult.

The share price of Ambac has dropped 65 percent over the last three weeks, while default insurance on its debt has rocketed by 620 basis points. MBIA's stock has fallen by half, slicing $4.5 billion off the company's value.

Ambac issued a statement yesterday adamantly denying that it had failed to come clean of the full scale of its sub-prime losses, saying it was not heavily exposed to the worst of the 2006 and 2007 "vintages."

"Ambac has a rigorous surveillance process surrounding its entire book of business. Transactions are within the parameters of Ambac's original stress tests."

The specialist group GimmeCredit has already dowgraded MBIA and Ambac and has accused the main rating agencies of delaying too long because of its "incestuous" relations with the companies.

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