Bond Insurer Downgrades Could Lead to Bank Downgrades
Downgrades of monoline bond insurers could lead to downgrades in the credit ratings of banks, Standard & Poor’s says in a new report, Downgrades Of Bond Insurers Can Add To Subprime Woes For Banks.
Downgrades of bond insurers (Financial Guaranty Insurance Co. was downgraded to ‘AA’; ACA Financial Guaranty Corp. to ‘CCC’; and ‘AAA’ rated MBIA Inc., Ambac Assurance Corp., and Security Capital Assurance Ltd. are on CreditWatch Negative) prompt questions about the effect on both commercial and investment banks, S&P says. “Of course, successful capital-raising efforts would eliminate the need to focus on the potential effect of downgrades on financial institutions. In the absence of additional capital, however, it is useful to think about the possible ramifications of downgrades, which could affect the $2.5 trillion of obligations guaranteed by the bond insurers.”
Bond insurers are suffering as a result of their roles as guarantors of mortgage-related securities, and downgrading them could affect all markets in which they are active, including the municipal bond, commercial mortgage-backed securities (CMBS), and other structured finance areas. In turn, dislocation in those markets could affect banks, S & P says.
Standard & Poor’s Ratings Services believes that the specific, identifiable effect on banks may be significant and, in a few cases, could lead to downgrades.
The area that represents the potential for the highest losses is the hedges that the bond insurers provide for the so-called “super-senior” CDO tranches. To date, losses that banks have reported on their CDO exposures have predominantly been on unhedged exposures. However, $125 billion of subprime-related CDOs hedged by bond insurers remains concentrated in the hands of a relatively small number of banks. Few banks have disclosed how much that exposure is.
Citigroup Inc. reported that it had bought protection on $10 billion of super-senior tranches of high-grade CDOs (not necessarily all from bond insurers), Merrill Lynch & Co. Inc. reported $19.9 billion of hedges with bond insurers, and Canadian Imperial Bank of Commerce (CIBC) $9.9 billion. The value of those hedges has increased as the values of the underlying CDOs have fallen and now can be presumed to be 40%-60% of the notional amounts. In some cases, banks have taken reserves against the increased counterparty risk represented by their own assessment of the credit deterioration in bond insurers. Citigroup added $900 million to reserves, Merrill Lynch added $3.1 billion, and CIBC announced $2 billion, with the majority of that related to ACA’s severe downgrade to ‘CCC’ from ‘A’.
More reserving may be necessary to reflect the increase in counterparty risk, if the ratings on guarantors are lowered.
The bond insurers cover $1.5 trillion of municipal bonds, a much greater amount than CDOs, but the effect is not likely to be as great for banks, S & P says. “Although the bond insurers’ downgrades will mean downgrades of the municipal bonds they insure, the stand-alone strength of the municipalities is generally investment grade, and even high investment grade.”
Morgan Stanley believes 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, according to Reuters.
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