Moody's CDS-Derived Ratings Imply Lower Ratings for Ambac and MBIA
Not too surprising to anyone following the situation but Bloomberg has a story about an experimental division of Moody's that generates ratings based on CDS (credit default swaps). According to those CDS-derived ratings, Ambac and MBIA should be rated junk.
This isn't really a surprise to anyone given that CDS swaps have been extremely high for the bond insurers for over 6 months. The stock market also shares the CDS swap market opinion and that's one reason the stocks of the bond insurers have dropped so much without actual insurance claims or any liquidity issue.
It'll be interesting to see what actually ends up happening. I personally think there is a lot of irrational behaviour out there. For example, CDS on 1 yr MBIA and Ambac holding company debt implied high probability of default even though there was enough money at the holding company to pay dividends (optional--can be cut at will) and pay operating expenses. Having said that, the real question is the longer term (say 5yr) CDS and how correct they will end up being.
I'm not really sure what the definition of accuracy is in the comment by the Moody's employee above. I'm not an expert on bonds or credit instruments but one thing to keep in mind is that the rating agency ratings are not volatile. They move in steps infrequently and only upon actual changes in the underlying company. In contrast, CDS is highly volatile and is a speculation on what may or may not happen at the underlying company. Because CDS prices change in real-time, they should be smoother and change gradually over time. In contrast, rating agency ratings can be abrupt with 3+ notch downgrades in one move.
Moody's Investors Service has created a new unit that surprises even its own director.
The team from Moody's Analytics, which operates separately from Moody's ratings division, uses credit-default swap prices as an alternative system of grading debt. These so-called implied ratings often differ significantly from Moody's official grades.
The implied ratings frequently show that swap traders think debt is in more danger of defaulting than Moody's credit ratings signify. And here's the kicker: The swaps traders are usually right...
The credit quality of bond insurers, which have been at the center of the subprime storm, differ dramatically. The official ratings of these companies say the insurers are in great shape; the alternative ratings say they're in dire danger of defaulting on their debts...
Moody's implied-ratings group paints a completely different picture. Using the CDS market, Munves's unit rates both MBIA and Ambac Caa1. That's seven notches below junk and 15 below the official Moody's rating.
This isn't really a surprise to anyone given that CDS swaps have been extremely high for the bond insurers for over 6 months. The stock market also shares the CDS swap market opinion and that's one reason the stocks of the bond insurers have dropped so much without actual insurance claims or any liquidity issue.
It'll be interesting to see what actually ends up happening. I personally think there is a lot of irrational behaviour out there. For example, CDS on 1 yr MBIA and Ambac holding company debt implied high probability of default even though there was enough money at the holding company to pay dividends (optional--can be cut at will) and pay operating expenses. Having said that, the real question is the longer term (say 5yr) CDS and how correct they will end up being.
Munves says that over one year, the implied ratings have been a more accurate predictor of defaults than Moody's ratings. The Moody's unit reports that implied ratings for one year have a 91 percent accuracy ratio compared with an 82 percent ratio for Moody's official ratings.
``The Moody's accuracy ratio is consistently lower,'' he says.
He says Moody's company debt ratings are designed to remain stable so they aren't influenced by short-term ripples, unlike the more volatile swap-implied ratings.
``The CDS market often ends up coming back towards Moody's rating,'' he says.
I'm not really sure what the definition of accuracy is in the comment by the Moody's employee above. I'm not an expert on bonds or credit instruments but one thing to keep in mind is that the rating agency ratings are not volatile. They move in steps infrequently and only upon actual changes in the underlying company. In contrast, CDS is highly volatile and is a speculation on what may or may not happen at the underlying company. Because CDS prices change in real-time, they should be smoother and change gradually over time. In contrast, rating agency ratings can be abrupt with 3+ notch downgrades in one move.
This doesn't seem to be anything new. CDS spreads have been at very elevated levels since the mortgage mess blew up. But they have been increasing rapidly for everyone not just MBIA or Ambac. Berkshire Hathaway has seen is' spreads sextuple. Are we seriously supposed te believe that company (almost no debt, about $36 billion cash and lost of free cashflow)is suddenly at an increased risk of bankruptcy?
ReplyDeleteCDS spreads may me a good indicator of trouble to come if they shoot up for a particular issue in an otherwise calm environment but in a panicking market they represent general fear and increased riskpremiums and not a problem at a particular entity.
Or am I missing something?
No, I completely agree with you. That's why I wasn't really surprised. The CDS spreads have been elevated for over 6 months so if someone relied on that, well, that's old news. The real question is how correct it is in the long run. Business decisions shouldn't be made on them since using them is sort of like trying to a build a factory based on the stock price movement.
ReplyDelete---------
Following up on your some items you mentioned in the prior comment...
MARKET CONSENSUS
I disagree with you and think the market is not pricing in more severe losses from second-liens (HELOC/CES). Ambac can potentially lose $10billion on that exposure alone (that's the superbear case of William Ackman and others). I'm just mentioning this because I think the stock price can come under pressure if Ambac posts more mark-to-market losses on those HELOCs. If the market priced all that in, further marks shouldn't weaken the stock price.
Having said that, I don't expect every single second-lien insured item to post a 100% loss. As you pointed out, only a few deals (Bear and Franklin for example) are posting huge losses, with some of the earlier vintages doing poorly but within the pessimistic market expectation.
MUNI DEFAULTS
Regarding your prior post about your concern with muni bond defaults, that is certainly something that will deteriorate. I'm not sure if you saw this Bloomberg article mentioning how muni defaults have tripled. Personally I am not so concerned with that because, if there is one thing that these bond insuers are experienced in that's pricing muni bonds. They have been doing it for decades, through some municipality crises in the late 70's, 80's and early 90's. As long as we don't get a high correlation, where a large number of municipalites default or go bankrupt at the same time, we should be fine. Remember, MBIA and Ambac sailed through the massive hurricane Katrina damages. MBIA also survived through the Eurotunnel default (closer to your home ;) ).
If you do end up with high number of muni defaults/bankruptcies at the same time, well, as you said, we are probably looking at a severe recession or almost-depression-like scenario and I have bigger problems than this investment...
MY OTHER CONCERN
If Ambac sails through the second-lien problems, my next concern would be student loans and auto loans (for MBIA it would be commercial real estate and credit card loans). Consumer credit is a shaky situation here in North America (large number of people living beyond their means on credit cards, car loans, etc). But Ambac's car loans, for example, were initially rated BBB on a depreciating asset so I imagine they priced it as such. In contrast, residential real estate was priced at AAA with an appreciating price assumption.
KEEP THE POSTS COMING :)
BTW, keep posting. I like to hear thoughts from long-term investors as well (better than those short-term momentum ones on the Yahoo Finance boards :) ). I had someone by the name of CAK posting here but haven't heard from him/her lately--hope he/she is ok. CAK pointed out this Yahoo Finance group message board where some knowledgeable investors (both long and short) were posting but it is mostly dead these days (it requires registration). One of the points raised by a "bear" is that subordination levels (the amount by which the lower rated tranches take the losses first) are being erased. For what it's worth, this guy who was short the bond insurers supposedly took half his gains from the shorts and bought Ambac recently. When short-sellers switch positions, it is a good sign :). He/she also thinks that Ambac and MBIA estimates and reserves for HELOC/CES are good but he is concerned about CDOs. I haven't looked into the detail but he was saying that there were some CDOs rated junk but MBIA (don't think it was Ambac) didn't post reserves for a potential loss...