Monday, July 21, 2008 16 comments ++[ CLICK TO COMMENT ]++

Wow, Moody's Potentially Close to Cutting Assured Guaranty's and FSA's AAA Ratings

I'm actually quite shocked by this. Moody's is reviewing Assured Guaranty and FSA for a potential downgrade of their AAA ratings.

Moody's Investors Service on Monday said it may cut its top ratings on bond insurers Assured Guaranty Corp and Financial Security Assurance, citing concerns about securities they guarantee and raising questions over the future need for bond insurance.


It's one thing for the tainted monolines to be cut but it's another for these two to face ratings dowgrade threats. Assured Guaranty steered clear of the subprime mortage bonds and didn't insure any of those risky stuff since 2004 (if I recall). Similarly, FSA has very low exposure to subprime RMBS, CDO, and CDO-squared. Assured Guaranty also received around $1 billion capital infusion from Wilbur Ross early this year so it is way above capital requirements.

As has been the mantra at the rating agencies lately, the rating cuts are coming due to uncertainty over future business. I don't know if they are going to put BHAC on ratings watch but if they don't, it's highly questionable in my eyes. If you are going to cut FSA and AGO, both of which have capital way above requirements, and one of your big reasons is that the future of the industry is in question, then it's totally ridiculous to leave Berkshire Hathaway Assurance at AAA. If FSA doesn't have a franchise value, BHAC does not either!

I don't know if this means they are going to cut Ambac, MBIA, FGIC, CIFG, and SCA further. It's also not clear if S&P and Fitch will make similar moves. If Ambac is not cut further this is good from a competitive point of view. However, it is very negative from an industry point of view because it literally means that no one--including seemingly overcapitalized firms--can get an AAA rating, regardless of what the agency capital requirements say. If they don't cut BHAC, they are also saying that only new entrants can get AAA. I want to see if they give a AAA rating to the new one being set up by Macquarie. If they don't, it really begs the question how BHAC can be rated AAA while others aren't.


In other news, Ambac's 2Q08 earnings call will take place on August 6th.

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16 Response to Wow, Moody's Potentially Close to Cutting Assured Guaranty's and FSA's AAA Ratings

synchro
July 21, 2008 at 10:46 PM

Bond and mortgage "insurance" is a bogus business, or more accurately, it's a racket. Unlike life, health or property and casualty insurance, claims under bond insurance is serially correlated, i.e., claims are not independent. Another way to put it is that when the claims happen, they tend to cluster in a systemic way so that no amount of premium is enough. You can have several fat years followed by a brief period of "unexpected" claims that bankrupt the company. This is especially true since the bond and mortgage insurers don't and can't set up active reserves -- they let all the premium not needed for claim reserves to flow to the bottom line.

I actually applaud Moody's for finally recognize the bogus nature of the bond/mortgage guaranty business model.

July 22, 2008 at 10:46 AM

I think you are completely wrong.

If what you were saying were true, who come the bond insurers and mortgage insurers have been operating for 30+ years? The bond insurers went through some qeustionable periods such as the late 70's/early 80's (muni insolvency crisis,) early 90's (real estate bust,) and 2000's (Eurotunnel bankruptcy and Katrina damages.) The mortgage insurers also went through their own issues including big real estate bust in the early 90's. If what you were saying were true, the industry wouldn't have survived.

Although correlation is higher than various other types of insurance, it isn't as high as you think it is. If it is anywhere near as high as you are implying, someone like Warren Buffett, who has a better grasp of the risk than you or I, would never have come anywhere near the industry.

I think your view of reserves is also misleading. Although they technically only need to keep enough for the claims, they generally had to retain capital way above any potential claims in order to meet AAA ratings. The AAA requirement is set several magnitudes higher than any potential claims so your view that reserving was weak is misleading in my opinion.

The core problem, which you ignore, is the PRICING of risk. The monolines simply got caught up in the low risk premia that was prevalent in the last 5 years. They underwrote insurance at a low price. If they had charged higher premiums, they wouldn't be shrouded in a cloud of insolvency. To see what I mean, watch what happens with Assured Guaranty. AGO did not underwrite any subprime mortgages since 2004 (or something like that) and hence did not end up charging too low of a fee. So what you will see is that they will survive and likely make a profit over the full cycle as well. If the problem was with correlations and lack of reserving then companies like AGO, which actually played a fairly big role in the industry, would be bankrupt within a few years. I don't think it will be...

synchro
July 22, 2008 at 7:15 PM

That's more like it.....

Still, wow, quite an emphatic response, but misguided in my opinon. And I don't think I am wrong. My point is that the risk that the bond/mtge insurers underwriting can't be priced. You can't price a systemic macroeconomic risk -- a happy-go-lucky view of the credit bubble implosion, yes, but not a realistic view of what this debt deflation will do to these hapless bond/mtge insurers.

Unfortunately, the deleveraging associated with the credit bubble implosion is a long process, so we can only let the unfolding events prove or disprove our theories.

But just to prove to you that I am not all doom and gloom, I noticed that Your Main Man is making quite a come back lately....A couple more days of this kind of kung-fu fighting, I might have to join him in the fun. Cheers!

July 22, 2008 at 7:37 PM

SYNCHRO: "My point is that the risk that the bond/mtge insurers underwriting can't be priced."

That's the case for almost any insurance, but particularly mega-catastrophe insurance. The fact that catastrophes cannot be priced doesn't preclude some companies, including Berkshire, Munich Re, Swiss Re, etc, from operating for decades. Everything comes down to price.

Furthermore, insurers are supposed to be picking "good risk" over "bad ones." Although the nature of the credit bust may bankrupt the monolines, it depends on their underwriting skill. The tainted monolines have shown horrible skills but AGO and FSA seem to have done ok...

synchro
July 22, 2008 at 9:29 PM

Flawed logic.

Property and casualty CAT risk is not man-made. It is a natural phenomenon that, though difficult, someone like Warren Buffet can attempt to handicap the chance of it happening with a fair degree of having things worked out.

Macroeconomic systemic risk is a _social_ phenomenon. The preumium pricing and the underlying risk _interact_. There is nothing accidental about these morons underpricing the risk. As much as I hate bring up Soros, macroeconomic systemic risk is "reflexive".

I find it hilarious that you use the experience of the past 34 years as some kind of "proof" that bond/mtge insurers have a valid business model.

I have some news for you: Financial history goes back 600 years. What is happening now is NOTHING NEW -- except the scale of the disaster. This one is unprecendented, and IMO, too big to resolve in a reasonable way.

AGO and FSA won't escape it. The muni default chain reaction would make what ABK and MBI experiencing right now look tame. Mercifully for ABK and MBI, they will be long gone before the muni defaults get to do them in -- the structured products would have done them in already by then.

synchro
July 22, 2008 at 9:34 PM

"Everything comes down to price"

Has it occurred to you that if the structured product risk were priced correctly (whatever that means), _There Won't Be a Business Model_?

This reminds me of the more clinically oriented actuaries that I had to deal with in my day job. Some of these precious souls would price an insurance product 50% higher than what the market would bear. And then they would react with hurt feelings when I had to inform them that they are out of their minds if there is still an insurance business to be run.

July 23, 2008 at 12:18 PM

SYNHCRO: "Property and casualty CAT risk is not man-made. It is a natural phenomenon that, though difficult, someone like Warren Buffet can attempt to handicap the chance of it happening with a fair degree of having things worked out."

Whether something is man-made is not important; what is important is the nature of predictability. I would say that catrophes are as unpredictable as anything out there.

Buffett cannot handicap catastrophes in the sense of knowing what will happen. All him and his team are going with is price. They attempt to price the risk so that they have a huge margin of safety. Now that they, as well as all the other big reinsurers, are big, they can diversify risk (across geography, risk type, and so forth.) But what were they doign 15 or 20 years ago (when they had smaller capital base, lower diversification, and so on)? All you could do is to price it so that you make money over a full cycle (and don't go bankrupt along the way.)

I'm not an insurance expert by any means but bond insurance is very similar to catastrophe insurance in my eyes. They both have low probability events with potentially massive damages. The fact that one involves human behaviour is kind of irrevalant.





Macroeconomic systemic risk is a _social_ phenomenon. The preumium pricing and the underlying risk _interact_. There is nothing accidental about these morons underpricing the risk. As much as I hate bring up Soros, macroeconomic systemic risk is "reflexive".

I find it hilarious that you use the experience of the past 34 years as some kind of "proof" that bond/mtge insurers have a valid business model.

I have some news for you: Financial history goes back 600 years. What is happening now is NOTHING NEW -- except the scale of the disaster. This one is unprecendented, and IMO, too big to resolve in a reasonable way.

AGO and FSA won't escape it. The muni default chain reaction would make what ABK and MBI experiencing right now look tame. Mercifully for ABK and MBI, they will be long gone before the muni defaults get to do them in -- the structured products would have done them in already by then.


SYNCHRO: "I find it hilarious that you use the experience of the past 34 years as some kind of "proof" that bond/mtge insurers have a valid business model.

I have some news for you: Financial history goes back 600 years. What is happening now is NOTHING NEW -- except the scale of the disaster. "


I "only" go back 30 years or so because that's when the bond insurance industry was created. I'm not too sure but mortgage insurance may much older. That's all the data we have in so far as insuring bonds is concerned. Although a longer period is ideal, I'm just going with what we have. Based on what I see, both the bond insurers and the mortgage insurers have gone through a few economic cycles and that's evidence of a functioning industry to me.

This is not to say that the current real estate bust is similar to the past, but no one can predict the future--even you ;) The situation could be worse than anything conceived by the superbears, or it may simply be similar to the past (say 1990 real estate bust.) The key point is that no one really knows.

"This one is unprecendented, and IMO, too big to resolve in a reasonable way.
"


I think our differences stem from that. I don't really think the problem is the difference in reasoning per se. Rather, it's your stance that this is something bigger than anything anyone faced before.


If you are certain that this is unprecedented and bigger than anything anyone has experienced in the last few decades then the onus is on you to prove why that is. You are making a strong prediction--one that you are certain of--so you better be sure and have reasonably probable scenarios.

I'm not saying that you need to prove anything to me; all I'm saying is that someone who says things are going to be really bad--bad enough to bankrupt Assured Guaranty*--should have some reasonably solid reasons for it. I have seen no reasoning from your discussion to indicate that things will be very bad--unprecedently bad! All I have seen are vague notions of municipalities defaulting en masse all at the same time; or some notion that this is the worst ever. This, to me, is no different that those claiming that the stock market is the same as Japan in 1990 while ignoring the fact that P/E was something like 50 in Japan while the US P/E, even if you think reduce earnings, is nowhere near that.

You may already have some justifications for your stance but I haven't seen anything. If you feel like summarizing your key points, I wouldn't mind posting them in an entry to represent a superbear's view.


(* I don't know AGO deeply but it looks ok from my quick look a few months back... and since Wilbur Ross did due diligence on AGO, I think it is unlikely to fail. So that's why I'm picking that--it seems ridiculous)

July 23, 2008 at 12:35 PM

Synchro: "Has it occurred to you that if the structured product risk were priced correctly (whatever that means), _There Won't Be a Business Model_?"

I thought about that before I invested in Ambac. A lot has changed and I think the industry has been irreparably damaged to some degree (but if the monolines survive then it will strengthen the industry.)

My feeling back then is similar to now. Some portion of the industry really never made any sense for various reasons. My opinion is that some portion of the industry wouldn't have existed if pricing was more rational. This does not mean that the whole industry or some area within the industry will totally dissapear; all it means is that it will be smaller.

I was always of the opinion that the housing portion from 2005 to 2007 was simply a bubble and if pricing was stronger (or controls were stronger,) it would never have got that big. When I was looking at Ambac initially, that's why I used a normalized profit of around $400m, which was their profit in 2001 or thereabouts (versus $800m+ in 06.) So everything in housing from, say, 2005 is froth and wouldn't have existed.

As for other structured products, it's hard to say right now. I don't see any material problems. Things will deteriorate, no doubt, but it remains to be seen if the monolines underpriced these assets as well. My feeling is that auto loans and student loans seem to be ok, but credit card loans may be a concern.

I don't think pricing higher would have impacted muni bonds as much. You are basically trying to beat the market price so your range is known ahead of time. If rational pricing ends up being above market price then the monolines won't insure that (it has always been like that.)


So to sum up, there was clearly froth in housing in the late 2000's. Some areas like auto loans will weaken due to a slowing economy but that should be temporary. But I have no reason to suspect that other parts of the industry would have dissapeared if pricing was stronger...

synchro
July 23, 2008 at 5:01 PM

You are right about one thing....you are not an expert on insurance. The first clue of that is you dismissed (I'm not even sure if you realized you dismiseed it) the importance of serial correlation and how crucial that aspect is in terms of being able to put a price to a risk. That is why "bond insurance" is completely different from traditional P&C CAT insurance.

Two years ago, when it wasn't so blindingly obvious (to people who are not of the Austrian economics persuasion) that the credit bubble is bursting, I would agree that the onus is on superbears like me to "prove" that what will happen is a "superbear" event.

But, dude, open your eyes and read the headlines for the past 12 months. You are getting more "proof" every day by reading the newspaper. I would argue that the onus is on YOU to use something other than magical thinking to demonstrate how the credit bubble implosion that is happening now will all of a sudden stop, reverse, and then go back to the happy-go-lucky pre-2007 days again.

Here is a simple thought experiment: Would ANYONE default on its debt if addiitonal credit is ALWAYS made available to roll into new debt? So, if bond "insurance" is priced using experience studies for the past 34 years where credit expansion has always been the means of getting us out of a bind, how relevant is that experience study if credit has to be now rationed?

Homework assignment: is credit currently now being rationed?

synchro
July 23, 2008 at 5:53 PM

Sometimes it only takes firing a couple brain neurons after reading the following links to see why long-term muni bond yields are now trading close to parity to treasury bond yield. And why muni defaults will soar.

http://online.wsj.com/article/SB121682740001077489.html


http://www.ajc.com/metro/content/metro/stories/2008/07/16/georgia_revenue.html?cxntlid=homepage_tab_newstab


http://www.southcoasttoday.com/apps/pbcs.dll/article?AID=/20080722/NEWS/807220314

synchro
July 23, 2008 at 7:18 PM

Here is an example of serial correlation, in case you don't understand it.

http://www.fdic.gov/bank/analytical/fyi/2003/images/011403chart2.gif

synchro
July 23, 2008 at 7:19 PM

sorry. Here is the correct link

http://www.fdic.gov/bank/analytical/fyi/2003/images/011403chart2.gif

synchro
July 23, 2008 at 7:20 PM

http://www.fdic.gov/bank/analytical/fyi/2003/images/ 011403chart2.gif

synchro
July 23, 2008 at 7:20 PM

Make sure you get rid of the space before the file name.

July 23, 2008 at 9:26 PM

I'll check out the stuff you posted and respond when I get a chance...

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