David Merkel says Connie Lee Shouldn't Receive a AAA Rating

David Merkel of the aleph blog (thanks to SeekingAlpha for picking up the story) gives two reasons why Connie Lee shouldn't receive a AAA rating:

1) It violates their notching standards. A parent company (ABK) with a senior unsecured debt rating of A/A3 should only get ratings of AA/Aa3 maximum. This is because a holding company can only provide so much incremental support to a subsidiary, so the degree of enhancement to a well-capitalized subsidary should only be three notches, particular given that there may come a time when the parent company is incapable of adequate support, and the subsidiary is in need as well.

2) Connie Lee has no track record of its own, and many on the management team that made the faulty decisions at Ambac, Inc. are still in place. Yes, they managed their muni business well, but what if they go down the same diversification path again?

The second argument is weak. I don't think past history matters and the rating agencies have never indicated that. Recall that SCA received a AAA rating fairly quickly after entering the bond insurance business. Berkshire Hathaway Assurance also received a AAA rating with zero past experience, and without even a proper team in place.

The first argument is a stronger one. I'm not familiar with the notching standard. I'm not sure if this is some strict guideline that the rating agencies follow or if it's just something they made up along the way (similar to how they made up a new guideline implying that future business prospects supposedly matter more than excess capital.) I am also not sure how the notching standard would apply given that Connie Lee is really a subsidiary of a higher-rated Amabac Assurance, rather than the lower rated parent, Ambac. If the argument is capital support, it would really be Ambac Assurance that is in first-line position to provie support, not Ambac.

Speaking as an Ambac shareholder who would benefit from a AAA rating, I think Connie Lee probably would not get a AAA rating--at least initially. My view is that it makes no sense to downgrade Assured Guaranty and FSA (only Moody's has downgraded) while giving Connie Lee a AAA rating. The fact that Connie Lee is also a subsidiary of Ambac Assurance makes it very tricky. My guess is that Connie Lee will be rated AA, with it being reviewed for an upgrade over the next year.

If Connie Lee is rated lower than AAA, I think it is in MBIA's interest not to start a new bond insurer (unless they are sure they can get rated AAA.) Given the fact that customers are wary of bond insurance right now, I don't really know if it's worth all the trouble right now...