The slow spread of toxic subprime slime may be about to consume another important but little-known group of market participants – the bond insurers.
A story in today’s FT reports that the monolines, as they are known, began life in 1970s to help regional public administrations get access to cheaper funding. Starting out by providing a back-up guarantee on debt issued by lower-rated issuers for a premium, these insurers have becoming increasingly involved in the rather racier business of guaranteeing asset-backed securities.
The companies insist they have sophisticated risk management practices and that any claims on defaulting paper are paid slowly over time – matching the profile of payments from the debt insured rather than in large, immediate outlays. Nevertheless, the companies have been hit in recent days, even if their direct exposure to pure subprime is small.
In raw numbers, and across all types of insured assets, the companies have built up huge exposure relative to their tiny capital bases. Barron’s recently reported that the CDO exposure of one insurer, ACA, totals an imposing $61bn of value – on a capital base, or shareholder net worth, of just $326m. And if the industry’s risk management practices were to prove unsound, that could post a threat to the ratings of more than $3,300bn of securities that they insure, which includes much of the municipal bond market.
Clearly, even if the threat is small, the size of the numbers involved lends the matter real importance.
One long-standing and vociferous critic of the credit insurance industry as a whole is Bill Ackman, the head of Pershing Square.
Back in April, Ackman rather presciently gave a presentation at an event organised by Grant’s Interest Rate Observer in which he charted how he saw the developments in the credit markets unravelling. The presentation was given again at the Ira Sohn charity event in May.
It is available online — and is best viewed with protective eye-wear.
Ackman has now also spoken direct to FT Alphaville. The bond insurers are, he says, “unique counterparties. They are the only counterparties of which we are aware that are not required to post collateral as a derivative counterparty.”
Over time the business of the largest insurers has changed, he says, and these companies are now “just big CDOs that are Triple A based on the same rating agency models that said that subprime CDOs were triple A,” with ever-increasing exposure to structured finance in their mix of business.
As credit spreads have widened, Ackman notes, “as far as we can tell, MBIA [one of the largest insurers] marks their CDO derivative exposure to model based on the rating agencies’ ratings. We believe that if they marked to market based on fair value pricing, small increases in spreads would wipe out all of their capital.
“We think the financial guarantee holding companies are at real risk of going bankrupt. If regulators act quickly enough, they may be able to save their insurance subsidiaries.”
In the worst case scenario, he adds, “all the banks who think they have shifted risk to [the credit insurers] are going to get their risk right back.”