SCA’s bond insurance business, XL Capital Assurance, lost its crucial AAA rating on Thursday evening. But Moody’s didn’t just cut XLCA, the fourth largest bond insurer, from AAA to AA. It downgraded it by six notches.
The implications for other bond-insurers are troubling. Monoline downgrades have previously only been imagined as cuts of one or two notches, with the expectation being that a recovery might well be probable in the future.
Although XLCA’s situation is particularly dire relative to its size (it, like ACA, was heavily involved in CDO insurance) it does nonetheless bode ill for the two biggest players: Ambac and MBIA. Were they to be downgraded it would be bad enough, were they to be downgraded further than AA, it would be absolutely disastrous.
XCLA has contracts on around $154.2bn of debt, which will be cut by at least the same number of notches – to A3, according to Moody’s. In fact, you can view the massive lists of securities downgraded here (40,151 munis), here (103 structured) and here (137 corporate).
An instant impact then, irregardless of what bond prices do, will be that banks holding those insured bonds will have to stump up a great deal of extra regulatory capital. AAA rated bonds require very little. But under Basel II, the extra capital needed for riskier tranches is considerable. Yves Smith at Naked Capitalism has a good take here.
And finally in Friday’s FT, Pimco’s Bill Gross has vivid words to put things in perspective:
That the monolines could shoulder this modern-day burden like a classical Greek Atlas was dubious from the start. How could Ambac, through the magic of its triple-A rating, with equity capital of less than $5bn, insure the debt of the state of California, the world’s sixth-largest economy? How could an investor in California’s municipal bonds be comforted by a company that during a potential liquidity crisis might find the capital markets closed to it, versus the nation’s largest state with its obvious ongoing taxing authority? Apply the same logic to the gargantuan size of the asset-backed market it has insured in recent years – subprimes and CDOs in the trillions of dollars – and you must come to the same logical conclusion: this is absurd.