The monoline sector has in some way come to epitomise the demise of the wider structured finance market that it was so inextricably linked to. Whilst some players decided to stay away from the ABS CDO sector, thereby preserving their ratings, others returned, believing they could withstand collateral losses that in hindsight proved fatally toxic. William Thornhill reports.
While a major monoline downgrade from Triple A has so far been averted, a failure to raise capital remains a distinct possibility. The two major players, and thus the industry as a whole, look set to continue making headlines for sometime yet.
MBIA and Ambac are by far the largest players, and together provide Triple A assurance on US$1.2trn of obligations, of which US$377bn are in structured finance deals. Since many of the firms holding these exposures are still writing them to Triple A, it is likely that a downgrade of one or both the two megaliths will result in another bout of forced selling, write-downs, de-leverage and balance sheet shrinkage.
Should that happen, the rally in ABS spreads that has shown impressive endurance in Europe since mid March, could unwind. Moreover, the bank balance sheet shrinkage – already the cause of untold damage to the ABS sector – may have considerably further to go. A downgraded monoline would cause knock-on downgrades of the municipal bonds they wrap, causing banks to take these assets back onto their balance sheets.
The discrepancy between the two major monolines' Triple A rating and their respective CDS suggests the market has little trust in their top rating, illustrating just how tenuous their position is. "The probability of default implied from five year CDS is now in the 45% area for Ambac & MBIA’s operating companies’, said Hank Calenti, director of financial institutions research at RBC Europe.
But that prognosis was made in January 2008, when CDS on Ambac and MBIA was much tighter than it is today. Ambac Assurance CDS finished January around 450bp, compared to a high in mid-April of nearly 900bp – and 600bp at the time of going to press in early May. MBIA Insurance traded a little over 400bp at end of January before widening to 875bp by mid April and then contracting to 625bp in early May.
Warren Buffett has been one of the more forthright in telling shareholders that his competitors did not deserve a Triple A rating. They borrow at 14% and their stock has plummeted by 95%, he asserted in a statement in which he also announced that his Berkshire Hathaway BHAC insurance unit had taken as much as US$400m in premiums in the first quarter of this year.
Blame where blame is due
The two monoline majors, along with most of the rest of the businesses in this sector, clearly made monumental and catastrophic mistakes in underwriting ABS CDOs backed by US sub-prime.
They would perhaps argue that these mistakes were not entirely of their own making. After all there was no history of sub-prime lending in a US housing market that had predominantly only ever gone up. Looking through the rear-view mirror, the rating agencies models' had judged the credit enhancement for a given probability of default and loss-given-default justified Triple A marks. How wrong they all were.
The more unseemly origination practices that had been going on into the tail-end of 2005 and throughout 2006 – characterised by a prevalence of high loan-to-value and self-certified mortgage loans that were made to credit impaired borrowers – were overlooked. Until last year rising house prices had masked problems.
But as the tide turned it quickly became evident who the skinny-dippers were, and who had taken the trouble to cover-up. After all, not all players were caught out; both Financial Guarantee and the FSA are still standing proud.
What motivated some to stay away from a market which, according to senior players at other shops, seemed to provide "an acceptable risk adjusted return on capital," at the time?
"ABS CDOs capture a huge amount of embedded leverage which philosophically we didn't like," Michael Schozer, president of Assured Guaranty (AG) explained.
Underwriting ABS CDO business did not provide an acceptable payoff profile, Schozer added. "It's not a linear pay-off profile. That does not work for companies with our leverage." Structural volatility in other products such as knock-in options or inverse floaters presented similar challenges, Schozer said.
Because the embedded structural leverage within ABS CDO multiplies what is an already highly leveraged business, his company never even considered writing ABS CDO business, he said. "We never took one to the credit committee, these deals were never considered."
Schozer went on to note that "there is a limited scope of business that you can and can't write outside the framework governed by rating agencies and regulators". That may be so, but clearly it didn’t stop the majority of other players from stampeding into the ABS CDO sub-prime quagmire.
That is not to say AG has steered completely clear of the securitisation business. It is still active in consumer ABS, including credit cards and autos, as well as CLOs of leverage loans.
The stability of the business relies in part on getting the right balance of sub-sector exposure, Schozer said; typically that means an equal split between public finance, securitisation and infrastructure. Of this, more than half is related to global public finance – that being considered the least risky – leaving less than half to global structured finance – the riskier business.
Back in February the firm made headlines when restructuring firm WL Ross LLC invested US$1bn in a move which owner Wilbur Ross said was designed to "enhance their position for internal growth." In the wake of that investment the firm has been busy hiring staff to build out its European platform.
"We have hired new people to grow our UK and European infrastructure business, as the current environment has given us the opportunity to step into other people's shoes," Schozer said. Following S&P's April announcement that it had lowered recovery assumptions of ABS CDOs, there could be a few shoes to step into.
According to S&P, recovery on junior Triple A ABS CDO is now just 35%, while senior Triple As is a pitiful 60%. Bankers have warned that the monolines, who hold among the largest exposure to this debt, will be hit.
"Monoline insurers are the most obvious potential losers here," said Michael Cox, of RBS's European securitisation research team. Cox's negative view on the monolines is shared by Calenti, who believes another round of monoline fatigue is brewing.
"S&P and Moody’s both use a 19% loss assumption on 2006 vintage sub-prime RMBS as a benchmark in their analysis. This is based on the expectation that US housing prices will decline by 8% to 10% from peak to trough," he said.
But, according to Calenti many other analysts are using peak to trough assumptions of 15%. There is a strong probability that the distressed monolines will be calling on investors for more capital soon, he said, given how meagre their capital position was versus expected losses, even back in mid January. (See graph.)
Investors are, however, more likely to put their money to work in other areas of the market, such as performing leverage loans, performing ABS deals and even in the banks. These investments could well be viewed as offering a more attractive return compared to struggling monolines.
Moreover, the monolines’ fee earning capacity looks set to be significantly reduced, if US Congress and agency discussions on US Municipal agency's come to fruition.
"Just as some ABS CDOs were rated too highly, it seems Muni debt was never rated high enough. The states are not incentivised to allow issuers to default, so there is implicit state support," said Calenti.
If Muni debt is rated on the same scale as corporate debt – as the US Congress hopes – most would be worthy of a Triple A rating, he said. If that is the case, then "what is the incentive for a Muni issuer to get a monoline wrap?"
To make matter worse few – if any – players want to face the distressed monolines across any type of deal.
The potential absence of Muni and other structured finance business will mean the earning capacity of distressed players will be cut. It could therefore take a long time to recapitalise and claw themselves back to a stable outlook.
It is a tough prospect. "Risk appetite for monolines in the international markets is still constrained, but we are taking a long term view,” said Chris Weeks, managing director and head of international at MBIA. “Our key focus is to get the firm back to a stable ratings outlook."
This, he believes, is just a matter of time: "We realise it is difficult for investors to see where things are going in the midst of a period of extreme market stress. We aim to reinforce the strengths of our business model and are actively engaging with investors to make sure they know what we are doing."