Toomre Capital Markets LLC

Real-Time Capital Markets -- Analytics, Visualization, Event Processing, and Intelligence

Incestuous Mix: Structured Credit, Financial Guarantors and Rating Agencies

The Stamford, Connecticut chapter of the Professional Risk Managers' International Association ("PRMIA") held a very informative meeting on Wednesday, November 7th 2007 entitled "The Emperors' New Clothes?: After the Credit Crunch, What's the Future of Structured Credit, Financial Guarantors and Rating Agencies". Toomre Capital Markets LLC ("TCM") thought this was one of the most informative industry events yet and strongly recommends that the reader pay close attention to the incestuous circle of structured credit, financial guarantors and rating agencies. The speakers were:

Some readers no doubt will recognize James Chanos and his fund Kynikos Associates as one of the most prominent short-seller hedge funds. Bill Ackman and his hedge fund Pershing Square Capital are primarily focused on the long side, but does have substantial short interest in the financial institution, rating agency and financial guarantor sectors. Bill is perhaps most well known for his excellent (and very negative) research report on MBIA from several years ago. The FORTUNE magazine article from May 16, 2005 entitled The Mystery of The $890 Billion Insurer has more information.

During the trading hours of November 7th, equities in the financial sector were under considerable pressure. This pressure is primarily tied to the great uncertainty about just what are Collateralized Debt Obligations worth, where the resulting large losses are buried and what are the secondary repercussions of the sub-prime meltdown, such as SIVs, option ARMs, and commercial mortgage credit-worthiness. After the close, American International Group ("AIG") reported 3rd quarter results that fell short of expectations primarily due to their losses from the mortgage markets. Then, Morgan Stanley ("MS") pre-announced that it be taking a $3.7 billion in losses in its proprietary trading businesses tied to principal investments in CDOs and other sub-prime mortgage-backed securities. (This amount may change over the balance of November until the end of Morgan Stanley's year end.)

Against this backdrop, James Chanos and William Ackman suggested that the markets are still in the early innings of this mortgage credit crunch process. Whereas some analysts have been suggesting as many as 1.5 to 2.0 million families may lose their residencies due to foreclosure in this mortgage credit cycle, their collective view is that the base level of foreclosures will be much worse, perhaps approaching 3.5 million or even 4.0 million incidents. They suggested that the collective market does not yet appreciate that things could get that bad nor have financial professionals begun to fully appreciate some of the national political repercussions of so many people losing their homes.

Through a few slides and much anecdotal comments, these gentlemen demonstrated how dramatically the composition of the financial guarantors' balance sheets have changed during the past two decades. Whereas more than 95% of their businesses were devoted solely enhancing municipal debt issues in the early 1990s, today more than 50% of the incremental financial guarantee business has been in the area of structured credit and structured finance transactions. As a result, for instance, today the MBIA book of insured business is composed of municipalities, structured credit and corporate/future flow on something close to a 50/35/15 percentage.

Their next point was that the rating agencies are the effective regulators for all of the mono-line financial insurers. Supposedly, each and every transaction that might be financially insured is reviewed beforehand by the rating agencies. Further, the rating agencies regularly (as frequently as weekly) review the risk composition of each financial guarantor. As a result, the rating agencies assign AAA/Aaa ratings to the bond insurers despite the fact that the generic financial guarantor has a leverage factor of more than 100:1 (amount of financial guarantees relative to equity). Their point was that the rating agencies have in essence blessed the credit worthiness of the financial guarantors even though the composition of the business has changed.

Their final point related to the current valuation of CDOs and other sub-prime securities. As market participants well know, both Merrill Lynch and Citigroup have lost their CEOs as a result of amazing losses tied to holdings in CDOs. The regulatory filings filed in both cases give some information both about the composition of the CDO portfolios and how those portfolios were marked to result in such extreme losses. The AAA or super senior portions of the portfolios were marked down from close to par to approximately 80% on the dollar in both cases. The financial guarantors have many of these same assets or risk exposures, yet their recent financial results did not reflect any losses nearly as steep.

Tying the whole circle together, they asked the question: How can these structured credit asset losses lead to sharp and immediate ratings reductions at Merrill Lynch and Citigroup for risk management concerns whereas nothing has happened with the bond insurers? For instance, what is different between what Merrill Lynch holds and what MBIA owns? Are comparable CDOs really worth below 80% at one place and in the very high 90%'s at another?

The clincher is that IF, and let TCM repeat IF, the financial guarantor CDO and sub-prime exposures were marked to market, much, if not all, of the equity in the financial guaranty insurance holding companies apparently would be wiped out. The question then is how can these institutions remain rated AAA if effectively there is no equity to pay claims?

The recent sharp losses in the equity value of Ambac, MBIA and other financial guarantors suggests that the market is beginning to figure out that the AAA promise may not be worth much, especially when the AAA gate keepers (rating agencies) have some self-interest "judgment" problems. As an institutional investor with billions of dollars under management, do you really want to "trust" what the rating agencies state the credit worthiness of complexity is, especially after those same gate keepers have just downgraded securities from AAA to BB in one fell swoop?

As stated at the start of this post, Toomre Capital Markets LLC thought this was a very informative and quite frankly very thought provoking event. Have the financial market professionals really begun to understand just what might happen when the SIVs need to dump assets, the financial guarantors are finally downgraded from AAA, the municipal bond markets are in chaos and the rating agencies have absolutely no more credibility?

TCM is not suggesting that this scenario will happen. However, the probability of such an event is no longer remote. TCM is even beginning to think this scenario might be becoming probable. Readers comments and thoughts are welcome.