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Commentary

The End Of The Road For Ambac and MBIA?

This is a non-India post. But it has some significance to the Indian markets. Ambac and MBIA are bond insurers in the US – called “monolines” (though they do work with multiple lines of business now).

These guys insure municipal bonds. That’s an organised crime by itself, something that unravelled after the S&L failures in the early 90s. The funda is: municipalities issue bonds to raise funds. School systems, road development authorities, states and city councils etc. Some of htem have “failed” earlier – i.e. they had to default on the bonds because they couldn’t collect taxes or had a tough situation.

The bonds therefore seem to have a “risk”, and monolines provide insurance on default (on both principal and interest).

But is it really risky? Of course not, a Moody’s study found only 41 defaults in 37 years. Not quite enough to be called “lots of risk”.

So why the insurance? This is the big insurance scam. The risk is defined by a rating – where AAA is practically no risk (don’t laugh), AA is little teeny weeny bit risk, and BBB- is junk. The three big rating agencies – who literally own the rating industry – are Moody’s, S&P and Fitch.

These guys (the rating agencies) get their biggest business from the monolines. If they rate the municipal bonds AAA, the bond issuers (the municipalities or school systems or whatever) will not buy bond insurance from the monolines. (Why buy insurance when there is no or low risk of default?). The monolines will then cut the rating agencies’ business as a revenge or as it’s known in business, quid pro quo.

So the rating agencies keep the municipal bond ratings low, so that the issuer of bonds will buy bond insurance and keep the system running. But that not only drives costs up, it also raises interest rates – a bond rated AA has to pay more than a bond rated AAA and so on.

But the underlying bonds are very safe in reality. Some of them get federal guarantees, some others are guaranteed via letters of credit from pension funds and state funds. That should give them a AAA rating, but the rating agencies don’t want to rock the boat.

So 15 states have revolted against the big rating and bond insurance game. They want their ratings to be top-notch and rated exactly like corporations are rated, which is likely to give most of the bonds a AAA rating, and therefore no insurance requirement. (Note that the muni rating process seems to be different from the way corporate bonds are rated, and even Moody’s has admitted that should they rate muni’s the same way corps are rated, most muni’s are likely to be AAA)

Giving muni bonds AAA ratings is a problem. So serious it will kill the bond insurers. Ambac and MBIA have had phenomenal losses in the subprime crisis, because they also insured subprime mortgages and CDOs. They still have a AAA rating from two of the three rating agencies even though they are far closer to insolvency than any of the municipal bond issuers! (Due to the you-scratch-my-back-i-scratch-yours between rating agencies and monolines)

If you take away their bond insurance income, (billions of dollars a year) the monolines would be insolvent very very soon.

The states can squeeze them now, because bonds and short term debt is being priced high, as if there was no insurance. (partly because no one believes Ambac and MBIA are solvent enough to pay on default) Some ports had to pay as much as 20% annualised, to roll over extremely short term debt. (Read this)

Apart from that, the subprime problem is huge. Read this presentation to see how horrible the situation is – there are a HUGE number of defaults waiting to happen in the next few months, and that alone may wipe out all the capital of MBIA and Ambac. Even after fresh capital raising efforts and all that.

What’s in it for us in India? Complex fundas but here goes: Ambac and MBIA are counterparties to hajaar MBS and CDOs held by hedge funds, pension funds and investment banks like Citibank, Goldman Sachs, Lehman Brothers etc. These entities have assumed that their CDO insurance would pay against default, but that is not going to happen if the monolines go bankrupt. Goldman actually recorded about $11 billion of profit last quarter, some of it on the mark-to-market price of the CDS they own. (The CDS may be priced high now, but is toilet paper if backed by a bankrupt company on the other side)

So if the monolines go under, a huge number of other entities will end up with massive losses. (They already have big losses, but they countered those with the profits made on this “insurance”) Many of these entities invest in India, directly or indirectly.

The Indian market will see massive cash-outs if this situation pans out. Hedge funds, investment banks and pensions are going to take out whatever little profit they have, to balance their other losses, and we will be in the next storm.

This situation is now looking increasingly likely within the next year. It will take the market deeply down, and at any sign of this happening, I would take all my long positions out. But watch first, it could take months before the first signs emerge.

  • Hari Swaminathan says:

    >Deepak – Detailed Prez, but note this Disclaimer by T2. “Note: Funds managed by T2 Partners LLC are short Ambac and MBIA stock and own an interest in credit-default swaps on MBIA.
    Sources: MBIA Prospectus, Form 424B5, filed 2/6/08 and Ambac Prospectus and 10-K, filed 3/5/08″.

    T2 partners are probably rubbing their hands in glee, wishing for this scenario to play out. Not that it won’t, but there’s an element of self-serving greed here.

    On a more philosophical level, this is emblematic of a principle America lives and dies by – They say that America is the best place for someone to get second chances. Very true – but the corollary is when someone is going down the first time, America also beats you down much harder..

    Hari

  • Deepak Shenoy says:

    >Hari: Not just are they short Ambac and MBIA, they are also short Moodys.

    I think that their being short makes sense in two ways.

    1) All this research is free for us to see, and that would not be the case if they weren’t cashing in some other way. This is a LOT of research, and it is the “fundamental” way to short a business – I think we need a lot more of this kind of work.

    2) If they did all this research and were NOT short, I would be very very apprehensive.

    There’s also an “open source model” of the business that shows how bad it is for Ambac and MBIA. Made and proliferated by another shorter.

    Enron was taken down by the shorts, who were the first to figure out Enron was nearly insolvent. They also made their research public and it took a few years for it all to unravel.

    I think we need to have such research in India. There are a lot of companies worth shorting all the way to their bankruptcy (no, ICICI is NOT one of them, they are only overpriced but a good business nevertheless). Maybe the new shorting rules applicable from April 21 2008 will help.