This week on our way to Financial Armageddon it was the turn of the monoline insurers to face the scythe. For over two months AMBAC Financial and MBIA, the two biggest insurers of municipal and structured debt, have been peering into the grave, pretending that they could revive themselves with just a little more capital and a little more time. The ratings agencies ”“ Moody’s and S&P and Fitch ”“ danced along with them in this delusion, delaying any downgrade of the insurers from their current Aaa status, waiting to see if help would arrive. It never did.
The final blow occurred this week in the stock market, when the share prices of the monoline insurers collapsed, making it impossible for them to raise capital publicly. Since no private investors have stepped up yet, Fitch took the inevitable step and downgraded AMBAC. It is only a matter of time before the other ratings agencies follow, and then comes bankruptcy and some sort of restructuring for these insurers.
Municipal bond insurance had always been a sleepy business, as AMBAC, MBIA and a few smaller insurers lent their Aaa ratings to state, county, city and related local government entities that on their own could not achieve the highest rating for their bonds. The insurers got a fee for their service, and the municipal borrowers got the lowest coupon rate possible for their bonds.
But this business wasn’t enough for the insurers. They branched out into providing Aaa guarantees for so-called structured investments, like Collateralized Debt Obligations and related mortgage-backed derivatives. And why not, they reasoned? The ratings agencies placed Aaa ratings on all this paper, just like they thought the monoline insurers were Aaa risk too. The ratings agencies have since confessed that their models for analyzing potential downside risks for these investments/bonds assumed that real estate prices would always go up at a steady pace, just like they had for nearly 70 years.
In fact, everybody with money to lend or a need to borrow made the same assumption, partly because the real estate industry kept repeating this mantra: real estate prices never go down. Nobody seemed to notice that this argument was true to a point; in local circumstances real estate values have declined, and in the best of times the rate of increase only matched the rate of inflation. Until around 1996, when this link decoupled and real estate prices nationally began soaring well beyond the rate of inflation. But even when it was obvious that real estate prices were two or three standard deviations above their historical norm ”“ in other words, they were in bubble territory ”“ industry experts began extrapolating these gains into their future expectations for housing values.
The financial industry did their part in helping the bubble to inflate, by inventing all sorts of ways to securitize, package and resell real estate loans to investors, and the industry was happy to pay AMBAC, MBIA and their like a fee to obtain back-up insurance on these deals. Depending on how the insurance was structured, if something went wrong with all or a part of the bond, the guaranty provided by the monoline insurers could be activated and make investors whole again.
Unfortunately, real estate prices nationally have gone down. Defaults on mortgages in the U.S. are rising and in some sectors of the market are at record levels. No end is in sight. The monoline insurers are being called on to honor their guarantees, and they simply do not have the capital to do so for the amounts involved.
All told, the insurers have $2.4 trillion in guarantees outstanding for municipal bonds and mortgage-related structured investments. It seems inevitable now that the ratings on all this paper will deflate. If Moody’s decides that AMBAC deserves a non-investment grade rating rather than a Aaa rating, then much of the paper insured by AMBAC becomes junk debt. And junk bond debt is really what we are talking about here. While the ratings agencies might toy around with a progressive series of downgrades, the stock market has already decimated the shares of the monoline insurers, declaring them virtually bankrupt.
It is true that someone like Warren Buffett could come along and buy one of these insurers, but he has already had a bad experience with derivatives and will certainly have nothing to do with the structured investment guarantees. Don’t count on a savior to ride to the rescue of this part of the market.
If you own a bond issued by your local water reclamation project and guaranteed by one of these insurers, are you going to lose money? Not necessarily. As long as the municipality can continue to pay principal and interest on the bond, and as long as you want to hold the bond to maturity, you should be okay. But in the secondary market, once the rating is trashed, the price will sink, and if you want to sell the paper before it matures you will lose money. Tens of thousands of bond issues across the country will be affected.
Don’t forget that state and local governments are already in financial distress. Tax receipts from income and real estate taxes are drying up, while costs are increasing. Many states are operating with huge deficits. Something will have to give, and in some cases there will be defaults on municipal bonds. Because the insurance behind these bonds is practically worthless, investors will lose money. You will want to look very carefully at the financial health of the municipal issuer now that the back-up insurance is no longer there to help.
Chances are you do not own some of the complex structured investments that were also given a guarantee by the monoline insurers. But chances are the biggest banks in the country own this paper, or sold it with the insurer’s guaranty backing it up. Difficult legal questions will now arise as to whether the banks will have to step up and replace the guaranty provided by the insurers. This means, effectively, that the banks will have to guarantee the bonds themselves, since no one is around anymore to do this.
The banks simply do not have enough capital to provide such guarantees, so the legal battles will be fierce and protracted. On top of this, the banks own paper that they thought was backed by a Aaa guaranty but no longer will be. This means that the bank’s credit portfolio is no longer of the quality they assumed. The loans and other investments that a large bank tends to keep on their balance sheet average out to about a Baa rating ”“ by no means Aaa, but still investment grade and not considered junk debt. If the banks have to reclassify a huge amount of their investments as junk debt, this could well tilt the entire credit portfolio of the industry into junk debt status. Banks will no longer be able to lend as freely as they have been in the past ten to twenty years if they themselves are poor investment quality.
This doesn’t even count the actual financial losses caused by these downgrades, which are already beginning to occur. Merrill Lynch announced this week a multi-billion dollar write down of its investment portfolio in structured bonds because the paper has been significantly downgraded in the secondary market with the loss of the Aaa rating. The U.S. financial industry is already scrambling about the globe trying to replace the capital lost through previous write downs. At some point the industry will run out of rescuers just like the monoline insurers did.
Who’s next in this ongoing financial trauma? Clearly more pain is in store for Wall Street and commercial banks, but we haven’t yet come to the realization that some of these financial institutions will not survive. This will happen, and you will definitely know when that day arrives because it will be the cause of serious damage to the stock market.
But the biggest victims to come are the other mortgage insurers ”“ Fannie Mae and Freddie Mac. Like the monoline insurers, they have guaranteed trillions of dollars of mortgages. Like them, they have only a tiny sliver of capital behind their guarantees. One reason they have escaped notice so far is that these companies did not guarantee the risky structured investments that destroyed the monoline insurers. Unfortunately, the financial default risk in the U.S. economy is ratcheting up daily. American Express alerted the market this week to a surprising increase in late payments and defaults on credit cards. Sears and other card issuers are seeing the same thing. Auto loan payments are also falling behind. The U.S. consumer is tapped out of tricks to keep their spending and lifestyle at existing levels. Millions of consumers considered now to be prime quality credit risks are going to default on their mortgages, and drag Fannie Mae and Freddie Mac down with them.
This is when we will see just how valuable the U.S. government support is to these two companies. They have acted for years as if they have a guaranty from the federal government backing up everything they do, even though Congress has insisted otherwise. A lot will depend on whether the U.S. government can still issue debt without any consequences whatever. Over half of all new federal debt in recent years has been bought by foreign investors, principally the governments of Japan and China. This has kept rates low for the government, and removed any sense of discipline over the federal budget. As long as these rich uncles are willing to take on such gargantuan risks with their own foreign reserves, the U.S. may be able to bail out Fannie Mae and Freddie Mac. But we are talking of a bailout in the trillions of dollars under worst case circumstances, and worst case circumstances have become the norm in this market.
Nor is time on the side of the U.S. government. The ratings agencies are already hinting that down the road, if nothing is done about social security and other growing federal entitlements, the U.S. will lose its Aaa rating. This may happen earlier than many suspect.
Somewhere in all this mess the U.S. stock market will collapse. At the moment the stock market is already in a correction, worrying about an economic recession. What it really should be worrying about is something much worse ”“ a complete collapse of the credit markets globally, leading to a depression that will last 3 ”“ 5 years. Once that is understood, the Dow will be trading well below 8,000.
So hold on to your job, whatever that may be. Pay down your debt and watch your expenses. Monitor the credit and market risks in your investment portfolio, and if you have any real concerns, U.S. Treasuries earning 2% will be a lot better than stocks or bonds that might collapse in value. As of now, the four horsemen of the apocalypse are mowing down the big players, but the little guy will be in their sights eventually.
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