The Financial Guarantors are receiving a lot of attention these days, and for good reason. I want to offer a few observations to give my own take on the problem:
1) With structured finance, the initial choice is “Do we ask a financial guarantor to bring the credit up to AAA, or do we do it through a senior-subordinate structure?” A senior-subordinate structure has classes of lenders with differing rights to payment. The AAA, or, senior lenders only take losses after the subordinate lenders (who are receiving higher yields) have lost all of their money. In the present environment, S&P and Moody’s have been downgrading subordinates, and even some senior bonds in senior-sub structures.
This should lead to downgrades of MBIA and Ambac, eventually. The rating agencies can’t keep downgrading bonds that are similar to those guaranteed by MBIA and Ambac, without downgrading them as well. Remember, MBIA and Ambac were late to the party; their bonds are disproportionately weak because later lending standards were weaker.
2) The main difficulty with a bailout of the guarantors is that most interested parties have different interests. That said, the beauty of a bailout is that the guarantor can sit back and pay timely principal and interest, while waiting for better times to come.
3) Did the rating agencies force the guarantors into the CDO business? I’ve heard rumors to this effect, but it would be pretty easy to prove or disprove. Look at when MBIA and Ambac entered the business, and look at the commentary from the rating agencies around it; if they are trumpeting diversification, then it is likely that they pitched it to the guarantors. If not, then the guarantors did it on their own.
4) Even in a bailout of financial guarantors, current shareholders may find themselves diluted beyond measure. Given current political pressures, those risks are elevated; remember that management teams want to keep their jobs, and that regulators have some say in that.
5) As I noted today at RealMoney:
|Considering the “Margin of Safety”|
|2/5/2008 11:07 AM EST|
Tim, I like your stuff, since I am a value investor. Be careful with XL Capital. The challenge is estimating what sort of guarantees they face from Security Capital Assurance. When I looked at them last, the potential payments could be huge — potentially larger than XL’s net worth, but hey, that’s the financial guarantee business. I looked at XL during my last portfolio reshaping — Finish Line also, and could not get past the potential risks. I had easier plays to go for, with less uncertainty, if also lower upside. I don’t try to hit home runs, so it makes it easier for me to not buy the stocks that are optically stupid cheap, but might have balance sheet issues. Cheap means that a company will have the capability to carry their positions through a downturn; it’s part of the “margin of safety” that we require.
Anyway, keep it up, and let’s see if we can’t make some money on our value investing.
Please note that due to factors including low market capitalization and/or insufficient public float, we consider Security Capital Assurance and Finish Line to be small-cap stocks. You should be aware that such stocks are subject to more risk than stocks of larger companies, including greater volatility, lower liquidity and less publicly available information, and that postings such as this one can have an effect on their stock prices.
XL was downgraded recently as a result of those guarantees. I would be cautious here.
Summary: there is still downside risk here. Avoid the financial guarantors, and economic areas affected by the overleveraging of our credit markets. Stick with companies that have strong balance sheets.