Here’s another recent post from RealMoney:
  |
|
David Merkel |
| Contemplating Life Without the Guarantors | ||
| 11/1/2007 1:30 PM EDT |
Hopefully this post marks a turning point for the Mortgage Insurers and the Financial Guarantee Insurers, but when I see Ambac trading within spitting distance of 50% of book, I cringe. I’ve never been a bull on these companies, but I had heard the bear case for so long that my opinion had become, “If it hasn’t happened already, why should it happen now?” Too many lost too much waiting for the event to come, and now, perhaps it has come. But, what are all of the fallout effects if we have a failure of a mortgage insurer? Fannie, Freddie, and a number of mortgage REITs would find their credit exposure to be considerably higher. The Feds would likely stand behind the agencies, because Fannie and Freddie aren’t that highly capitalized either. That said, I would be uncomfortable owning Fannie or Freddie here; just because the government might stand behind senior obligations doesn’t mean they would take care of the common and preferred stockholders, or even the subordinated debt.
Fortunately, the mortgage insurers don’t reinsure each other; there won’t be a cascade from one failure, though the same common factor, falling housing prices will affect all of them.
Other affected parties will include the homebuilders and the mortgage lenders, because buyers without significant down payments will be shut out of the market. Piggyback loans aren’t totally dead, but pricing and higher underwriting standards restrict availability. Third-order effects move onto suppliers, investment banks and the rating agencies. More on them in a moment… this will have to be a two-parter, if not three.
Position: none
And since then, the mortgage insurers have fallen a bit further.? On to part two, the financial guarantors:
Unfortunately, the financial guarantors have had a tendency to reinsure each other.? MBIA reinsures Ambac, and vice-versa. ? RAM Holdings reinsures all of them.? The guarantors provide a type of “branding” to obscure borrowers in the bond market.? Rather than put forth a costly effort to be known, it is cheaper to get the bonds wrapped by a well-known guarantor; not only does it increase perceived creditworthiness, it increases liquidity, because portfolio managers can skip a step in thinking.
Now, in simpler times, when munis were all that they insured, the risk profiles were low for the guarantors, because munis rarely defaulted, particularly those with economic necessity behind them.? In an era where they insure the AAA portions of CDOs and other asset-backed securities, the risk is higher.
Now, guarantors only have to pay principal and interest on a timely basis.? Mark to market losses don’t affect them, they can just pay along with cash flow.? The only trouble comes if they get downgraded, and new deals become more scarce.? Remember CAPMAC?? MBIA bought them out when their AAA rating was under threat.? Who will step up to buy MBIA or Ambac?? (Mr. Buffett! Here’s your chance to be a modern J. P. Morgan.? Buy out the guarantors! — Never mind, he’s much smarter than that.)
Well, at present the rating agencies are re-thinking the ratings of the guarantors.? This isn’t easy for them, because they make so much money off of the guarantors, and without the AAA, business suffers.? If the guarantors get downgraded, so do the business prospects of the ratings agencies (Moody’s and S&P).
Away from that, municipalities would suffer from lesser ability to issue debt inexpensively.? Also, stable value funds are big AAA paper buyers.? They would suffer from any guarantor getting downgraded, and particularly if Fannie or Freddie were under threat as well.?? All in all, this is not a fun time for AAA bond investors.? A lot of uncertainties are surfacing in areas that were previously regarded as safe.? (I haven’t even touched AAA RMBS whole loans…)
This is a time of significant uncertainty for areas that were previously regarded as certain.? Keep your eyes open, and evaluate guaranteed investments both ways.? I.e., ABC corp guaranteed by GUAR corp, or GUAR debt secured by an interest in ABC corp. This is a situation where simplicity is rewarded.
I’ve drawn different conclusions about the bond insurers in general, RAMR and ABK in particular. My points of difference are summarized below.
1) “Are the bond insurers in deep trouble?” – the pattern of current insider buying across the industry suggests to me that insiders – the people who understand the business best – don’t think so. If they were worried about their careers, they wouldn’t be sinking extra capital into the stocks.
2) “Are they going to lose their ratings?” – if subprime default rates for 2004-2007 hit some astronomical figure like 30% or so within the next year or two, then this is definitely possible. But so much of the financial sector and the stock market as a whole would be in deep doodoo if that level of deterioration happened, so the risk/reward ratio for these stocks – which are off 70% at the same time current business conditions in terms of rates and market demand is very strong – is more attractive than most of the market. Also, the evidence of capital risk is from the ABX market pricing, not the operational results of these insurers (which is what the rating agencies consider for capitalization). Operationally, they have all increased their capital cushions over recent quarters. Supposedly Marty Whitman has a newish position in RDN, which strikes me as much more risky than ABK, which in turn is more risky than RAMR.
3) “If these companies lost their rating would this sort of business end?” – Doubtful. It would be an opportunity for new players with excess capital to enter a profitable line of work. They probably would think hard about buying the “brand names” and their work force to get started, but even if they didn’t, someone would pick up the slack.
4) “Would municipalities be hurt?” – Because of point 3), I think others would step in for new issues. But if the existing guarantors went out of business, there would be chaos in the municipal bond market and holders world be hurt, and perhaps reluctant to step up for new issues for some time.
5) “Do reinsurance patterns pose an extra risk?” – Speaking specifically of RAMR, my understanding is that they write yearly contracts stating the type and volume of business they are willing to take on, and then during the year they get “filled” with that type of business, where the fills are a small fraction (less than 10%) of some business from the primary of the agreed upon type. To the extent that the primaries made bad deals of that type, it would hurt RAMR, and if the primaries went out of business they would have to look for new customers or change their business model. But if other deals, or portfolio weightings of the primaries caused them to suffer losses, or doesn’t literally imply that RAMR does in the role of reinsurer. In fact, only about 5% of RAMR’s portfolio is in the U.S. residential area, and the sub-prime part is a small fraction of that. Also – from their conference call – their HELOC exposure is better quality than what the listing on their website made it out to be (it is BBB up through AAA and somewhat seasoned). SCA sounded very bullish as well on their recent conference call, but the composition of their portfolio is definitely more aggressive.
Josh, I am on the fence on this one. The valuations are cheap, and I know that the guarantors can pay over time. My problem is not knowing that total amount of decay from structured finance. I would expect that many guarantors will get capital infusions to keep their ratings, or merely to survive. If any significant loss of capacity occurs, new guarantors will be capitalized, and the game will begin again.
I respect Marty Whitman and Al Zucaro, though. I might take a position in one of them — maybe RAMR, because their book is so diversified.
That was a very timely followup, because Fitch apparently pulled the plug on SCA yesterday. I don’t know what they will do, but I suspect that equity investors there would be best served by not defending their rating and going into runoff mode.