We’re not quite to the endgame yet, but the jig is up for MBIA and Ambac, after the downgrades from Moody’s at the holding companies to Baa2 and A3 respectively.? Wait, why I am I mentioning the holding companies?? Isn’t it the operating subsidiaries that matter?

Well, yes, for sales and regulatory purposes, but the ratings at the holding companies matter for a different reason — notching.? But let me tell a story first.

Failure improves markets by introducing risk-based pricing.? In the late 80s and very early 90s, virtually all of the life insurance industry was rated AAA/Aaa, or A+ from A.M. Best.? Taking advantage of the good opinion that the raters had of the industry, many life insurance companies issued Guaranteed Investment Contracts [GICs] to institutions for their Defined Benefit and Defined Contribution pension plans.? The insurance companies levered up issued AAA liabilities, and invested the proceeds in lower rated bonds, commercial mortgages, limited partnerships, and other things yet more risky.? (These were the days prior to risk-based capital.)

After a few failures hit — Pacific Standard (who?), Executive Life, Mutual Benefit, Fidelity Mutual, Confederation, and the near miss on the Equitable (what a story — I was on AIG’s failed takeover attempt team), the rating agencies went into full scale defense mode, downgrading every company in sight.? It was everything a company could do to retain its ratings — and there were almost no ratings upgrades until 1996 or so.

The rating agencies are ratchets. (or, do I mean rackets? 😉 )? Downgrades come easily, upgrades come hard, and almost no corporate credit ever gets upgraded to AAA.? But, in this case, the downgrades have come for this industry in the way that I predicted earlier this year:

		David Merkel
		Moody’s Downgrades XL Capital Assurance
		2/7/2008 3:34 PM EST

When the main rating agencies begin downgrading the lesser guarantors, the big guarantors are likely not far behind. Moody’s just downgraded XL Capital Assurance from Aaa to A3, and Security Capital Assurance From Aa3 to Baa3 (barely investment grade).

Psychologically, the major rating agencies, Moody’s and S&P, have been taking baby steps toward downgrading Ambac, MBIA and FGIC. But first they have to do the lesser guarantors that are in trouble. As I have pointed out before, the major rating agencies are co-dependent with the major guarantors, and that will only throw the guarantors over the edge if hurts them more to leave the guarantors at AAA. That will cost them future revenues to cut the ratings of the major guarantors, but it might save their larger franchises. (Fitch, on the other hand, has less to lose and can downgrade with impunity.)

Now, the effects on the broader insured bond market are probably overestimated. There will be new entrants to take the place of the legacy companies that may have to go into runoff. The holding companies for the major guarantors could die, but a rescue of the operating insurance companies in runoff mode is more likely. Those who own equity in the holding companies or debt claims to the holding companies will not be happy with the results, though.

Watch for downgrades of the major guarantors. Unless a lot of new capital gets pumped into their operating insurance companies, the downgrades are coming, maybe within a month.

Please note that due to factors including low market capitalization and/or insufficient public float, we consider Security Capital Assurance to be a small-cap stock. 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.

Position: none

Once your insurance operating subsidiary is downgraded below AAA/Aaa, there are many classes of business that cannot be written anymore.? Revenue dries up.? What’s worse, is that the rating agencies no longer have any practical reason to not downgrade further; the revenue model is broken for the rating agencies, and if there are highly rated new entrants, there is no reason to care about the company; the industry will survive, and the rating agencies will get fees.

Now, supposedly, New York doesn’t want to take the operating subsidiaries into conservation because it would trigger acceleration clauses in the CDS.? If those contracts were written at the operating companies, the insurance commissioner has the power to nullify any seniority those contracts possess — you can’t favor one insurance claimant over another.

But Dinallo wants to favor municipal claimants, which is probably illegal.? They could force the capital into the operating company, but they would rather see the municipal business reinsured.

Oh, notching — once a holding company is rated lower than Aa3/AA-, there is no way to get a subsidiary to have a Aaa/AAA rating.? The rating agencies will not allow it to happen.

So, I don’t see good things ahead for the guarantors.? Two final notes: Ambac tells Fitch to take a hike.? Fitch won’t do it.? Expect a downgrade soon.? Triad goes into runoff; my old colleague John must be smiling… he always thought they wrote the worst business.