What Exactly is a Monoline Insurer?

[Bill M]

A new term I've only just started hearing about is Monoline Insurers, what are they? What do they do and why are they talking about them in the same line as Sub Prime? I have no idea? I've done a search but it doesn't clearly define it to me, thanks.

 

[dhukka]

A new term I've only just started hearing about is Monoline Insurers, what are they? What do they do and why are they talking about them in the same line as Sub Prime? I have no idea? I've done a search but it doesn't clearly define it to me, thanks.

Hi Bill,

I think John Maudlin in his weekly column had a good summary of what Monoline insurers are and the potential problems they face. The part in bold is a short summary of how they work but the most interesting part is how far up s**t creek they are without a paddle.

Credit Default Swaps: The Continuing Crisis

As noted above, I said three weeks ago that the big story for 2008 would be the counter-party risk for credit default swaps. That story is coming faster and larger than I thought. Bill Gross of Pimco suggests that the ultimate cost could be another $250 billion dollars on top of the $250-plus billion in subprime losses. That means we have only seen the tip of the iceberg in write-offs in the financial sector.

The real problem is the "monoline insurers" like ACA, Ambac, and MBIA. Here's a quick primer on how they work. Let's say you are a small municipality and want to borrow $10,000,000 for a bond offering to build a road or a water treatment plant. If you went to the market with your credit rating, it would be a low rating and the cost of the money would be high. But if you get one of the seven monoline insurers to guarantee your bond, then you get whatever their credit rating is. The fees for such insurance are lower than the savings you get on the bond, so everyone wins.

But over the years, most of the monocline insurers went from boring municipal bonds and jumped into the mortgage-backed security markets, selling credit default swaps that significantly juiced up their earnings. But it also added a lot of risk that they clearly, in hindsight, did not understand.ACA has already seen its rating go from A to CCC, which is basically junk.

This puts it out of business, as no one will pay to be rated as junk. ACA now has only $425 million in capital to cover the $69 billion in mortgage and corporate bonds they insure. Interestingly, they added $20 billion of that between April and September of last year. Talk about doubling down on a losing trade. Merrill wrote down almost $2 billion in bonds that were insured by ACA. They will not be alone.

Today, Fitch downgraded Ambac Financial Group two notches from AAA to AA. That doesn't seem like a lot, until you realize that 74% of their revenue comes from that AAA rating that covers $556 billion in municipal and structured finance debt. Fitch did so because Ambac decided not to do an equity offering for $1 billion to stem the bleeding. Six months ago Ambac was at $96 or thereabouts. Today it is as $6.20. Its market cap is only $629 million, so a $1 billion offering would dilute current shareholders by around 70%. Ouch. And you can bet any offering they do now will be on terms that shareholders will not like, most likely a convertible offering that dilutes current shareholders even more.

Oh, and that means that 137,990 municipalities that were insured by Ambac will see their credit ratings drop and their costs rise. Think their customers will hang around?

Moody's says it is going to review MBIA. MBIA, which is rated AAA, raised $1 billion last week from Warburg Pincus and did another offering for surplus notes for $1 billion at 14%. As Michael Lewitt noted, that means 14% is the new price for AAA bonds. Except that today it is 23%. If you bought that note, you are not looking good right now. They are trading at 70 cents on the dollar. Of course, that is better than Ambac's 30-year bonds, which are trading at 35 cents on the dollar.

When Warren Buffett bought Gen Re, the large re-insurer, five years ago, he presciently made the decision to reduce their exposure to credit default swaps. It took them four years to reduce the number of contracts from 23,218 to just 197 at the end of 2006.

"We lost over $400 million on contracts that were supposedly 'safe and properly priced' and we did it in a leisurely way in a benign market," says Mr. Buffett. "If we had to unwind it today in one month, who knows what would have happened?" (The Wall Street Journal)

If you are a bank or regulated entity, and you have mortgage-backed securities that have been written by a AAA monocline company, you can carry that debt on your books as AAA. But as the companies get downgraded, you have to write down the potential loss. Quoting from a recent note from Michael Lewitt: "MBIA's total exposure to bonds backed by mortgages and CDOs was disclosed to be $30.6 billion, including $8.14 billion of holdings of CDO-squareds (CDOs that own other CDOs, or mortgages piled on top of mortgages, or, to quote Jeff Goldblum's character in Jurassic Park again, 'a big pile of s&*^'). MBIA was being priced as a weak CCC-rated credit when it issued its bonds last week; it is now being priced for a bankruptcy. MBIA's stock, which traded just under $68 per share last October, dropped another $3.50 this morning to under $10.00 per share.

"The bond insurers' business model is irreparably broken. In HCM's view, it will be all but impossible for these companies to raise capital at economic levels for the foreseeable future and certainly in enough time to work out of their current difficulties. The performance of MBIA's 14 percent bond issue will prove to have been the death knell for this business. The market needs to come to the realization that the so-called insurance that these companies were offering is not going to be there if it is needed. The fact that these companies were rated AAA in the first place will remain one of the great puzzles of modern finance for years to come."

You can bet that the $8 billion in CDO-squareds is gone. It is a matter of time. MBIA's market cap is about $1 billion. Current shareholders will be lucky if they only get diluted 75%.

Watch Warren Buffett swoop in and take that boring old municipal bond insurance business. Watch a few large hedge funds buy the remains of the monoline carriers to get their staff and experience (especially the municipal sales teams), and launch new companies with pristine credit.

If you have Ambac or MBIA insurance, as a bank you have not yet written down any debt they insured. They are still rated AAA. But that re-rating is coming. And what about the monster CDS business in the hedge fund world? Who wins and loses? There will be huge winners, and there will be total wipe-outs. There are going to be more losses in the biggest banks, and even bigger investments by Sovereign Wealth Funds. Count on it. This is a story we will return to time and time again.

 

[Bill M]

Thanks for that dhukka. From what I understand from that article it seems these monoline insurers guarantee several high risk organisations but if these organisations collaped or stopped paying their mortgages/loans all at once the the monoline insurers will not be able to bail them out. They simple don't have enough reserves for the guarantees they provided. Mind you this will only happen if too many default, which these days seems a possibility.

 

[dhukka]

As you rightly point out Bill, they don't have enough capital, but a lack of defaults will not stop them from losing their AAA credit ratings (without which they are effectively out of business). Thus they desperately need more capital as they keep taking writedowns on the CDO junk they insured.

The ratings agencies have been propping these guys up for too long. Since when does a AAA rated company like MBIA have to raise capital at a cost of 14%? These companies should be slashed to junk. They had a sweet low risk business and made some really stupid business decisions ala Bear Stearns, Countrywide and are now paying the penalty.