Standard & Poor’s is considering whether Assured Guaranty’s credit is really 'AA-plus'. The credit-default swap market made that decision a while ago and its verdict is no.
The agency issued a 39-page report Monday seeking comments on proposed new criteria for rating bond insurers. The new method could result in downgrading investment-grade insurers “by one or more rating categories … unless those insurers raise additional capital or reduce risk.”
The insurer on Tuesday said it was “astonished” by the proposed new criteria. Assured “has consistently reported positive operating earnings throughout the financial crisis and has achieved record operating earnings through the first nine months of 2010,” the company said in an e-mailed statement.
Assured, the only company still actively writing policies to wrap municipal bonds, lost its sole triple-A rating in October when S&P downgraded it to 'AA-plus'.
The proposed methodology looks at financial and business risk profiles as determined by evaluating nine categories of criteria, including industry risk, competitive position, financial flexibility, and management strategy. S&P is seeking commentary on the proposal until March 25, and will hold a conference call Feb. 2.
Assured called the proposal an example of why federal regulation is needed to assure consistent credit rating principles and processes are applied transparently.
By some measures, however, S&P is behind the curve.
Moody’s Investors Service stripped Assured Guaranty Municipal Corp., formerly Financial Security Assurance, of its 'Aaa' in May 2009. It took away Assured Guaranty Corp.’s 'Aaa' rating in November 2008. Both insurer platforms were last rated Aa3 — two notches lower than S&P’s current rating.
Spreads for credit-default swaps seem to be suggesting that the ratings remain too high.
The CDS market — where investors trade a type of protection that offers insurance against default — demands a much higher premium for insurance on Assured Guaranty versus similarly rated companies.
Among five-year CDS contracts, for instance, a buyer must pay $753 per year to protect $10,000 of Assured debt against default. A comparable contract for triple-A rated Microsoft demands just $24, according to Bloomberg.
A five-year contract on Berkshire Hathaway, which carries the same rating as Assured, costs less than $101 per year.
In fact, five-year protection on Assured costs more than any of the 125 companies within the Markit CDX North American Investment Grade Index, where the average price on five-year CDS is $81.80 per year.
“Clearly, in Assured’s case, the business model is in question,” said Mike Pietronico, chief executive at New York-based Miller Tabak Asset Management. “There are people making bets that perhaps the business model is going away.”
Assured has struggled to expand its public finance operations in recent years. Perception in the muni market turned negative when its competitors were left in shambles due to heavy exposure in the mortgage-backed market. In 2010, Assured’s two platforms wrapped $26.8 billion of munis — 24% less than in the prior year. That amounted to a fraction of the overall insured penetration rate before the 2008 crisis, according to Thomson Reuters.
Pietronico said trading of CDS can be thin, so it’s possible the wide spreads reflect an exaggerated bet by a hedge fund or some other sophisticated players.
"You have to keep in perspective the size of the CDS market,” he said. “There could be some outsize-looking bets. In reality, the volume behind them may not be nearly as onerous.”
Assured said in an emailed statement that “movements in CDS levels for AGM and AGC continue to be significantly affected by technical factors, such as supply/demand imbalance and light trading volume.”
Oddly enough, the higher spreads actually help Assured’s quarterly statements because they allow the insurer to record gains on the derivatives that it is counterparty on. Thanks to this accounting quirk, a higher CDS spread implies Assured could default on a given derivative. Therefore, the derivative is less valuable, giving Assured a lower liability.
For instance, Assured’s CDS contracts have a fair value of negative $5.43 billion, based on their exposure. Giving weight to the fact that Assured is itself a default risk, the value drops to $1.71 billion. If CDS against Assured were to become risk-free overnight, its liabilities would jump $3.7 billion.
S&P’s new criteria would be another hurdle for the industry’s recovery as the proposal clearly requires bond insurers to put up more capital.
“The amount of capital needed to achieve high investment-grade ratings will increase significantly under the proposed criteria,” the agency said.
The rating agency attributes the increase to the higher capital charges used in scoring capital adequacy, as well as a new leverage test which will serve “as an independent constraint on the amount of exposure a bond insurer can have relative to its capital.”
Kevin Brown, a spokesman for MBIA, which hopes to one day write public finance policies again, pending legal setbacks, said he was encouraged by S&P’s efforts to provide greater transparency.
“However, certain aspects of the proposed criteria appear unduly punitive even in the context of industry losses over the past few years,” he said. “While reconsideration of the capital required to support the insurance of structured products is entirely appropriate, we can see no justification for what appears to be a substantial increase in capital requirements for a public finance portfolio.”
For start-up insurers, the new criteria could be a boon, according to John Pizzarelli, former head of global public finance at bond insurers MBIA Insurance Corp. and CIFG.
“If you have a clean slate, you can control the leverage,” he said. “Legacy companies which already have exposure in their portfolios will have to meet the new criteria, versus another company that can manage the criteria from out of the box.”
Shares of both Assured and MBIA were weaker yesterday after reports about Standard & Poor’s proposed new criteria.
Ironically, the detailed methodology may in fact be a direct response to Assured’s repeated requests for increased clarity from the rating agencies.
In Assured’s most recent conference call for the third-quarter, chief executive Dominic Frederico blamed rating agencies for a lack of transparency in rating bond insurers.
“There are no controls,” he said. “There are no checks and balances — there are no clear regulations so that you would know the rules by which you’d have to play by.”